Financial Markets, Money and the Real World
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Financial Markets, Money and the Real World

Paul Davidson

Paul Davidson investigates why the 1990s was a decade of financial crises that almost precipitated a global market crash. He explores the reasons why the global economy still struggles with the aftermath of these crises and discusses the possibility that volatile financial markets in the future will have real impacts on whole industries and national economic systems.
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Chapter 2: Keynes’s Principle of Effective Demand

Paul Davidson


2. Keynes’s principle of effective demand Keynes’s general theory demonstrated that even a competitive economy with instantaneously flexible wages and prices can suffer from persistent high levels of unemployment. To understand why this can occur, it is necessary to discuss the major aspects of Keynes’s analytical framework. Some rather technical matters are discussed in Sections 2.3–2.5 and Appendix 2A2 of this chapter. Those general readers not interested in these analytical intricacies can skip these portions of the current chapter. 2.1 IS LACK OF COMPETITION THE FUNDAMENTAL CAUSE OF UNEMPLOYMENT? LIQUIDITY VERSUS SAY’S LAW Long before Keynes developed the principle of effective demand in his general theory, classical economists ‘explained’ that unemployment was the result of short-run ‘imperfections’ or monopoly elements on the supply side of the market system. These imperfections took the form of rigidities in the money wage rate (and/or product prices) due to noncompetitive labor and product markets.1 If the government did not interfere during this temporary period of unemployment, then the resulting weak markets would induce increased competition that would weed out these imperfections leaving a stronger, more powerful economy to carry on. In the long run, the causes of these imperfections would always be liquidated by market forces and full employment of resources would be restored. If, on the other hand, the government intervened in economic matters during these temporary periods of unemployment, then the economic situation could only deteriorate and the economy would take a longer time to right itself. In...

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