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THEORY OF INCOME ANDEMPLOYMENT
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Chapter 1 An introduction to economic analysis
Chapter 2 Macroeconomic analysis: an overview
Chapter 3 Measurement of macroeconomic aggregates
Chapter 4 The simple Keynesian Model of Income determination
Chapter 5 Income determination model including money and interest
Chapter 6 fundamentals of aggregate demand and aggregate supply
Chapter 7 Money supply and banking system
Chapter 8 Aggregate supply, price levels and employment: macroeconomic equilibrium in classical
model
Chapter 9 Aggregate supply, price levels and employment: macroeconomic equilibrium in
Keynesian model
Chapter 10 Post-Keynesian macroeconomics Monetarism, rational expectations and supply-side
economics
Chapter 11 Economic fluctuations and unemployment
Chapter 12 Price stability
Chapter 13 The open economy and balance of payments: Indias balance of payments
Chapter 14 Modern macroeconomics: Fiscal policy, budget deficits and the Government Debt
Chapter 15 Modern macroeconomics: Monetary policy and Interest Rate Structure
Chapter 16 Economic growth, development and planning
Chapter 17 Trade and exchange rate policies
Chapter 18 Technology policy
Chapter 19 Industry structure and policy
Glossary
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Detailed curriculum
Overview of Macroeconomics: Microeconomics vs. Macroeconomics, fundamental Concerns of
Macroeconomic policy, Objectives and instruments of Macroeconomics, Aggregate Supply and
Aggregate Demand.
The national Income and product accounts: Gross domestic product, Two measures of National Product:
Goods-flow and earning-flow, business accounts and GDP, the problem of double counting, details of
the National Accounts.
Consumption and Investment: Consumption and saving, the consumption function, the saving function,
Investment: Determinants of Investment, The investment demand curve, shifts in the Investment
demand curve.
Aggregate demand and the multiplier: The downward-sloping Aggregate demand curve, shifts in
aggregate demand, relative importance of factors influencing demand. Output determination with
saving and investment, the meaning of equilibrium, output determination by consumption andinvestment, the multiplier, the multiplier in the AS-AD framework, the paradox of thrift.
Government, International trade,and output: Impact of fiscal policy on output, fiscal policy multipliers,
impact of international trade on GDP..
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Economics has a bold approach to solve the multi-dimensional problems facing the nation. It is useful
for eradicating poverty, unemployment and overcome problems such as inflation, stagnation, recession,
population explosion and adverse balance of payments etc. Knowledge of economics is being used for
accelerating growth in the economies of the world. Economics is a social science concerned with the use
and allocation of resources for achievement and maintenance of growth with stability.
Some important branches of economics are:
y Agricultural economicsy International economicsy Business economicsy Labor economicsy Development economicsy Natural resource economicsy Econometricsy Rural economics and rural developmenty Financial economicsy Welfare economicsy Industrial economics
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National income: concepts and measurement
Before we take up the study of theory of income determination and its fluctuations it will be useful to
understand the meaning of National Income or National Product.
National income defined
Broadly speaking, National Income or National Product is the sum total of all the commodities and
services produced by the economy as a whole during a given time, conventionally one year. In
Marshalls words, The labor and capital of country acting on its natural resources produce annually a
certain net aggregate of commodities, material and immaterial, including the services of all kind. This is
true National Income or National Dividend. It must be noted here that the value of goods and services
produced in a year must be measured in terms of money as they cannot be measured in non-monetary
terms. To overcome the difficulty, Prof. Pigou has defined as: that part of the objective income of the
community including of course income derived from abroad, which can be measured in terms of
money. According to Prof. Pigous definition only those services or commodities can be included innational income which will be exchanged in money.
Simon Kuznets defined National Income as a net output of commodity and services flowing during the
year from the countrys productive system into the hands of the ultimate consumer or into net addition
to the countrys capital goods.
There are a number of concepts pertaining to national income. For instance, Gross National Product, Net
National Product,Net National Income at Fact or Cost, Net Domestic Product at Factor Cost, Personal
Income, Disposable Income, and Real Income. One by one, these concepts are discussed below:
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Marginal Efficiency of Capital
Investment function is the second main determinant of employment within an economy. According to
Keynes marginal efficiency of capital and rate of interest are the main determinants of level of
investment. Marginal efficiency of capital is the highest rate of return over cost accruing from an
addition al asset (machine etc.). Rate of interest is determined by the supply of money and the demand
of money. Since the rate of interest is stable, marginal efficiency of capital is considered to be more
important in determining the level of investment in an economy.
Consumption function and investment function are the two major determinants of income and
employment within an economy. It has been established that consumption function is stable in short
period; hence investment function rules supreme in determining employment. We shall analyze here
the factors which determine investment.
In view of the multiple objects of spending, it is not simple to explain what determines investment in theeconomy. However, through empirical research Keynes came to the conclusion that investment in
private enterprise economy depends upon two factors; viz.; MEC (Marginal Efficiency of Capital) and
Rate of Interest.
Suppose a businessman makes an additional investment with borrowed money. He has to pay interest
on it. This is his expenditure on new investment. Even if the money belongs to him the case is the same
because now he is foregoing the interest which compares the interest he has to pay and the profit he is
expected to get on the investment. According to Keynes, the net return expected from a new unit o
capital is called Marginal Efficiency of Capital (MEC). Let us suppose that he has to pay 10% rate of
interest on the investment and the expected rate of profit or return from it is 15%. This is a worthwhileinvestment and so the inducement to invest will be more. He will continue increasing investment until
the expected rate of profit and the rate of interest become equal to each other. Thus we find that the
inducement to invest depends on Marginal Efficiency of Capital (MEC) and rate of Interest.
Investment, in Keynesian sense, does not imply purchase of existing shares or securities but it means the
production and purchase of capital goods. These capital goods include
y Plants and equipmentsy Inventoriesy Construction works either in the form of house, shop, factories or
in the form of public works like canals, dams etc.
y Net foreign investment.Classical economists believed that investment was determined by marginal productivity of capital
(actual marginal yield of capital) and rate of interest. But Keynes criticized that view. He proved that the
MEC (marginal efficiency of capital) and the rate of interest are the main determinants of investment.
