The Subtleties of Effective Demand

(Continuation of   Lectures on Advanced Macroeconomics  )

As I read more and more about effective demand, I got more and more confused — how can I explain this concept to my poor students, if I don’t understand it myself? There are a huge number of articles with different and conflicting views and interpretations of this concept, which Keynes describes as being central to his theory. Let me proceed to clarify the insights that have resulted from struggling with this material, and going through many iterations of revisions in terms of how to make sense of this theory.

Keynes and followers — both the Hicks-Hansen-Samuelson variety, as well as true blue post Keynesians — argue that it is deficiencies in the Aggregate Demand which lead to the unemployment equilibrium which is central to Keynesian economics. Stated in very simple terms, the argument can be phrased like this. The process of production generates factor incomes. These incomes are exactly the source of the demand for the product. If all the income generated is always spent on purchase of products, then the aggregate demand will exactly equal the aggregate supply — this is Say’s Law. In this case, there is no concept of shortfall in aggregate demand which could lead to unemployment.

However, Keynes and his followers deny the equality. They argue that some portion of the factor income could go into savings, thereby lowering the aggregate demand. Now the aggregate demand could be greater or lesser than the aggregate supply. An equilibrium would occur when the two are the same, but there is no guarantee that this equilibrium would occur at full employment. The standard diagram used to illustrate this idea is given below:


For our purposes, we can assume a direct proportionality between N, the amount of labor employed, and Y, the value of the output produced. Furthermore, it makes no difference for our argument whether prices are fixed or flexible, so let us assume them to be fixed for simplicity. The X-axis just measures the value of total output Y (equivalent to N, rescaled, since the two are directly proportional).  The 45 degree line just measures the total factor income generated by the production of output worth Y — by definition. The consumption function is C=a+bY, where a>0 and b<1 is the marginal propensity to consume. When Y is low, the laborers/consumers demand is greater than the total product. However, since the slope b is less than 1, this consumption demand must intersect the 45 degree line. At points beyond the intersection, we have deficient demand. Both deficient and excess demand would set in motion processes to eliminate the disequilibrium so that equilibrium would occur at the point at which the demand for consumption generated by factor incomes is exactly equal to the value of the total output. This intersection can occur at a point at which full employment does not occur, demonstrating the existence of an unemployment equilibrium — which is the CENTRAL goal of Keynes.

According to Keynes, classical economics is based on Say’s Law, which requires C=Y — the consumption function has a=0 and b=1, so that the consumer demand is exactly the same as the factor income, and there is zero savings. In this case the consumer demand is exactly the same as the aggregate supply function — both are the 45 degree lines, and equilibrium can occur at any point — however much is produced, it will generate exactly enough demand required to purchase and consume it. In this case, standard economic forces will automatically drive the economy to full employment.  Keynes, and post-Keynesians argue that consumer savings will disrupt the operation of Say’s law, and create a divergence between the demand for consumption at a given level of factor income Y (which will be C=a+bY) and the supply of goods at the same level (which will be Y). Because of this violation of Say’s Law, equilibrium will not occur at all possible levels of production Y. It will occur only at one particular point of intersection, and that point could easily be an unemployment equilibrium.

This idea actually works in a one period static economy, which was the mode of analysis used by Keynes. However, despite a lot of effort, I was unable to make it work in very simple dynamic extensions of the same economy. After many trials, I realize that this savings argument is much more subtle than it appears at first blush. The problem in the dynamic, multi-period setting is actually very simple. Today the consumers/laborers SAVE a portion of their income S=Y-C, reducing the aggregate demand. However TOMORROW this same saving will be available to the consumers as additional amount of money, over and above the factor income. When we talk about saving for the future, then we cannot ignore what happens in the future as a result of this saving. Furthermore, in a dynamic setting, except for the very first period, every period has a past as well as a future. Let M(T) be the total money in the hands of the consumers in period T. This amount is split into C(T) and S(T), the consumption and savings in period T. Now, in period T+1, the money holdings in hands of consumers will be M(T+1)=F(T+1)+S(T) — the factor income PLUS the amount the consumers saved. The consumption function should be defined using THIS amount, and not just the factor income amount — if savings plays no role (as it does not in a one period static analysis) then the model is not logically consistent.

