If the supply of final goods is assumed to be infinitely elastic at a constant price over a short period of time, aggregate output is determined solely by the value of aggregate demand. This situation is called effective demand. In other words, effective demand refers to a situation in, which equlibrlium output is determined solely by the level of aggregate demand.

This is because of the assumption that the supply is infinitely elastic and if there exists any inequality between aggregate demand and aggregate supply, then the equilibrium output will only be influenced by the aggregate demand and not supply.

The derivation of aggregate demand under fixed price of final goods and constant rate of interest in the economy can be discussed here. In order to hold price constant at any particular level, however, one must assume that the suppliers are willing to supply whatever amount consumers will demand at that price.

If quantity supplied is either in excess of or falls short of quantity demanded at this price, price will change because of excess supply or demand. To avoid this problem, we assume that the elasticity of supply is infinite i.e., supply schedule is horizontal – at the fixed price. Under such circumstances, equilibrium output will be solely determined by the aggregate amount of demand at this price in the economy. This is called effective demand principle.