Marginal Efficiency of Capital (MEC) is the highest rate of return over cost accruing from an additional
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unit of a capital asset. Thus before purchasing a new plant a businessman considers the supply price of
asset and the total net yield (profit minus depreciation) over the entire life time of the plant. By relating
these two forces he arrives at MEC (marginal efficiency of capital).
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According to Keynes, investment means real investment and not financial investment like purchase of
shares or securities. By real investment, Keynes means real capital assets like machines, plants,
equipments, factory buildings, residential construction, public works like canals, bridges, roads, etc. and
net foreign investment.
Investment may be of two types, viz., gross investment and net investment.
Gross investment refers to the
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Effective demand = total output = total income = employment
Aggregate demand functionAggregate supply function
Consumption Government expenditurInvestment
Prize of Income Propensity to
consume
Marginal efficiency of
capital
Rate of
Interest
Supply price of
ca ital asset
Prospective yield
from capital asset
Liquidity preference
of the people
The supply of
Money in the
country
Precautionary
motive
Transaction motive Speculative moti
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Paradox of thrift:
Saving is defined as an excess of income over consumption expenditure in a
given period of time.
The classical economists believed that saving is a virtue for an individual
because every time when he saves (i.e., spends less than his income), he
increases his savings. Now since savings of the society or community is the
aggregate of the savings of all the individuals in the society, it will also increase
total saving of the society and so it was considered a virtue for the economy
also.
But Keynes holds a different view. He says that
although community saving is sum total of all the individual savings in the
economy, yet individual saving does not always increase the community
savings. The reason is obvious since one mans expenditure is other mans
income. According to Keynes the classical economists ignored this truth which
led to their belief that saving is virtue both for an individual as well as for the
society. But the reality according to Keynes is that when one person has saved
by spending less on consumption, the other members of the community or
society would reduce their income (since one mans expenditure is another
mans income) by that extent and there would be dissaving to the same
degree. Thus according to Keynes, more a community tries to increase its
savings out of a given income, the less it is able to do so. Therefore, attempts
by individuals to increase their savings out of their given income by spending
les on consumption would result only in decreasing the aggregate savings of
the community. This is known as the famous PARADOX OF THRIFT.
According to Keynes more a
society tries to increase its
savings out of a given
income, the less it is able to
do so.
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Macro Economics deals with the overall dimensions of
the economic life of a country. It is the study of an economy as a whole. It is
concerned with such variables as the aggregate volume of output and income,
with the aggregate consumption, with the aggregate demand and supply, with
the aggregate saving, investment and employment etc, of an economy. It is for
this reason that macro economics is sometimes referred to as INCOME AND
EMPLOYMENT THEORY.
Micro Economics: - Micro Economics, on the other
hand deals with particular individuals, house holds, firms, industries or with the
problems of individuals prices or income distribution. Micro economics also
uses aggregates but not economywise totals.
Thus whereas Macro economics offers explanation for
the growth or decline of the entire economy. Micro economics explains the
economics motive, behavior of individual consumers and producers and the
growth and decline of individuals firms or industries. Since Micro economics
primarily concerns with the determination of prices of goods and factors of
production, it is sometimes referred to as Price Theory.
The earlier writers were greatly interested in Micro
economic analysis and as such most of the contents of traditional economic
theory is Price Theory, theory of firms and industries etc. Though Malthus,
Sismondi and Marx had made some contributions towards Macro economics
analysis yet the development of Macro economics started with the coming of
the Great Depression in the thirties of the 20th
century. The hyper inflation
after the First World War and large scale unemployment during the Great
Depression exposed the fallacy of self-adjusting nature of the Economic
System. This paved the way for the development of micro-economics. In
matters concerning national economic policy, we are more concerned with the
national economy as a whole rather than with small atomistic units. Therefore,
Macro economics is assuming greater importance than Micro Economics.
USES OF MICROECONOMICS:-
Micro economics is useful in achieving a worms eye
view of some very specific components of our economic system. Microeconomics studies only particular part of the economy but does not study the
economy in its totality.
Dr. Marshalls leading work Principles of Economics
published in 1890 is concerned mainly with Micro economics. Marginal
analysis is an important tool used in micro economics. Some of the important
laws of micro economics as law of diminishing utility, law of equimarginal
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utility, theory of consumers surplus have been directly derived from marginal
analysis.
Micro economics theories help to understand the
complex economic problems and suggest their solutions.
LIMITATIONS OF MICRO ECONOMICS:-
1 What is true of individual units may not be true in case of aggregatese.g. saving is good for an individual but saving on the part of total economy is
harmful because if every one begins to save, effective demand would be
reduced and unemployment may increase. In the same way wage cutting
would certainly reduce the volume of employment in an economy.
2 Micro economics is based on certain assumptions like other thingsremaining the same, full employment in the economy etc. But these
assumptions are not true in real life. So validity of micro economic theories is
doubtful.
But this does not lead us to conclude that micro economic analysis is not useful. In fact micro economic
analysis is useful for macro economic analysis. Many micro economic studies help to understand macro
economic problems e.g. the study of individual family budget can help us to understand the
consumption of the community.
USES OF MACRO ECONOMICS:-
Though Macro economics is relatively new but it has many uses:
1 It is useful for governments to formulate and execute successfully the various economicproblems. It is so because present governments are more concerned with aggregate
variables and not individual variables of the economy i.e. general price level, general level of
production, general volume of trade, general unemployment etc.
2 Modern economic system is so complex and complicated that some aggregative approachi.e. the study of macro economics which deals with aggregates namely national income,
national output, national expenditure etc. has to be depended upon.
3 Macro economics is also indispensible for purpose of developing micro economics. e.g. thelaw of diminishing marginal utility could have been formulated on the experience of masses
of individuals.
4 Macro economics helps the governments of developing economies in the formulation otheories o economic development.
5 Macro economics helps in international comparisons regarding national income, nationalconsumption and saving in different countries.