Once we realize that for logical consistency, savings MUST enter into any dynamic analysis, we are led to the realization that it MUST also enter into even a static one-period analysis. This is because we must have M(T)=F(T)+S(T-1). The money in the hands of the consumers today must be the factor incomes in the current period PLUS the savings from the previous period. It is logically inconsistent for a model which has savings in current period to ignore the savings from the previous period.  But, as soon we put in the CRUCIAL missing variable S(T-1) into the analysis of the current period, the savings gap appears in a very different light — as we shall soon see. To the extent that today’s saving reduce current demand, yesterdays savings offset this by adding to demand. Let S* be a normal level of savings. Then in long run equilibrium S(T-1) = S* = S(T), and so the savings gap created by present savings will be exactly made up for by savings coming in from period T-1.

As this analysis demonstrates, normal levels of savings S* do not create deficiencies in aggregate demand, and hence cannot create unemployment. However, abnormal levels can indeed create such deficiencies, and lead to the kind of unemployment that Keynes wanted to explain. To see how this can happen, suppose we are at a full employment equilibrium, with shortfall in aggregate demand from saving S* being exactly compensated for by the increased income due to savings S* from previous period. Now suppose that there is a catastrophic crop failure. The Landlords have cushions, but the laborers draw down their savings and go into debt to survive. Come planting season, the landlords note the general misery in the land, and how the general population is in debt, and times are tight. They wonder whether they should go to the trouble and expense of producing a huge amount of crop. Who will buy it? Would it not become surplus, and drive down the price of crops? In this situation, they are likely to restrict production to have enough for self-consumption, and a moderate surplus for sale. The concept of restricting production to get good prices on crops is well known. The aggregate demand has gone down because the normal savings cushion S* of the laborers has been wiped out. Now, when they are paid wages, instead of using it to buy corn, they will use it repay debts, and to build up their savings back to the normal levels. This abnormally high savings is what causes the collapse of aggregate demand. This corresponds exactly to the analysis of Atif Mian and Amir Sufi in the House of Debt. See my brief analysis and summary in Why does Aggregate Demand Collapse?.

The relation between debts and depression was emphasized in the debt-deflation theory of Irving Fisher. Even though Keynes was aware of the links, he chose not to emphasize this in his General Theory. Making the connection explains why “helicopter money” would go a long way towards ending the depression. A moratorium on debt repayments, and an infusion of money to rebuild savings and restore aggregate demand create full employment. This would then create prosperity which would allow people to pay off debts. The Aggregate Demand Depression leads to loss of jobs which further inhibits the ability of people to pay of debts, creating a vicious cycle, as has been noted by many.





7 thoughts on “The Subtleties of Effective Demand

  1. “The problem in the dynamic, multi-period setting is actually very simple. Today the consumers/laborers SAVE a portion of their income S=Y-C, reducing the aggregate demand. However TOMORROW this same saving will be available to the consumers as additional amount of money, over and above the factor income…. To the extent that today’s saving reduce current demand, yesterdays savings offset this by adding to demand.”

    This is a FALLACY. It is the ROOT of why economists are so CLUELESS and fail to see the banking system as the Ponzi scheme it is.

    For some deeper thinking on the subject watch the following animated flow diagram that explains causation (verified by the Bank of England) and demonstrates 100% correlation with the EVIDENCE provided by the Federal Reserve.

    1. To a man with a hammer, everything looks like a nail. Paul Grignon, you are so obsessed with recursive re-lending that you cannot see anything else in the world. We are talking about a two period model here, and thinking about why unemployment occurs. Although money does matter for effective demand, the central issues under consideration are unaffected by the nature of money in two periods — even in your recursive relending models, crash will not occur in two periods, and here the unemployment can occur in two periods. So unemployment is not caused by recursive relending. Actually, in class I showed that with SIMPLE interest, if landlords borrow to pay laborers, then DEFAULT necessarily occurs, because they cannot collectively earn more money than existed in the system — So in one period, with simple interest, system crashes. We have NO DISAGREEMENT that lending at interest will lead to system crashes. Huge numbers of people agree on this, for a variety of reasons. As Lord King said, we have the worst possible financial system, which is guaranteed to lead to period crashes. Minsky has said the same thing. BUT there are other things going on in the world — children are being born, environment is being polluted, lovers continue to exist, people can fail to find jobs — EVERYTHING does not have to do with recursive re-lending.

