Question

What is effective demand? How will you derive the autonomous expenditure multiplier when the price of final goods and the rate of interest are given?

Answer 1

Effective demand refers to a situation in which equilibrium output is determined solely by the level of aggregate demand. This is because of the assumption that supply is perfectly elastic. If there exists any difference between AD and AS, the equilibrium output will be determined only by AD.

The X-axis represents the level of output or income, the Y-axis represents the level of aggregate demand. E is the point of equilibrium where the AD and the AS curves intersect. EG is the effective demand.

The autonomous expenditure multiplier is derived as:

Y= AD

Y= A + cY

Y - cY= A

Y (1-c)= A

Y = $\frac{A}{1-c}$

The multiplier is, therefore, $\frac{A}{1-c}$. It is dependent on the income and the MPC.