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LIMITATIONS OF MACRO-ECONOMICS
1 The first limitation of macro economics is the danger of excessive generalization forindividual experiences to the economy as a whole.
2 Macro economics uses aggregates on the assumption that they are homogeneous. But thisis not true always. We always do not have homogeneous aggregates.
3 An aggregate tendency may not influence all the sectors of the economy in the samemanner. A general rise in prices, for example, may not affect all the sectors of the economy
in a similar manner.
4 Sometimes aggregates results are misleading. For example if prices of agricultural productsfall by 50% while prices of industrial goods rise by 50% then there would be no change in the
general price level. This means that government should have no new price policy. But the
correct thing is that government should have a new price policy to help agriculturalists, the
prices of whose products have fallen. Thus we can say that aggregate results are sometimes
misleading.
5 There are difficulties in measuring aggregates in many cases.CONCLUSION
However, we should not have the impression that the two analyses (micro and macro) are separate.
Rather, the two are complimentary and interdependent. It is often difficult to draw a dividing line
between Micro economics and Macro economics. After all the aggregate variables are just the sums of
individual variables. So each analysis (micro and macro) is incomplete without the other. What a firm
should pay for the services of a factor of production (say labor) is a question of micro-economics as it
relates to a firm. Now the question is whether wage rate depends upon the demand of a single firm.
Obviously not, we know that wages are related and depend upon the total demand for labor in the
economy as a whole. This involves the study of Macro economics. Thus the two approaches (micro and
macro) of economic analysis are complementary and interdependent.
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BASIC CONCEPTS
1 STOCK AND FLOWA stock is a quantity measurable at a particular point of time. It has no time dimensions. e.g.
national capital is a stock because it refers to the nations capital at a particular point of
time. Similarly, wealth of the nation is a stock. Flow is a quantity that can be measured overa specified period of time say a year. Capital formation in the economy is a flow.
2 RATIO VARIABLESSuch variables express functional relationship between two variables at a given point of
time. For example relationship between income and saving or income and consumption are
known as ratio variables. The ratio between saving and income is known as average
propensity to save (APS). Symbolically it is expressed as S/Y where S is saving and Y is
income and the ratio between consumption and income is known as average propensity to
consume (APC). Symbolically it is expressed as C/Y where C is consumption and Y is income.
3 INDEPENDENT AND DEPENDENT VARIABLESSome economic variables are independent and some are dependent variables. For exampleincome is an independent variable while consumption is a dependent variable as such one
can say that consumption is a function of income. Symbolically we can express this
functional relationship as C= f(Y) where C is consumption, f is function of and y is
income. This function al relationship shows that consumption is a function of income as
income increase, consumption also increases though less than the increase in income.
4 EQUILIBRIUMEquilibrium refers to a state of balance between two variables. We can define a state of
equilibrium as a situation in which the effective demand for every good and every factor of
production is exactly equal to the supply of it. When equilibrium is achieved there is no
tendency to change from it. So it can be said that equilibrium is the best situation.5 EX-ANTE AND EX-POST
This Basic concept is used in saving and investment. Ex-ante means, what we plan or
anticipate doing and Ex-post means what we have actually achieved or done.
For example, economists classify saving and investment into two parts:
i EX-ante saving and investment i.e. what they plan to save and invest.
ii Ex-post savings and investments i.e. what they actually save and invest.
Our plan to save and invest depends upon many independent variables like income, prices,
future outlook etc. So saving may or may not be equal to investment.
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KEYNES PSYCHOLOGICAL LAW OF CONSUMPTION
Keynes psychological law of consumption occupies a pivotal position in the determination
of full employment in an economy.
From the early start of human civilization, it was considered a virtue to keep consumption at
the barest minimum. But nobody knew about the series of chain reactions of holding
consumption in check. Keynes analyzed the consumption function in a scientific way. He
calls it psychological law of consumption. The law states Macro behavior of consumers in
the short period. It states that there is a tendency of people to spend on consumption goods
the full amount of increase in income. This tendency is known as consumption function or
propensity to consume.
The statement of Keynes psychological law of consumption consists of three propositions
which are inter-related.
1 The first proposition is that with an increase in the aggregate income of an economy, itsexpenditure on consumption goods also increases but by less than the increase in
income. The reason is quite obvious. As the income increases, more and more wants of
the people are satisfied and thus they would be less keen to spend more. Thus the
increase on consumption expenditure would be less than the increase in income. The
balance is saved.
2 The second proposition is based on the first proposition. It says that spending andsaving are complementary. Income is always divided in some proportion between
expenditure and saving. We have said in the first proposition that as income increases
consumption expenditure would increase but less than the increase in income. It shows
that a part of the income which is not spent is saved. Thus income and expenditure go
side by side. Hence when income increases, the whole is not spent. A part is spent on
consumption and a part is saved.
3 The third proposition is derived from the first two propositions. It says that whenincome increases both consumption expenditure and saving increase. It is because when
income increases, consumption expenditure also increases though less than the
increase in income. This will also lead to an increase in saving. Thus it is clear that as
income increases both consumption and saving increase.
LIMITATIONS
Keynes psychological law of consumption is based on the following three important assumptions or
limitations:
1 It is assumed that only income of the commodity changes and other variables like incomedistribution, prices, population, etc. (i.e., propensity to consume) does not change. The
assumption is made in order to study the effect of the change in income on consumption
and saving. If these variables were to change with the change in income, Keynes law of
consumption would be shattered.
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2 It is assumed that conditions remain normal. By normal conditions we mean that thereshould be no hyper-inflation, or any other abnormal condition like war since during
abnormal condition the law may not operate.
3 It is assumed that there is no State interference in the free working of the economic forcesin the economy. Thus Keynes law of consumption holds good only in a capitalistic laissez
faire economy.
Implications of Keynes law of consumption
Keynes law of consumption has stated a very important tendency that as income increases; the
consumption also increases, but not as much as the increase in income. The increase in consumption
expenditure is always less than the increase in income. As a result of it the economy becomes low
consuming and high saving economy.
