1 Principal of Effective Demand The level of employment and income in any economy depends up on the size of effective demand. The equilibrium of aggregate demand and aggregate supply is the point of effective demand. The equilibrium level of employment may or may not be the full employment equilibrium. In other words a full employment equilibrium is also an equilibrium level of employment. However, an equilibrium level of employment may not be the full employment equilibrium. The effective demand thus is determined by aggregate demand and aggregate supply.

2 Aggregate Demand In keynesian theory the amount of labour employed is taken as a measure of the out put as a whole. At any given level of employment there is a given level of out put. The aggregate demand price for that output is the total sum of money which is expected from the sale of the output produced when that amount of labour employed. In other words AD is a function of employment ( N ). This means that with the increase in employment the aggregate demand price of producing that level of output will also increase. The increase in aggregate demand however, is not proportionate to increase in employment and output. Cont…..

3 Aggregate Demand From the point of view of the economy as a whole the aggregate demand is the expected expenditure which does not rise proportionately in response to increase in employment, output and income. In other words, when output increases as a result of expansion in employment, aggregate demand also increases but at a diminishing rate. This is the reason why the slope of the aggregate demand curve diminishes as it moves upward to the right. Diagram of Shape of the AD Curve.

4 Aggregate Supply In a capitalistic society production is organized for profit. Hence, producers will employed that number of workers which will maximize their profits. When we combined all workers employed by all the producers in the economy that will be the total employment which is the proxy for production. We can define aggregate supply price as under: To induce producers to offer any given aggregate amount of employment it is necessary that the employers must receive a minimum amount of income flow. This minimum price or proceeds which will be sufficient to induce that level of employment is called the aggregate supply price of that amount of employment. Cont…..

5 Aggregate Supply The aggregate supply function is a scheduled of the minimum amount of proceeds required to induce varying quantities of employment. For example let Z be the aggregate supply price of the output from employing N capital workers, then the relationship between Z and N can be expressed as Z= G(N) this is aggregate supply function. The shape of aggregate supply curve depends on technical conditions of production. In other words, it will depend on how cost rises in response to expansion in employment. He factors which shape the AS curve can be mentioned as marginal cost is positive; the production is subject to law of diminishing returns and under the condition of full employment production can not be expanded but only cost will rise. AS diagram.