Aggregate demand represents the total value of goods and services consumers need to buy for a market to remain in equilibrium. Effective demand captures the total value of products consumers actually buy at a given price. Say’s Law, which dominated economic theory in the early 19th century, was rejected by John Maynard Keynes in the 1930s, who argued that demand creates supply. The concept of effective demand can be illustrated graphically using an aggregated expense function.
In economics, aggregate demand represents the total value of goods and services that consumers need to buy for a market to remain in equilibrium. At equilibrium, the supply of goods exactly equals the demand, so there is no shortage or oversupply. This equilibrium demand is also called a notational demand and represents a largely theoretical value. For a more realistic approach, economists rely on effective demand. Effective demand captures the total value of the products that consumers actually buy at a given price, rather than the value of the products needed to reach equilibrium.
In the early 19th century, economic study was dominated by the idea that supply dictated demand. According to a widely accepted economic theory of that period, known as Say’s Law, the level of aggregate demand will exactly equal the amount of output that manufacturers choose to produce. One critic of this theory was Thomas Robert Malthus, an economist who argued that Say’s law led to economic recessions. Malthus believed that companies that assumed consumers would buy what they wanted to choose would end up producing too much or the wrong product. When consumers didn’t buy these products, the economy slowed down, resulting in a recession.
Malthus’ theory was largely ignored for the next century, and Say’s law remained the dominant theory. It wasn’t until the 1930s that John Maynard Keynes published a new work in economics that rejected Say’s Law and adopted the concept of effective demand. According to Keynes, demand creates supply, not the other way around. Theoretically, equilibrium occurs when aggregate supply and aggregate demand are equal. After the publication of Keynes’s main works, economists began to understand that, in the real world, it was up to consumers to define aggregate demand, leaving suppliers to respond by establishing the appropriate level of aggregate supply based on that demand.
The concept of effective demand can be illustrated graphically using an aggregated expense function, which shows the relationship between production rates and expenses. If Say’s Law were true, expenses would increase by one unit for every increase in production. Instead, the aggregate expense function illustrates that for every unit of increase in output, expenses increase by less than a full unit. This helps illustrate the concept of effective demand and disproves the idea behind Say’s Law. Rather than simply buying what suppliers produce, consumers choose how to spend their money and may decide not to spend it if supply does not match demand.
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