Another implication of Keynes law of consumption is that propensity to consume is stable and the
marginal propensity to consume is less than unity. It shows that income might increase but
consumption lags behind. If this propensity to consume is not increased, the marginal efficiency of
capital will fall and this would lead to the fall in the expected rate of profit. The demand of investment
will fall and the entire economic progress of the economy will be held up. Hence the State must
interfere in order to increase MPC.
Keynes law of consumption explains clearly that since consumption declines with the increase in
income, it is necessary to increase investment. If this is not done, increased output and employment will
not be profitable. Hence the law emphasizes the importance of investment.
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THE THEORY OF INCOME AND EMPLOYMENT
The classical economists, following Says Law of Markets assumes the existence of full employment in
an economy and the economy will normally be producing output and income corresponding to the level
of full employment. Occasional lapses from full employment are taken as abnormal and are considered
to be self-adjusting as there is always a tendency towards full employment so long as there is free play
of economic resources. Keynes has criticized the classical theory of income and employment on various
grounds. Keynes had developed his own theory of income and employment. According to Keynes, level
of income and employment in an economy depends upon the effective demand. Effective demand is the
point where aggregate demand and aggregate supply are equal. Effective demand consists of
consumption function (consumption expenditure) and investment function (investment expenditure).
Thus effective demand is the sole determinant of income and employment in an economy.
In this chapter we shall discuss both the Classical and Keynesian theories of income and employment.
The classical theory of Income and employment
Economists assume the existence of full employment. Occasional lapses from full employment are taken
as abnormal and are considered to be self-adjusting. As there is always a tendency towards full
employment so long as there is free play o economic forces. It is for this reason that they advocated for
laissez Faire policy. Any interference with the free play of economic forces would fail to bring about full
employment in an economy. The law states, Supply always creates its own demands. Thus according
to classical view, there can never be involuntary unemployment. However, they admit a certain amount
of voluntary and frictional unemployment. Voluntary unemployment is due to the refusal of work by the
workers for want of higher wages etc. Frictional unemployment arises due to such causes as ignorance
or job opportunities.
Statement of Says Law of Markets. The law of markets is propounded by J.B.Say, a French economist.
This law is the very basis of the classical theory of employment. Say rejects the old ideas that
overproduction and unemployment are of common occurrence. He believes that there can never be
general overproduction and hence general unemployment. It is so because according to his law of
markets, Supply always creates its own demand. He further says that it is production which creates
market for goods.
Explanation of the law. Say explains the law as follows:
According to him, demand of goods comes from the factor income (or householders income). The
factor income is created with every process of production. So every increase in production also
increases the factor income and thereby the demand for goods. In other words, we can say that every
increase in output generates an equivalent amount of purchasing power in circulation. This new
purchasing power is ultimately utilized in the purchase of increased output. So Says law, by saying that
supply creates its own demand, denies the possibility of deficiency of aggregate demand and hence the
possibility of overproduction and unemployment. Thus general unemployment is impossible. If at all
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there is any unemployment, it must be a temporary one and it will be cured automatically after
sometime.
Implication of Says Law of Market. Below we give some implications of Says Law of Markets. In fact,
they are the important features of the classical theory of income and employment.
1 To begin with, Says Law states that there is automatic adjustment between production andconsumption. There is no need for the Government to interfere in the working of the
economic system. If at any time supply increases, the factor income also increases which
raise the demand and soon there will again be equilibrium between supply and demand.
2 Secondly, Says Law states that since there can never be general production, there is nogeneral unemployment. If there is some unemployment, it is purely of temporary nature
and can be removed through money wage cuts. Such money wage cuts will make labor
relatively cheap and hence will lead to more employment. Thus through money wage cuts
the economy can attain the stage of full employment.
3 Thirdly, Says Law states that as long as there are unemployed resources in the economy, itis useful to employ them. The employment of these resources will increase production and
so they will cover their own costs. Hence the economy will work at full employment level.
4 Fourthly, Says Law states that saving is just a form of investment. That is whatever is savedis automatically invested. Thus there is equality between saving and investment and this
equality between the two is brought through changes in the rate of interest.
5 Lastly, Says Law states that since every economy is self-adjusting, the Government need notinterfere in economic matters. This will increases economic welfare of the economy.
Criticism of the law. In the first place, Dr. Keynes in his General Theory has criticized the classical
assumptions of full employment which is essentially based upon Says Law of markets. According to
Keynes, inequality of income and wealth has always been the most outstanding feature of every
capitalist society. The rich have always so much wealth that they cannot consume all. On the other
hand, the poor have so little wealth that they cannot fulfill all their wants. The result will be that the
total consumption or demand will fall short of total output and so deficiency in aggregate demand will
be created. This will result in overproduction and hence unemployment.
Secondly, Keynes does not accept Says Law which states that supply always creates its own demand.
This law is based on the assumption that the economy spends all its income on the purchase of goods so
that the entire output is sold. But this is not so in real life. In every economy people also save and hence
they do not spend all what they earn. Thus the demand for goods will fall short to the extent of savings.
So supply here will not be able to create its own demand. This will lead to overproduction and
unemployment. Further, Keyness doctrine of consumption function has shattered Says law of markets.
Keynes has provided that consumption lags behind income. So marginal propensity to consume is less
than unity; overproduction may arise and cause unemployment.
Thirdly, the great depression of the thirties (1929-1932) has proved the fallacy of Says law of markets
that supply creates its own demand. During the depression stocks of goods remained wit the producers.
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There was none to demand these goods. It shows that there was deficiency in aggregate demand in
relation to the aggregate supply. It means that supply could not create its own demands and hence Says
law of markets stands rejected.
Lastly, Says law of market is rejected on the basis of everyday experience. The law states that
involuntary unemployment can never exist. If at all there is unemployment, it is temporary and will cureitself in course of time. Hence Says law assumes full employment in the economy. It means that at the
existing wage rate every laborer can get employment. But, on the contrary, we see that there is always
some involuntary unemployment. People demand work but work is not available to them.
Points to remember:
The classical economists following says law assume the existence of full employment.
The law of market was propounded by J.B.Say. The law states that supply always creates its own
demand. Every increase in output generates an equal amount of purchasing power.
