The Principle of Effective Demand

“Consumption and savings depend first and foremost on the level of national income, but what decides the latter? This is the crucial question. Keynes answered: it is the level of investment demand. Investors, not consumers (alias savers), are the active element in the economic system.” — Heinz Kurz

This week, we are featuring two exciting new economics titles: Economic Thought: A Brief History, by Heinz Kurz, and The Power of a Single Number: A Political History of GDP, by Philipp Lepenies. Today, we are happy to present a short excerpt from Economic Thought, in which Heinz Kurz breaks down John Maynard Keynes’s “principle of effective demand.”

The Principle of Effective Demand
Heinz Kurz

Let us now have a closer look at Keynes’s view that the economic system is typically not fully utilizing its productive resources—it is not “supply-constrained,” as neoclassical economists contend, but “demand-constrained” (except during booms). More specifically, Keynes’s “principle of effective demand” means that there is no reason to assume that aggregate investment demand will always be large enough to employ all of an economy’s productive resources. To see this we must turn to how he determined the two components of private domestic aggregate effective demand—consumption and investment expenditures.

Before doing so, it should be noted that Keynes conceived savings (correctly) as the nondemand of goods and services. The saver keeps a part of his or her money income and does not spend it, that is, does not buy goods. Savings in themselves involve “leakages” in the stream of expenditures and pose the problem of sufficient effective demand. The praise Adam Smith had showered upon the “frugal man” was justified only to the extent to which the saver was at the same time an investor, who spent the saved sums not on consumption goods (food, beverages, clothing, etc.) but instead on investment goods (plant and equipment, raw materials, etc.). In this perspective investments involve “injections” into the stream of expenditures and may compensate for the leakages stemming from savings.

In what he called a “fundamental psychological law,” Keynes stated that aggregate consumption expenditure (C) depends first and foremost on the level of national income (Y): the larger the latter, the larger also the former. Consumers are not the active agents in the economic system, investors are. Consumers tend to be passive, reacting to changes in national income. In the simplest case of a linear consumption function, we have C = cY, with c representing the propensity to consume. (Keynes assumed a slightly different consumption function, in which the propensity to consume was not a constant but decreased as national income increased, but this need not concern us here.) With c = 0.8 or 80 percent (meaning that 80 cents of each dollar earned are spent on consumption), a total income of $100 billion yields a total consumption expenditure of $80 billion. Since savings (S) equal income minus consumption, S = Y – C, the savings function that corresponds to the above consumption function is given by S = sY, with s representing the propensity to save or savings rate. Obviously, the percentage of income that is not consumed will be saved, which means, of course, that s = 1 – c. So from our example above, 1 – 0.8 = 0.2 or 20 percent. Savings out of a total income of $100 billion would accordingly be $20 billion. Hence, both consumption expenditures and savings increase (or decrease) when national income increases (or decreases). At a total income of $200 billion, consumption expenditures would be $160 billion and savings $40 billion.

Consumption and savings depend first and foremost on the level of national income, but what decides the latter? This is the crucial question. Keynes answered: it is the level of investment demand. Investors, not consumers (alias savers), are the active element in the economic system. Whoever invests today generates a larger capital stock and thus a larger productive capacity in the hope and expectation that the larger output that can be produced tomorrow and thereafter will be absorbed by the market and yields higher profits. The investors operate their way into an uncertain future. Since they cannot have reliable information about that future, they must base their decisions to invest on long-term expectations about future economic situations. Depending on whether they are optimistic or pessimistic—Keynes famously described the emotions and instincts of investors as “animal spirits”—they will invest either more or less.

The important point to note here is that while consumption expenditures are decided dominantly on the basis of an economic magnitude (national income) describing the actual state of the economy (a “state variable”), investment expenditures depend dominantly on magnitudes that cannot be known as yet: the investors cannot know the future and whether their investments will be profitable or not. They cannot know the prices of commodities in the future, the wage rates they will then have to pay to workers, the increase in technical knowledge that might make their investments technologically obsolete, and so on. They cannot even base their decisions on a probability calculus, because they do not know the probabilities with which different outcomes of their investment activities occur. In terms of a distinction suggested by Frank Knight, investors are not simply confronted with risk but with fundamental uncertainty. They must base their decisions to invest on long-term profitability expectations.