      1. NOTE I am not censored at this WEA pedagogy blog. I have been censored at the other one for years already.

        What is the relevance of my comment to your article? You present a simplified model that has no application to the real world and I claim is dead wrong in its conclusion as a result. Effective demand is very much affected by savings in the real world.

        As well, I have never said interest is a mathematical problem, quite the opposite, and I told you that long ago. So why do you write this?

        Asad writes: “So in one period, with simple interest, system crashes. We have NO DISAGREEMENT that lending at interest will lead to system crashes.”

        We have no disagreement within your one period interest-in-one-lump sum model. The problem is that it is irrelevant to the real world because most credit is paid back in monthly instalments of mixed principal and interest. The principal is extinguished but the interest is not. Therefore, there can never be a mathematical shortage of money with which to pay interest. There may be a lack of opportunity to earn it but that applies to principal as well.

        “Huge numbers of people agree on this, for a variety of reasons.”
        I demonstrate with irrefutable math and logic why they are mistaken at the following web page.

        I harp on about recursive re-lending which includes saving because my analysis proves it to be the ROOT of the problem with money and economics, NOT INTEREST, NOT GREED, NOT CRIMINALITY, NOT SUBPRIME BORROWERS, but SYSTEM DESIGN. It is the Ponzi scheme math of banking, itself a case of recursive re-lending, that creates the grow-or-collapse imperative that prevents us from adapting to our dire situation that will result in the extinction of most life on this planet. According to these scientists it’s already futile. It’s game over within a decade.

        So that is a very big nail I am trying to hammer with my last gasp of hope. It’s obsessive in the same way an ambulance crew is obsessed with saving lives.

        Simple-minded models like you and other economists present are, in my opinion, criminally negligent.

        Here’s a more realistic one.

        The worker puts his money in a money market mutual fund. Only the dividends are spent. Some are re-invested. The original money invested was created as someone’s principal debt to a bank. It is now NOT available to the original borrowers to retire their debt, except as another loan. In this scenario, the original borrowers are faced with an actual shortage of principal. The original borrowers have to pay their loan off with someone else’s bank created principal debt laying the shortage on them. The new debt-money is quickly EXTINGUISHED. NOTHING is left to purchase output. “Effective demand” is ZERO. Interest wasn’t involved.

        See the relevance now?

        The other result is that payment of current principal debt is entirely dependent on the timely creation of new principal debt to banks, thus is created, by the DESIGN of banking, the grow-or-collapse scenario that threatens us all.

      2. I learned that money is created by promising to pay it back to a bank back in 1993 as the president of a newly formed conservancy trying to save the central forest of our island from both clearcutting and development. The developer who did eventually cut it down was my helpful consultant and in the process he told me he never used his profits to finance the next project. He always created new money by borrowing it from a bank.

        That was a startling revelation as it is for most people. I asked “Is that how all money is created” and he said “ Yes, I think so, and after I pay the bank back that money is extinguished and I use my profits, (ie. his SAVINGS) to buy mortgages.” As I scanned his computer screen he scrolled through millions of dollars of mortgages he owned and told me “ I want to own at least 2 BILLION dollars worth of mortgages before I retire.”

        I’m sure it’s his corporation that owns the mortgages. And corporations don’t die. So this is ONE MAN who’s aspiration in life is to make 2 billion dollars worth of other peoples’ debt to banks only payable if it is first borrowed a second time from him. Then, when it is extinguished, the debt to him still exists with NO money available to pay it except newly-created bank credit.

        Thus the grow or collapse treadmill is created by RECURSIVE RE-LENDING of the same money.

  2. Go to it gentleman. I was hoping to read, with no guarantee of course, something which troubles me greatly about the disputes on demand. More specifically, a portion of the economic community insist that the current great income and wealth inequality does not effectively dampen demand, and that it would not improve if the bottom 60-80% of the population had more income to spend. Any thoughts on this?

  3. Effective demand (say’s law, L Walras. SMD theorem ) is very easy to understand. Only thing you have to deal with is ‘friction’ or ‘imperfect information’. That takes it from equilbrium to Keynes and nonequilibrium. The same situation occurs in physics.

  4. “Now suppose that there is a catastrophic crop failure.”

    But then the ensuing recession would have been set off by a failure of aggregate supply. The fall in aggregate demand would be an effect, not a cause.

    To see why recessions are indeed caused by a fall in aggregate demand, see my book “Macroeconomics Redefined”.

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