The famous economist John Maynard Keynes tried to put forth a theory of effective demand. Keynes even devoted chapter 3 of his General Theory book to it. However, nowadays you will not see the term effective demand in economic textbooks. What happened to it? Why is the term effective demand missing from common discourse?

Keynes laid down some basic ideas about effective demand but did not give specific equations. It is clear that Keynes distinguished effective demand from aggregate demand. Still modern economists equate effective demand with aggregate demand. This is a mistake. Now we only see the term aggregate demand in textbooks.

Consequently, there is a missing piece of economic theory that is still yet to be found. How then can we understand effective demand? Will we ever have a workable model for it?

Developing a model of effective demand was my doctoral work. This is the cornerstone equation of the model.

         0% < labor share – (utilization rate of capacity * utilization rate of labor)

The equation basically says that the percentage of national income going to labor (labor share) sets a limit upon the multiple of the utilization rates of capital capacity and labor. The multiple cannot be greater than labor share.

The equation shows ‘demand’ through a relative amount of money given to labor (labor share) as opposed to money given to those who own capital. Capital income at a macro level depends on selling to those who do not have capital income. Certainly many economists would say there is no difference between money spent in the economy from capital and labor incomes. However, capital production is ultimately directed towards a final consumption by people who give their labor.

The equation shows the term ‘effective’ by saying that the income share of final consumers sets a limit upon how firms utilize their capital and employment. There is an effective demand limit upon production. Capital income measures its production according to the relative strength of labor income. Thus, if people are paid less, they demand less, and firms would have to produce less for them. On the other hand, if people are paid more, they can demand more, and firms would have to increase production.