The implication of Says law is that since supply creates its own demand, there is no possibility of
deficiency of aggregate demand and hence no possibility of overproduction and unemployment.
Keynes has criticized the law on various grounds. In his General Theory he has proved the fallacy of the
law that supply creates its own demand.
Keynesian theory of Income and Employment
(Determination of national income by equality of saving and investment)
During the pre-Keynesian era, existence of full employment was presumed. Occasional lapses from fullemployment were considered to be self-adjusting according to the Says law of markets (i.e., supply
always creates its own demand). But the existence of involuntary unemployment on a large scale
challenged the truth of full employment thesis. Keynes in his General Theory of Employment, Interests
and Money re-examined the determinants of income and employment.
The concept of aggregate demand is in the ex-ante sense. In other words, aggregate demand tells us
the total quantity of goods and services that people want to by (unlike in national income accounting).
Equilibrium level of output is that level o output at which the total desired spending on goods and
services (desired aggregate demand) is equal to the actual level of output (y).
According to Keynes, effective demand is the sole determinant of income and employment. Effective
demand is determined by the forces of aggregate demand and aggregate supply. Aggregate demand
consists of two elements. Viz., consumption expenditure (consumption function) and investment
expenditure (investment function).
So we can say
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Y=C+I
Aggregate demand schedule
(Rs. in crores )
Income Consumption Investment Aggregate demand
(Y) (C) (I) AD
0 25 50 75
50 50 50 100
100 75 50 125
150 100 50 150
200 125 50 175
250 150 50 200
Aggregate Supply Schedule
(Rs. in crores )
Income Aggregate Supply
(y) (AS)
0 0
50 50
100 100
150 150
200 200
250 250
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Income consum- Investment Saving Agg. Agg.
ption demand Supply
(y) (C) (I) (S) AD AS
0 25 50 -25 75 0
50 50 50 0 100 50
100 75 50 25 125 100
150 100 50 50 150 150
200 125 50 75 175 200
250 150 50 100 200 250
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Classical versus Keynesian analysis of income determination
Only three differences are revealed in the formal structure of the two systems of macro analysis.
(i) Keynes rejected the neo-classical function of supply of labour and assumed rigid wages(W=w ) for situation of less than full employment;
(ii) Keynes added the speculative demand for money to the neo-classical transactions andprecautionary demand for money and
(iii) Keynes assumed that income would be far more important determinant of saving(consumption) than the neo-classical rate of interest
These three theoretical innovations constitute Keynes denial of the neo-classical automatic mechanism
generating employment.
1. The classical believed in the existence of full employment in the economy and a situation of lessthan full employment was regarded as abnormal. On the other hand, Keynes considered the
existence of full employment the existence of full employment as a special case. His notion of
underemployment equilibrium is indeed revolutionary reflecting real life situation.
2. The classical analysis was based on Says law of market that supply creates its own demand.The classical school thus ruled out the possibility of overproduction. Keynes propounded the
opposite view that demand creates its own supply. To Klein, the revolution was solely the
development of a theory of effective demand.
3. The classical economics was based on the laissez-faire policy of self-adjusting economic systemwith no government intervention. But Keynes discarded the policy of laissez-faire and he
favoured state intervention.
4. Pigou, one of the foremost classical economists, favoured the policy of wage cut to solve theproblem of unemployment. But Keynes opposed such a policy both from the theoretical and
practical points of view. Theoretically, a wage-cut policy increases unemployment instead of
solving it. Practically, workers are not prepared to accept a cut in money wage.
5. The classicists emphasized the importance of saving or thrift in capital formation for economicgrowth. To Keynes saving was a private virtue and a public vice.
6. The classical economists failed to provide an adequate explanation of the cyclical phenomena.They could not explain the turning points of the business cycle satisfactorily and generally
referred to boom and depression. Keynes real contribution to business cycle analysis lies in his
explanation of turning points of the cycle. In this field as opined by Mrs. Joan Robinson
Keynesian revolution commands the field.
7.
The classicalists artificially separated the monetary theory from the value theory. Keynes, on theother hand, integrated monetary theory and value theory through the theory of output. He
regarded the rate of interest as a purely monetary phenomenon.
8. Classical economics was a microeconomic analysis which the orthodox economists tried to applyto the economy as a whole. Keynes, on the other hand, adopted the macro approach to
economic problems. Keynes approach to economic problem was dynamic rather than static. The
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fundamental flaw in Pigous analysis is that he applied partial equilibrium analysis, which is valid
in the case of individual industry. But Keynesian analysis is general equilibrium analysis.
9. The classical economists being the votaries of laissez-faire policy had no faith either in fiscalpolicy or in monetary policy. They believed in the balanced budget policy. Keynes, on the other
hand stressed the importance of deficit budget during deflation and surplus budget during
inflation along with cheap money and dear money policies respectively. He was thus a practical
economist whose models clarify both inflationary and deflationary episodes and prosperous and
depressed economies.
Despite the theoretical and practical significance of the Keynesian theory, it has its own weaknesses and
failures. Many economists consider his analysis less than adequate for meeting such special problems lie
cyclical forecasts and controls, persistent inflation, maintenance of full employment booms, secular
growth, non-linear structural relations and macro functional distribution.
Income determination model including Money and Interest: IS LMmodel
In the earlier models the focus was entirely on the goods market. Certain simplifying assumptions were
made like the investment being autonomous, thereby completely avoiding the role of interest rates (and
money supply) in determining the level of income. But, it is a known fact that interest rates and money
supply have a major role to play in the economy. Monetary policy affects the economy first by affecting
the interest rate and then by affecting aggregate demand. An increase in the money supply reduces the
interest rate, increases investment spending and aggregate demand, and thus increases equilibrium
output. Changes in monetary and fiscal policy affect the economy through the monetary a fiscal policy
multiplier.
We study two markets the goods market and they money market and their linkages through two
economic variables interest rats and income. A two-market two variable model is developed with
relation to the economic operation of each market.
