An outline of Keynesian Theory of Employment

Dr. Gopalakrishna B.V.

Faculty in MBA,

SDM, Mangalore.

J. M. Keynes

John Maynard Keynes was the greatest and the most eminent economist of the mid-twentieth century.

During the period 1929-33 - Great Depression in the capitalist countries which caused huge unemployment, low income and low production.

His famous book “General Theory of employment, interest and money” published in 1936” challenged the validity of the classical theory of employment.

He is not only criticized the classical theory of income and wealth but also - propounded new theory of employment and output Keynesian Revolution

This book gives a systematic treatment to the theory of employment, explaining the real causes of unemployment.

He tries to provide that under employment equilibrium is the normal features of capitalist economy.

Keynes advocated many concepts like Propensity to Consume, Multiplier, Marginal Efficiency of Capital and Liquidity Preference.

Keynesian theory of income and employment• Keynesian theory of income and employment is a - short

period – where the stock of capital techniques of production, efficiency of labour, size of population have been assumed to remain constant.

• In this theory, the amount of employment depends upon the level of national income and output.

• This is because, given the amount of capital, technology and labour efficiency increase in income and output can be obtained by employment of more labour.

• Unemployment causes due to lack of effective demand/deficiency of outlay on consumption and investment function.

• The level of income and employment in an economy at any given time depends upon the effective aggregate demand.

The Keynesian theory of employment touches all aspects of the economy as a whole and hence his theory can be called macro economics.

According to him, national income determined the level of employment – greater the national income, higher will be the level of employment and lower the level of national income, the lower the amount of employment.

He strongly argues that Government intervention must be required at time of depression – where level of income, employment and output at the lower level – lack of aggregate demand.

Keynesian concepts

1. Fundamental Equation

2. Principle of Effective Demand

3. Consumption Function

4. Marginal Efficiency of Capital (MEC) and rate of interest

5. Multiplier

6. Trade Cycle

7. Fiscal Policy

1. Fundamental Equation The fundamental equation of Keynes is

Y = C + IY = National IncomeC = ConsumptionI = Investment

According to Keynes, the level of national income determines the level of employment.

If NI increases the level of employment could also be increased.

So that, increasing the level of NI employment also increases and thereby the economy should be move from the under-employment to full employment condition.

According to Keynes the three constituents of national income are – consumption, investment and expenditure

Government expenditure plays a dominant role and according to Keynes formula

Y = C + I + GY = National Income C = Consumption I = Investment G = Government Expenditure.

Keynes total income depends on total employment – this depends on effective demand in the economy.

Effective demand depends on consumption expenditure and investment expenditure.

Consumption depends on income and propensity to consume – Investment depends on Marginal Efficiency of Capital (MEC) and rate of interest.

Level of Effective Demand

Consumption Investment

Level of Employment and Income

Size of Income

Propensity to Consume

Rate of Interest

MEC

Supply of Money

Liquidity Preference

Expectation ofProfit

Replacement cost

Transaction Motives

PrecautionaryMotives

SpeculativeMotives

Government Expenditure

2. Principle of Effective Demand The level of income and employment in a country at

any given time depends on effective demand. An increase in effective demand will lead to an

increase in production and income and it leads to increases in employment.

A decrease in effective demand will result in contraction of production and income and in the level of employment.

Effective demand is the point at which aggregate demand will be equal to aggregate supply.

It is the equilibrium point determined by the equality of aggregate demand function and aggregate supply function.

According to Keynes, effective demand is equal to the total volume of output available in the economy

• The aggregate demand function includes consumer and capital goods.

• Keynesian theory of employment related to short period – where technique of production as unchanged.

• Therefore, an increase in the output of the economy is possible only if there is an increase in employment.

• Thus according to Keynes – effective demand = total output = employment = total income = consumption expenditure + investment expenditure.

• Consumption expenditure is determined by two factors – level of income and the propensity to consume.

