Keynes’ Theory of Employment

Keynes’ criticism of the

Classical Theory of Employment
 Keynes criticized the
Classical Theory on the
following grounds

 1) Supply / Production
generates income but its
not necessary that the
entire income will be
spent on consumption. A
part of it will be saved
Y=C+S
Keynes’ criticism of the
Classical Theory of
Employment
 2) It is not necessary that Saving = Investment
 Savers and Investors are different
 Households save and Businessmen invest
 HHs save for old age, marriage, education
 Businessmen invest based on MEC, rate of
interest, population growth and technological
progress
 If S > I, Equilibrium(AD=AS) will occur at less than
FY i.e. there will be unemployment
Keynes’ criticism of the
Classical Theory of
Employment
 3) Money wage cut to cure unemployment
 Trade unions and welfare state

 4) Full employment is rare;

underemployment is more realistic

 Laissez-Faire is not applicable to modern

economic systems - not self- adjusting
Keynesian Theory of
Employment
 On the background of the Great Depression
(1929-1933) , Lord John Maynard Keynes put
forward his “ General Theory of Employment,
Interest and Money”
 In his book, he not only criticized the Classical
theory but also propounded a new theory of
income and employment
 His theory is a short-run theory. This enabled
him to hold a lot of variables constant
Keynesian Theory of
Employment
 Keynes tried to prove that FY is not a normal
feature of an advanced capitalist economy
but underemployment equilibrium is
 Level of Output/Income depends on the level
of employment
 Keynes believed that over-production is a
possibility
 He gave more importance to AD than AS to
determine equilibrium
Aggregate Supply (AS)

 AS or Aggregate Supply Price is the total

amount of money which all the entrepreneurs
in an economy taken together must expect to
receive from the sale of the output produced
by a given number of labourers employed
 In other words it is the total cost of
production incurred by employing a certain
given no. of labourers
 Diagram
Aggregate Demand (AD)

 AD or Aggregate Demand Price is the total

amount of money which all the entrepreneurs in
an economy taken together actually receive
from the sale of the output produced by a given
number of labourers employed
 In other words it is the total amount of
expenditure expected by the entrepreneurs
when a given no. of workers are employed to
produce the G+S
 AD = C+ I+ G+ (X-M) we assume AD= C+I in our
analysis
 Diagram
Point of Effective Demand

 The point at which AD = AS in the short - run,

is the point of effective demand
 In other words effective demand is the
Aggregate Demand which becomes effective
because it is equal to Aggregate Supply and
thus represents a position of short-run
equilibrium

 Diagram
Consumption Function

 A functional relationship between the level of

Consumption ( C ) and the level of National
Income ( Y ) of an economy

 C = f (Y)

 C and Y are directly related

Psychological Law of
Consumption
 As income (Y) increases people’s expenditure
on consumption also increases but less than
proportionately
 C= f (Y)
 This is because a part of the income is also
saved (Y=C+S)
 Thus as Y increases, Consumption and Saving
also rise
Average Propensity to
Consume (APC)
 It is the proportion of a country’s National
Income that is devoted to consumption
 APC = C
 Y
 If Y= 1000 crores and C= 800 crores
 APC = 800/1000 = 0.8 or 80%
Marginal Propensity to
Consume (MPC)
 It is the proportion of each additional level of
country’s NY that will be devoted to
additional spending on consumption
 MPC= C
 Y
 If NY rises from Rs. 1000 cr. to Rs. 1200 cr.
and C rises from Rs. 800 cr. to 900 cr.
 MPC= 200/100 = 0.5 or 50%
 C= a + bY
Saving Function

 A functional relationship between the level of

Saving ( S ) and the level of National Income
( Y ) of an economy

 S = f (Y)

 S and Y are directly related

Average Propensity to Save
(APS)
 It is the proportion of the NY that is saved
 APS = S
 Y
 APC + APS = 1
 Since Y= C+ S i.e. Y = C + S
 Y Y Y
 1 = APC + APS
Marginal Propensity to Save
(MPS)
 It is the proportion of each additional level of
country’s NY that will be devoted to saving
 MPS = S
 Y
 MPC + MPS = 1
 Since Y= C + S i.e.
 Y= C+ S 1 = MPC + MPS or
Y Y Y MPS= 1 – MPC
Paradox of Thrift

 People save more in order to survive a future

recession or unemployment
 In order to save more they not only end up with
lower savings but may also see a decline in their
standard of living
 An economy as a whole in their bid to save more
can fall deeper into recession
 This is because, if there in underemployment/
recession, an increase in savings will cause AD to
decline as consumption would fall
 Falling AD will cause National Income to decline
Paradox of Thrift

 At lower incomes, saving would fall to its

original level or lower while consumption will
be less than before
 This will bring down the standard of living
 Also, as Investment depends on Saving,
Investment would also decline causing fall in
Employment/ Output / Income
 This will aggravate the recession
Investment Demand

 Real Investment is addition to the stock of

Physical capital
 Expenditure incurred on addition of capital
goods such as machines, buildings,
equipments, etc
 Investment increases the level of
employment and income in an economy
Autonomous Investment

 Does not change with a change in the income

level
 Investment on roads, power, transport,
housing, communication, etc.
 Depends on Population growth and technical
progress
 Mostly undertaken by the government
Induced Investment

 Affected by the changes in the level of

income
 Both are directly related
 To increase production of consumer goods,
more investment is required on capital goods
 Mostly undertaken by the private sector
Determinants of Investment

1) Marginal Efficiency of Capital (MEC)

2) Rate of Interest (ROI)
 MEC is the expected rate of profit from a given
investment
 ROI can be interpreted in two ways:
 A) If instead of investing, the amount saved is
lent, the ROI it will fetch
OR
 B) In order to invest if the fund is borrowed, the
ROI charged
Determinants of Investment

 For profitable investment

 MEC > ROI
 Investment will continue till MEC = ROI
 Of the two MEC is more important in affecting
investment
 As ROI does not fluctuate much in the short run
 When profit expectations or MEC fluctuates it
can cause cyclical fluctuations in an economy
 High MEC ----- Prosperity
 Low MEC ------ Recession
Determination of Equilibrium
Income, Output and
Employment Level
 Equilibrium is achieved in the Keynesian
model when AD = AS

 Diagram