Aggregate output is determined solely by the level of aggregate demand. This is known as effective demand principle. Which of the following is not the assumptions behind this principle?

Aggregate demand is perfectly elastic.

The correct answer is Option (4) → Aggregate demand is perfectly elastic.

Under the principle of effective demand, the aggregate output in the short run is determined by the level of aggregate demand, assuming:

• Price of final goods is constant: This is a key assumption in the simple Keynesian model (and the principle of effective demand). It means that when demand increases, firms respond by increasing output and employment rather than increasing the price of the final goods.

• Interest rates are constant, and

• Aggregate supply is perfectly elastic till full employment level. This assumption is a direct result of the "constant prices" and "idle capacity/unemployment" assumption. Up to the point of full employment, firms are willing to supply any amount of output demanded at the existing price level because they have idle resources (unemployed labor and capital). Graphically, the Aggregate Supply (AS) curve in the Keynesian range is horizontal.

However, aggregate demand is not perfectly elastic; it changes with income. Hence, this statement is not an assumption of the effective demand principle.

..."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."....