The IS-LM model presented in this chapter is the basic model of aggregate demand that incorporates the
money market as well as the goods market. It lays particular stress on the channels through which
monetary and fiscal policy affect the economy. The model is broadened by introducing interest rate as
an additional determinant of aggregate demand.
We first have to derive the IS curve for the goods market. The IS curve shows combinations of interest
rates and levels of income such that the goods market is in equilibrium. Increases in the interest rate
reduce aggregate demand by reducing investment spending. Thus, at higher interest rates, the level of
income at which the goods market is in equilibrium is lower: The IS curve slopes downwards.
Then, we shall study the asset market and derive the LM curve. The demand for money is a demand or
real balances. The demand for real balances increases with income and decreases with the interest
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rates, the cost of holding money rather than other assets. With an exogenously fixed supply of real
balances, the LM curve, representing money market equilibrium, is upward sloping.
Next, the interest rate and level of output are jointly determined by simultaneous equilibrium of the
goods and money markets. This occurs at the point of intersection of the IS and LM curves.
Finally, The IS and LM curves together determine the aggregate demand schedule. The aggregate
demand schedule maps out the IS LM equilibrium holding autonomous spending and the nominal
money supply constant and allowing prices to vary.
In the previous chapter we looked at a simple model of the goods market and found the value of GDP at
which equilibrium output equaled aggregate demand. We had one market goods cleared by one
variable GDP(Y). The first thing we do in this chapter is introduce the interest rate into the goods
market (via investment demand), leaving us with one market and two variables, GDP and the interest
rate (i). We will eventually call the goods market equation the IS curve.
Next we introduce the money market, where equilibrium is determined when the demand for moneyequals the supply of money. The demand of money depends on income and interest rates. The supply of
money is set by the Central Bank. Solving for equilibrium in the money market again gives us one market
and two variables, GDP and the interest rate. We will eventually call the money market equilibrium the
LM curve.
Finally, we put the goods and money markets together, giving us two markets (goods and money) and
two variables (GDP and the interest rate). The IS-LM model finds the value of GDP and the interest rate
which simultaneously clear the goods and money markets.
The good market and the IS curve
In this section we derive a goods market equilibrium schedule, the IS curve. The IS curve (or schedule)
shows combinations of interest rates and levels of output such that planned spending equals income.
The IS curve is derived in two steps. First, we explain why investment depends on interest rates. Second,
we insert the investment demand function in the aggregate demand identity just as we did with the
consumption function in the last chapter and find the combination of income and interest rates that
keep the goods market in equilibrium.
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The L-M Curve
The L-M schedule sets out all of the possible combinations of real output, y and the rate of interest, r
consistent with equilibrium in the money market.
The money market will be in equilibrium if
MD = MS
where
MD is the Demand for Money
and MS is the Money Supply
In the foregoing analysis, we will be examining the demand and supply of real balances.
i.e. MD/P = MS/P
where P is the price level
MD/P is the demand for real balances
MS/P is the real money supply
To make progress, we will examine the determinants of real money demand and real money supply.
The Demand for Money
In general, we can write that
MD/P = g(y, r)
where y is income and r is the rate of interest.
This expression indicates that the demand for real money balances depends on real income and the rate
of interest. To examine this more closely, we follow Keynes and partition money demand into 3
components or motives for holding money. Viz
y Transactions motivey Precautionary motivey Speculative motiveThe Transactions Motive for Holding Real Balances
Let the real money demand for transactions purposes be MDT/P
MDT is the amount of money carried around by an agent in a period in order to undertake known
transactions.
Keynes argued that the demand for real transactions balances will depend on the level of real income.
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i.e. MDT/P = f(y)
As real incomes rise, people will be able to afford to satisfy a greater range of wants and needs and will
plan to make a greater level of known expenditures in a period.
Therefore (MDT/P)/y > 0
This expression says that, as real incomes rise, the demand for real balances for transactions purposes
will also rise.
The Precautionary Motive for Holding Real Balances
Let the real money demand for precautionary purposes be denoted by
MDP/P
Where MDP is the amount of money held by an individual in a period in order to cater for unforeseen or
unpredictable transactions.
The demand for real balances for precautionary purposes will also depend on the level of real income.Thus
MDP/P = g(y)
As real incomes rise, the type and price of unforeseen or impulse purchases will also increase. Thus,
(MDP/P)/y > 0
i.e. as real incomes rise, the demand for real precautionary balances will likewise rise.
The Speculative Motive for Holding Real Balances
Denote the money demand for speculative balances as
MDS/P
It is this motive for holding money that links money demand to the rate of interest. Recall that the
classical economists regarded the interest rate as being determined in the capital market by
The flow of savings (supply of loanable funds)
The flow of investment (demand for loanable funds)
Classicists viewed that the rate of interest adjusted quickly to balance savings and investment.
Keynes rejected this view by arguing that the rate of interest was determined in the money market
There are several accounts/models which can be deployed to justify a relationship between MDS and r.
We will consider a simple account based on the notion of the Opportunity Cost (OC) of Holding Money.
There is a slightly fuller account in Appendix L-M
The opportunity cost of holding money can be regarded as what is lost by not holding your wealth in the
form of interest bearing assets. In simple approaches, there are 2 ways of holding wealth
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Money pays no interest
Bonds pay a rate of interest per period
Clearly, the OC of holding money is the interest payments foregone
N.B
. You can conceptualise money as notes, coins and zero interest bearing bank accounts such ascheque accounts. The alternative to this would be to hold interest bearing accounts (deposit or savings
accounts) or less liquid assets such as bills, bonds shares etc.
The argument is simple. If interest rates rise, the OC of holding money rises and people will hold less
money and more bonds. We can represent this insight graphically in Figure 1. At a low rate of interest,
r1 the incentive to switch from money into bonds is not great and people will tend to hold (demand)
more money, MDS1. At a high interest rate, r0 , the OC of holding money is high and people will
economise on money holdings (MDS0)
The Supply of Money
The real money supply / supply of real balances is denoted by MS/P. As prices rise the real money supply falls
and vice versa.
The money supply is taken to be exogenously determined and controlled by the monetary authority / central
bank. Thus, the money supply does not depend on either r or y and is a policy instrument which can be
changed at the behest of the authorities.
