Effective Demand Principle & Keynesian Income Determination

1) Keynes’ core claim: demand determines output in short run

Keynes argued that in the short run, the economy may settle at an equilibrium with:

• less than full employment because aggregate demand may be insufficient.

This is the Principle of Effective Demand:

• the level of output and employment is determined by the level of aggregate demand that becomes “effective” through actual expenditure.

2) Planned expenditure vs actual output

In Keynesian models:

• Firms produce based on expected sales.
• If planned spending is not equal to output, inventories change, and firms adjust production.

Equilibrium occurs when:

where:

• $Y$ is actual income/output
• $AE$ (aggregate expenditure) is planned spending.

3) The consumption function (foundation)

Keynesian consumption:

Where:

• $a$ = autonomous consumption (consumption even if income were zero)
• $b$ = marginal propensity to consume (MPC), $0<b<1$

3.1 MPC and APC

With $C=a+bY$, APC falls as Y rises because $a/Y$ falls.

4) Simple 2-sector model (Closed economy, no government)

Assumptions:

• $AE = C + I$
• Investment $I$ is autonomous (given)