The principle of effective demand revisited

Abstract

The 'Keynesian Revolution' in macroeconomics established a role for public expenditure as an instrument of economic policy that through the creation of an appropriate level of effective demand would ensure full employment. However, traditional analysis of Keynesian 'demand management' has invariably failed to take into account the response that an optimising private sector may make in the light of a such a policy adopted by the central authorities. Many economists, most notably the 'New Classical' school, have stressed the role that the expectations of the private sector may have in negating the effectiveness of government policy, but this analysis has again typically been within a framework that has not fully specified the objectives of either the government or the private sector. In consequence the strategic aspects of Keynesian 'demand management' policies have been poorly understood. It could also be argued that the Keynesian and Classical models implicitly assum~ cooperative and non-cooperative environments, respectively. For instance, the usual mechanism by which an increase in effective demand leads to an increase in aggregate supply is via a reduction in real wages and the fact that those in employment are willing to accept lower real wages, albeit achieved by an increase in the price level, in order to achieve an increase in employment for their fellows is clearly a position of cooperation.