MD
S1/PMD
S0/P
MD
S/P
r1
r0
Figure 1 - Speculative Demand for Money
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Equilibrium in the Money Market
We can take our expressions for transactions, precautionary, speculative balances and the money supply and
set them out in Figure 2 . Here, re is the rate of interest/ price of bonds at which agents in the economy
willingly hold the issued real money stock.
Changes in the Money Supply
Suppose the Central Bank decided to increase the money supply from MS0 to M
S1. This would cause the money
supply line to shift out as seen in Figure 3. The money supply schedule shifts but the money demand curve is
unaffected because income, which determines transactions and precautionary holdings has not changed
r
MD/P
re
Figure 2- Equilibrium in the Money Market
MS/P
MD/P
MD
S/P
MD
T/P +
MD
P
MD/P = M
S/P
MD/P
& MS/P
MS1/PM
S0/P
re
0
re
1
r
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Following the increase in the money stock, money holdings are greater than those required to finance known
and precautionary transactions. Agents will attempt to purchase bonds driving up their price and down the
rate of interest from re
0 to re
1. The price of bonds will rise/ rate of interest fall until the increased money stock
is willingly held.
Thus, changes in r, the rate of interest, are the mechanism which re-equilibriate the money market. There is noa priori reason why r should also serve to equate savings and investment as the classical school believes.
Deriving the L-M Schedule
The L-M curve is defined as all values of r and y consistent with equilibrium in the money market. This suggests
that to derive the L-M schedule we should vary y and establish what happens to r in order to restore money
market equilibrium.
If y increases, both the transactions and speculative demand for money will increase out of a fixed real money
stock. This will require agents to sell bonds in order to finance higher known and precautionary purchases. If
there is increased selling pressure on the fixed stock of bonds, then the price of bonds will fall (i.e. the interestrate will rise). This is set out in Figure 4a for the case when income rises from y0 to y1 to y2 and where we
assume a linear money demand curve
We obtain the L-M curve by mapping r versus y. As real income increases the transactions and
precautionary demand for real balances increases out of a fixed real money stock. This necessitates
bond sales which drive down the price of bonds/ up the rate of interest in order to restore equilibrium in
the money market.
r
MD/P
Figure 4a Deriving the L-M Curve
MD/P (y=y2)
MS/P
MD/P (y=y1)
MD/P (y=y0)
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What Determines the Slope of the L-M Schedule
The slope of the L-M curve depends on
1. the interest sensitivity/ elasticity of the speculative demand for money2. the income elasticity of money demandYou should attempt to construct L-M schedules for different interest and income elasticities
What causes the L-M Schedule to Shift
The L-M curve is sets out all the combinations of r and y consistent with equilibrium in the money market.
Equilibrium in the money market results when MD/P = MS/P. The L-M curve is derived by varying real income
given a fixed real money stock and examining the changes in r required to maintain money market equilibrium.
If the real money stock changes, then a new L-M curve will be engendered.
The real money stock is the nominal money supply deflated by some measure of the price level. Thus:-
1. A rise in the real money stock results when either the nominal money supply rises or the price level falls.2. A fall in the real money supply results when either the nominal money supply falls or the price level rises.Consider a rise in the real money supply from (MS/P) to (MS/P)*.
r
y
Figure 4b Deriving the L-M Curve
y0 y1 y2
r0
r1
r2
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At the original level of the money stock, MS/P, the equilibrium rate of interest when y = y0 is r0. As incomeincreases to y1, the money demand schedule shifts up to M
D/P(y1). The higher money demand from a fixed
money stock causes agents to sell bonds to obtain money for increased transactions and precautionary
purposes. This causes the interest rate to rise until the money market returns to equilibrium at the higher
interest rate, r1. Mapping r versus y we obtain L-M.
When income is y0, an increase in the money stock from (MS/P) to (MS/P)* causes an excess supply of money
for transactions and precautionary purposes. Agents attempt to purchase bonds, increasing the demand for
bonds from a fixed supply. This drives up bond prices and down interest rates from r0 to r0* until the expanded
money supply is willingly held.
If income rises from y0 to y1 and the money supply is at the higher level (MS/P)*, there is an increased demand
for money for transactions and precautionary purposes. Agents attempt to sell bonds driving down the bond
price and pushing up the rate of interest from r0* to r1*. The L-M schedule for the expanded money stock is L-
M*.
MD/P(y0)
MD/P(y1)
y0 y1
r0*
r0
r1*
r1
(MS/P) (M
S/P)*r
real MD
& Ms
r
y
Figure 5: An Increase in the Money Stock causes the L-M
Curve to Shift Outwards.
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Thus, at any level of income, lower interest rates are necessary to equilibriate the money market given a rise in
the money supply. The higher money stock results in excess balances for transactions and precautionary
purposes which agents use to attempt to increase purchases of bonds. This drives up bond prices and down
the rate of interest. Therefore at any level of income, interest rates must fall to restore money market
equilibrium. Hence, a rise in the real money stock causes the L-M schedule to shift outwards.
Explain the concept of effective demand. In what respect is it important for the determination of level of
employment?
Keynes, measured employment in terms of national output or income. Thus greater the output greater shall
be the employment, and lesser the output lesser shall be the employment. But national output, in turn ,
depends upon effective demand.
In equilibrium,
Effective demand =National output or income =Employment
By effective demand we mean not mere desire but desire backed by ability and willingness to buy both consu
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KEYNESIAN THEORY AND UNDERDEVELOPED ECONOMIES.
Keynesian theory of employment does not apply in case of underdeveloped economies. The main
reason is that Keynes advocated his theory in the context of developed countries such as U.K., U.S.A etc.
