When, at a particular price level, aggregate demand for final goods equals aggregate supply of final goods, the final goods or product market reaches its equilibrium. Aggregate demand for final goods consists of ex ante consumption, ex ante investment, Government spending etc. The rate of increase in ex ante consumption due to a unit increment in income is called marginal propensity to consume. For simplicity we assume a constant final goods price and constant rate of interest over short run to determine the level of aggregate demand for final goods in the economy. We also assume that the aggregate supply is perfectly elastic at this price. Under such circumstances, aggregate output is determined solely by the level of aggregate demand. This is known as effective demand principle. An increase (decrease) in autonomous spending causes aggregate output of final goods to increase (decrease) by a larger amount through the multiplier process.

The 'Effective Demand Principle' states that aggregate output is determined solely by :

The level of aggregate demand in the economy

The correct answer is option (3) : The level of aggregate demand in the economy

Effective demand principle: If the supply of final goods is assumed to be infinitely elastic at constant price over a short period of time, aggregate output is determined solely by the value of aggregate demand. This is called effective demand principle.