Keynesian Theory of Income and Employment Class B

Keynesian Theory of Income and Employment Class : B. Com-I (IInd Semester) Subject : Macro Economics Topic : Keynesian Theory of Output College: IB (PG) College, Panipat (Affiliated to Kurukshetra University, Kurukshetra) By : Sukhjinder Singh

What is Keynesian Theory of Employment? According to Lord Keynes, there is not always full employment in a developed capitalist economy. In fact, unemployment situation can be found in every economy. The main reason for this unemployment is fall in AD or effective demand. Unemployment can be removed and full unemployment can be restored by increasing the effective demand. Effective demand is that level of aggregate demand (AD) at which it is equal to aggregate supply (AS). Keynes believed that it is the 'aggregate demand‘ (effective demand), not wages, price level and rate of interest, which determine unemployment.

Principle of Effective Demand In the Keynesian theory of income and employment determination, principle of effective demand occupies a significant place. In the capitalist economy, the level of employment depends upon the level of aggregate effective demand. According to Keynes, effective demand is determined by aggregate supply and aggregate demand. Only that level of demand is effective where aggregate demand supply are fully matched and entrepreneurs have no tendency either to expand or contract output and employment.

Assumptions Time period is short because “In the long run we are all dead”. A developed capitalist closed economy No time lag Excess capacity is available Under-employment equilibrium Saving and investment function Money serves as store of value and medium of exchange Interest is a monetary phenomenon

Contd… Labour has Money illusion : It means that labourers believe that the proportion in which money (nominal) wages increase in the same proportion real wages also increase. Labourers ignore the effect of change in prices. Wage rigidity : According to keynes, wages could be reduced upto a certain limit only. Beyond that limit wages become rigid due to several reasons for it, viz. opposition by the unions, compulsions of minimum wages act, welfare schemes, etc.

Keynesian Theory of Income determination According to keynes, “ In the short period, level of national income and so of employment is determined by aggregate demand aggregate supply in the country. The equilibrium of national income occurs where AD is equal to AS. This equilibrium is also called effective demand point”. Y = f(N)…. (I) N = f(ED)…. (II) ED – (AD = AS)

Explanation of Keynesian theory of Employment

Contd… Aggregate Supply: It is the total supply of goods and services produced by a national economy during a specific time period. It tells the addition of total things and services produced in an economy. Aggregate Demand : The total addition of demand of things and services in economics is called aggregate demand. It is the total of total consumption demand total investment demand. AD is related to the total expenditure flow in an economy in a given period.

Contd… Consumption Function : Consumption expenditure is an important constituent of aggregate demand in an economy. Keynes has used two technical attributes or properties of consumption function. Average Propensity to Consume (APC): Average propensity to consume refers to the ratio of consumption expenditure to any particular level of income. APC = C/Y Marginal Propensity to Consume (MPC): Marginal propensity to consume refers to the rate of change in consumption to the change in income. MPC = ∆C/∆Y

Contd… Size of National Income : Consumption demand depends upon the level of income and the propensity to consume. when income increases then consumption expense also increases but in low quantity. If it is assumed that all things and services are available for consumption and investment, then total supply will be equal to national product and national income. Investment : Keynes investment refers to real investment which adds to capital equipment. It leads to increase in the levels of income and production by increasing the production and purchase of capital goods. According to Keynes, the investment in a new project depends on the marginal efficiency of capital and interest rate of market.

Contd… Marginal Efficiency of Capital : Marginal efficiency of capital is the highest rate of return expected from an additional unit of a capital asset over its cost. In the words of Kurihara, “it is the ratio between the prospective yield of additional capital-goods and their supply price”. Rate of Interest : It is determined by demand for and supply of money. Rate of interest is determined by demand for and supply of money. Demand for money depends on liquidity preference.

Liquidity Preference Liquidity preference means the demand for money to hold or the desire of the public to hold cash. Liquidity preference of a particular individual depends upon several considerations. Transactions Motive : It relates to the demand for money or the need for money balances for the current transactions of individual and business firms. Precautionary Motive : It refers to the desire of the people to hold cash balances for unemployment, sickness, accidents, and the other uncertain perils. Speculative Motive : It relates to the desire to hold one’s resources in liquid form in order to take advantage of market movements regarding the future changes in the rate of interest (or bond prices).

Determination of Equilibrium Level of Employment AD and AS curves are moving in the same direction, but they are not alike. There are different aggregate demand price and aggregate supply price for different levels of employment. In As curve, the orgnaisation would employ ON 1 no. of workers, when they receive OC amount of sales receipt. In case of AD curve, the organisation would employ ON 1 no. of workers with the expectation that they would produce OH amount of sales receipts.

Contd… At certain level of employment, the aggregate demand price and aggregate supply price become equal. The aggregate demand price (OH) is greater than the aggregate supply price (OC). However, at certain level of employment, the aggregate demand price and aggregate supply price become equal.

Contd… In Figure, point E represents the equilibrium level of employment because at this point, the aggregate demand curve and aggregate supply curve intersect each other. After equilibrium (ED), price would be constant and AD curve become horizontal. When the economy reaches at full employment the AS curve become vertical.

Criticism of Keynesian Theory The concept of equilibrium is self-contradictory Keynesian economics is mainly static It has ignored the long period equilibrium Unrealistic assumption of perfect competition Keynesian theory is not a general theory Based on the assumption of closed economy Keynesian analysis is not so empirical Rate of interest is not a purely monetary phenomenon Keynesian concept of secular stagnation is unfounded

Classical vs. Keynesian According to classical economists, money is demanded for transaction motive alone. On the contrary, keynes maintained that money is demanded for transaction motive as well as speculative motive. According to classical economists, supply of labourers depends on real wage (W/P). On the contrary keynes believes that it depends on money wage. In classical theory saving is a function of rate of interest and keynes is of view the saving is a function of an income.

Contd… The classical economists laid relatively more stress on aggregate supply in the determination of income and employment while keynes laid relatively more emphasis on aggregate demand. Classical economists held the view that full employment could be achieved by lowering the money wage. Keynes, however, believed that any reduction in money wage was likely to cause fall in effective demand. This in turn will lead to fall in employment.

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