Keynes built his theory on certain assumptions keeping a developed economy in mind but those
assumptions do not hold good in case of underdeveloped economies as their problems are quite
different from those of developed economies. The nature of unemployment in under-developed
countries is quite different. In the developed countries the unemployment is generated due to lack of
effective demand. Such unemployment is the emergence of conditions of depression which is purely
temporary and this type of unemployment is called cyclical unemployment or involuntary
unemployment. He suggested three important measures to be taken by the government to remove this
type of unemployment, namely (a) Supervision; (b) Public works programme; and monetary and fiscal
measures. The above tools or remedies to remove cyclic unemployment work well in case of developed
countries but do not apply in case of underdeveloped countries. The main reason for the non-
applicability of Keynesian tools or remedies in underdeveloped countries is that Keynes advocated his
theory in the context o a developed economy which was caught in the grip of depression and was facing
cyclical unemployment which is purely a temporary phenomenon and can be cured by the Keynesian
tools as said above. But the nature of unemployment in underdeveloped economies like India is quite
different from that of the developed economy.
Nature of unemployment in underdeveloped countries: The main cause of unemployment in the
developed countries is the lack of effective demand which is the result of less expenditure on
consumption and investment goods.
Because of less demand, volume of production fall in factories and consequently unemployment follows.
This type of unemployment is purely temporary and can be removed by Keynesian tools or remedies like
public works programme, monetary and fiscal policies. These measures will increase the effective
demand and remove the unemployment.With the help of these measures more money can be injected
in the country which in turn would increase the purchasing power of the people and thereby increase
the effective demand. The increase in effective demand would increase the level of unemployment.But
the nature of unemployment in underdeveloped countries is quite different from that in developed
countries. There is the chronic and permanent unemployment in underdeveloped countries.
Unemployment in underdeveloped countries arises mainly due to lack of capital resources and
technology. As a result of lack of capital resources people remain unemployed permanently. Further,
underdeveloped countries suffer from over-population and being predominantly agricultural countries
all the members of the family work on agricultural land but actually all of them are not required to work
there. Such people, no doubt, are seen working but actually there is no work for them and of these
people are removed from the work; there would be no loss in production. Thus these people are
unemployed in disguise and this type of unemployment is known as disguised unemployment and it
exists on a very large scale in underdeveloped countries. Therefore, Keynesian tools fail to remove
unemployment in underdeveloped countries.
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Keynesian assumptions do not hold good in underdeveloped countries:
Further, Keynes advocated his theory on certain assumptions which are valid in developed countries but
do not hold good in underdeveloped countries and for this reason also Keynesian theory is not
applicable in underdeveloped countries.
(1) Keynes assumption of unemployment is of short period (as exists in developed country) but inunderdeveloped countries the problem of unemployment is chronic and permanent.
(2) Keynes prescribes the remedy for cyclic unemployment which is due to lack of effective demandbut nature of unemployment in an underdeveloped country is different. Here there is disguised
unemployment and chronic unemployment due to lack of capital resources and technology.
(3) Keynes assumes that both labor and capital remain unemployed. This type of situation can beseen in developed countries but not in underdeveloped countries. In underdeveloped countries
it is labour that remains unemployed and not the capital since there is always a lack of capital.
(4) Keynes advocated his theory on the assumption of the closed economy which does not haveeither imports or exports but this assumption does not hold good in underdeveloped countries
because these countries have trade relation with other countries also.
Keynesian tools and remedies do not apply to underdeveloped countries:
1 Increase in effective demand: According to Keynes the level of effective demand determinesthe level of employment in a country. Thus to increase the employment effective demand
must be increased by raising the investment. This is true in a developed country but not in
an underdeveloped country since MEC (Marginal Efficiency of Capital) i.e. business
expectation is low and also other necessary factors needed for investment are lacking. So as
a result of increase in money supply, money income increases but the production does not
increase and consequently prices start increasing. Thus in an underdeveloped economy,
creation of credit money or deficit financing would not be enough to simulate investmentand have monetary measures simply to generate inflationary forces. Hence in
underdeveloped countries level of employment cannot be increased by increasing the
effective demand.
2 Propensity to consume: Keynes assumption which is based on a developed economy is thatwhen income increases, propensity to consume decreases and propensity to save increases.
But this is not true in case of an underdeveloped country. In underdeveloped countries the
propensity to consume does not increase with the increase in income. It remains equal to
unity i.e. it remains very high when income increases. The reason is that the standard of
living in these countries is very low and most of the expenditure is incurred on food grains.
These countries being dominantly agricultural countries cultivate more food grains andconsume more for self-consumption than for market. The result is that even with increase in
consumption, production does not increase and as a result of it the price starts rising.
3 Investment multiplier: It is an important tool of Keynesian theory. The existence of non-monetized economy also presents a problem in underdeveloped countries. So even though
the marginal propensity to consume is higher in these countries and therefore multiplier
should be higher yet in actual practice it fails to stand, because the increased demand is
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directed towards consumption goods (food etc.) industry which fails to offer effective
additional employment. Since the supply curve of food is highly inelastic in short period,
increase in the value of output need not necessarily lead to an increase in the volume of
output.
Underdeveloped countries are primarily agricultural countries. The agricultural producer is reluctant toact in the same way as the entrepreneur in developed countries as visualized by Keynes. Thus
investment multiplier does not function properly. The multiplier principle functions only when the
following assumptions are satisfied:
1. Existence of involuntary unemployment2. An industrial economy with rising supply curve3. Excess capacity in consumption good industries4. Elastic supply of working capital
But these assumptions do not hold good in case of underdeveloped countries. According to the view of
Mrs. Robinson, the existence of disguised unemployment introduces complications in the formal
scheme of General Theory of Employment. Where disguises unemployment prevails, increase in
income increases consumption not saving. Thus the working of multiplier theory fails and savings fail to
be equal to investment due to hoarding habit of the people in the underdeveloped countries. Household
enterprises prevail instead of market economy. They produce more for self consumption rather than or
market. The result is that even with increase in consumption, production does not increase and
consequently prices begin to increase. In the opinion of Dr. V.K.R.V.Rao the application of Keynesian
theory of employment in underdeveloped countries will lead to increase in prices rather than increasing
income and employment.
Thus, we conclude that Keynesian theory of employment is not applicable to underdeveloped countriesor two reasons: (i) assumptions of Keynesian theory do not hold good in these countries; and (ii)
Keyesian tools or remedies are not applicable to these countries.
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