Keynesian theory of Employment
Assumptions
1. The theory is applicable in advanced capitalistic Economy
2. Assumption of short period
3. Assumption of Perfect competition
4. Closed economy
5. It ignores the role of Government as a spender and Taxer
6. No time lag
7. Money also act as a store of value
8. Labor is the only variable factor of production
9. Under Employment Equilibrium
Saving depends upon income and Investment depends upon Rate of Interest
Keynes has strongly criticized the classical theory in his book ‘General Theory of Employment,
Interest and Money’. His theory of employment is widely accepted by modern economists.
Keynesian economics is also known as ‘new economics’ and ‘economic revolution’. Keynes had
invented new tools and techniques of economic analysis such as consumption function,
multiplier, marginal efficiency of capital, liquidity preference, effective demand, etc. In the short
run, it is assumed by Keynes that capital equipment, population, technical knowledge, and labour
efficiency remain constant. That is why, according to Keynesian theory, volume of employment
depends on the level of national income and output. Increase in national income would mean
increase in employment. The larger the national income the larger the employment level and vice
versa. That is why, the theory of Keynes is known as ‘theory of employment’ and ‘theory of
income’.
Theory of Effective Demand:
According to Keynes, the level of employment in the short run depends on aggregate effective
demand for goods in the country. Greater the aggregate effective demand, the greater will be the
volume of employment and vice versa. According to Keynes, the unemployment is the result of
deficiency of effective demand. Effective demand represents the total money spent on
consumption and investment. The equation is:
Effective demand = National Income (Y) = National Output (O)
The deficiency of effective demand is due to the gap between income and consumption. The gap
can be filled up by increasing investment and hence effective demand, in order to maintain
employment at a high level. According to Keynes, the level of employment in effective demand
depends on two factors:
(a)Aggregate supply function, and
(b)Aggregate demand function.
(a) Aggregate supply function:
According to Dillard, the minimum price or proceeds which will induce employment on a given
scale, is called the ‘aggregate supply price’ of that amount of employment. If the output does not
fetch sufficient price so as to cover the cost, the entrepreneurs will employ less number of
workers. Therefore, different numbers of workers will be employed at different supply prices.
Thus, the aggregate supply price is a schedule of the minimum amount of proceeds required to
induce varying quantities of employment.
We can have a corresponding aggregate supply price curve or aggregate supply function,
which slopes upward to right.
(b) Aggregate demand function:
The essence of aggregate demand function is that the greater the number of workers employed,
the larger the output. That is, the aggregate demand price increases as the amount of employment
increases, and vice versa. The aggregate demand is different from the demand for a product. The
aggregate demand price represents the expected receipts when a given volume of employment is
offered to workers. The aggregate demand curve or aggregate demand function represents a
schedule of the proceeds of the output produced by different methods of employment.
Difference between Classical and Keynes Model
Classical
1. Economy is in full employment
2. The wages and prices are very flexible
3. There is no need of fiscal or monetary policy
4. The Aggregate supply curve is Vertical according to classical so any rise in aggregate demand
will increase prices not production
5. There is a direct relationship between the money supply and the price level
6. Saving-investment equality is brought about by the rate of interest mechanism.
7. Supply creates its own demand
8. Laissez Faire or Capitalistic economy
9. Automatic adjustment works
10. Long run concept
11. Saving is good
Keynesian theory:
1. Economy may not be in full employment in short run
2. Wage are rigid and prices are sticky (menu cost etc)
3. Fiscal as well as monitory policy may be needed to correct the disequilibrium or improve the
efficiency of economy
4. Aggregate supply is upward sloping in the short run so a rise in aggregate demand may rise
the production as well
5. No such direct relationship exists between the money supply and price level. The relation is
only indirect.
6. The equality between saving and investment is brought about by the income level.
7. Demand creates its own supply
8. No is no adjustments
9. No laissez Faire
10. Short run
11. Saving is bad
Consumption Function
It is a functional relationship between two aggregates i.e., total consumption and National
income. Consumption is an increasing function of income. It was developed by John Maynard
Keynes
Symbolically, C= f (Y)
Consumption expenditure increases with increase in income.
But increase in consumption is less than increase in income. It is known as Fundamental
Psychological Law”.
Consumption Schedule It is the tabular representation of various amounts of consumption
expenditure corresponding to different levels of income.
Consumption is basically of two types:
Autonomous Consumption: This is the level of consumption which does not depend on
income. The argument is that even with zero income you still need to buy enough food to eat,
through borrowing or running down savings.
Induced Consumption: This is that level of consumption which depends on income and varies
at different level of income. When income increases, induced consumption also increases.
This function can be written as C= Ca + bY
Where
C= Total consumption
Ca= Autonomous Consumption
By=Induced Consumption (b= Marginal Propensity to consume and Y= income)
Ca+bY
Induced
Consumption
Autonomous
Consumption Consumption
Income (Y)
Propensity to Consume
Propensity to consume is of two kinds:
Average Propensity to Consume
Marginal Propensity to Consume
Average Propensity to consume: APC is the ratio of total consumption to total income. It is
found by dividing the total consumption with total income.
APC= C/Y
Marginal Propensity to consume: MPC is defined as the ratio of change in consumption to
change in change in income. It is found by dividing the change in consumption expenditure with
the change in income.
MPC = C/ Y
Characteristics of MPC
1.It is always positive
2.It is greater than zero and less than utility
3.MPC of the poor class is higher
4.Constant MPC in the long period
5.Falling MPC in the short period
6.MPC can be greater than 1 in abnormal conditions
Saving Function
Saving function may be defined as a schedule showing amounts that will be saved at different
level of income.
S=f(Y)
Saving increases with increase in income and decreases with decrease in income, i.e., saving is
income elastic.
Propensity to Save
Average Propensity to Save: APS is the ratio between total saving (S) and total income (Y) at a
given level of income and employment in the economy.
APS= S/Y
Marginal Propensity to Save: MPS is defined as the ratio of change in consumption to change
in income. It is found by dividing the change in consumption expenditure with the change in
income.
MPS= S/ Y
Relationship between Consumption and Saving Function
1. When consumption is more than income than saving is negative or when consumption graph is
above to income graph than saving is negative.
C>Y, than S becomes -S
2. When consumption becomes equals to income or consumption graph meet to income graph at
that time saving is zero.
C=Y, than S=0
3. When consumption is less than income or consumption graph is below to income than saving
increases and becomes positive.
C<Y, than S becomes +S
Relationship between APC and APS
We know that APC = C/Y and APS = S/Y
Y=C+S
Divide both side by Y Y/Y = C/Y + S/Y
1 = C/Y + S/Y
1 = APC + APS
1 - APC = APS
Relationship between MPC and MPS
We know that MPC = dC/dY and MPS = dS/dY
Y=C+S
And, dY= dC+dS Divide both side by dY dY/dY = dC/dY + dS/dY 1 =
dC/dY + dS/dY 1 = MPC + MPS
1 - MPC = MPS
