Importance or Significance of Theory of Effective Demand

Importance of Theory of Effective Demand

The Importance or Significance of Theory of Effective Demand is as follows:-

1. Determinants of Employment

Effective Demand determines the level of employment. When effective demand increases employment also increases and when it decreases employment also decreases. According to Keynes, involuntary unemployment can be removed by raising consumption expenditure and investment expenditure. The same can be achieved by government expenditure. Thus, the principle of effective demand is the basis of the theory of employment.

2. Invalidates Say's Law of Full Employment

Keynes's theory of employment rejects the Say's Law of markets stating that "supply creates its own demand and that of full-employment equilibrium."

The principle points out that under employment is a real situation, and full employment is an accidental situation. In a free-enterprise economy, supply fails to create its own demand.

3. Invalidates Pigou's Wage Cut Policy

Prof. Pigou says, "full employment is attained by reducing the money wages."

However, the wage cut policy of Prof. Pigou is also cancelled by this principle. According to Keynes, reduction in money wages will bring down the consumption expenditure on goods and services there by causing a decline in the level of employment.

4. Importance of Investment

The principle of effective demand is based on aggregate expenditure, i.e. Consumption expenditure and Investment expenditure. When income increases, consumption expenditure also increases but in the lesser proportion. Thus there is a gap between income and consumption, which leads to a reduction in level of employment. This gap can be filled up by increasing investment expenditure because in the short-run consumption expenditure remains stable.

5. Paradox of Poverty in the Midst of Potential Plenty

In a free-enterprise economy, the theory of effective demand explains the paradox of poverty in the midst of potential plenty. Effective demand is determined by aggregate demand function, which is composed of consumption expenditure and investment expenditure. The basic principle is that when income rises consumption also rises but in lesser proportion. This leads to a gap between income and consumption, which must be filled up by the required investment expenditure. If sufficient investment is not forth coming to fill up this gap then it leads to deficiency of effective demand resulting in unemployment.

In a poor country, the gap between income and consumption is small because the marginal propensity to consume (MPC) is high. Therefore, this gap can be filled up by investment expenditure. There are fewer difficulties in employing all its resources to maintain an equilibrium level of income and employment.

In a rich country, the gap between income and consumption is very high because MPC is low. Therefore, it will require large investment expenditure to fill up the gap between income and consumption in order to maintain the high level of income and employment. However, in a rich country, there is a problem of inadequate aggregate demand resulting in wide unemployment. Further in such a community inducement to invest is low due to decline in marginal efficiency of capital (MEC) and low MPC.

Therefore, investment expenditure fails to fill the gap between income and consumption. This leads to a reduction in aggregate demand of income and employment. Thus, the downward trend in aggregate demand in income and employment may continue. The decline in saving becomes equal to investment. The economy attains equilibrium but there would be massive unemployment.

Thus in a rich country where there are plenty of unutilized resources, unemployment and poverty prevail in the midst of potential plenty.