• Investment expenditure depends upon the marginal efficiency of capital (MEC) and rate of interest.

• Deficiency of effective demand means – when increases in the national income, consumption is not increasing proportionately, thereby creating gap between income and consumption (MPC < 1).

• This gap should be covered by an increase in investment.• Therefore Y = C + S

Y = C + S S = I

• Therefore, level of employment in the economy at any time depends on the volume of effective demand.

• These effective demand determined by aggregate demand function (ADF) and aggregate supply function (ASF) – where both ADF & ASF intersect each other that point is called as equilibrium.

• This equilibrium point is known as fully employment equilibrium

3. The Propensity to Consume Consumption function or propensity to consume

forms a vital part of Keynesian analysis. As we studied that effective demand depends on

consumption and investment in the economy. Consumption is one of the important determinants of

level of employment. According to Keynes, consumption depends on two

factors size of income and propensity to consume. The amount of income which is spent on

consumption out of a given total income is known as propensity to consume.

Propensity to consume expresses a relationship between income and consumption.

When income increases, consumption are also increases not as much of income increases – a part of income is likely to be saved. So consumption will be less than income.

An individual/family/community will spend a part of the income on consumption – it may be 70% - 80% of the income and the rest may be saved.

The propensity to consume depends on various factors such as price level, interest rate, stock of wealth and several subjective factors remains constant (short period).

Thus Keynesian consumption function depends on level of income.

C = a + bYab = constant

C = consumption represents MPC

Y = level of income

C1

C2

Y1 Y2

P

R

C + Y

Income

Con

sum

pti

on

• The propensity to consume higher in the lower income level and lower in high income level (poor and rich)

• Propensity to consume is fairly stable during short period as the consumption habits of the community will not change.

• Propensity to consume – two types• Average propensity to consume (APC) – refers to the total

amount of consumption expenditure divided by a given total income at a particular period.

APC = Total Consumption Total Income

• Marginal propensity to consume (MPC) –refers to the additional changes in consumption as result of changes in income

MPC = C Y

A P CC

Y

4. Marginal Efficiency of Capital (MEC) Keynesian effective demand consists of two major components –

consumption and investment. Consumption function – more or less stable in the short period.

Therefore investment function has the vital role in determination of effective demand.

The level of investment depends upon two important factors – marginal efficiency of capital and rate of interest.

MEC refers to the expected profitability of an additional capital asset.

It may be defined as the highest rate of return over cost expected from the marginal or additional unit of capital asset.

For example, suppose a plant costs Rs. 10.000 to an entrepreneur and the expected yield from the plant is Rs. 500 per annum.

Then the marginal efficiency of the plant would be 500 X 100 = 5% 10.000

Q1 Q2 (1 + r)

+(1+r)2

+Q3____

(1=r)3+ ……..

(1+r)n

Qn

5. Rate of Interest The rate of interest is determined on the

liquidity preference of the people. Liquidity preference is governed by

transaction motive, precautionary motives and speculative motives.

The supply of money and the liquidity preference together determine the rate of interest.

Investment function Investment function is the crucial factor in the

determination of effective demand. Investment demand depends upon two factors MEC

and rate of interest. Rate of interest is comparatively stable and does not

frequently change in the short run. Therefore, the fluctuations in the level of investment depends on MEC.

Higher the MEC higher will be the level of investment and vice-versa.

During the period of depression the prospects of profit will become little and they may not be increased by the economy.

Investment has two types 1. Induced investment and 2. Autonomous investment.

Autonomous investment is an investment which does not change with the changes in the income level – independent of income.

Keynes thought that the level of investment depends upon MEC and rate of interest – therefore, changes in income level will not affect investment.

Autonomous investment generally takes place in houses, roads, public undertakings and in other types of economic infrastructure such as power, transport and communication.

This autonomous investment depends more on population growth and technical progress than on the level of income.

Most of the autonomous investment undertaken by government – at time of depression enhancing aggregate demand.

Ia

Inve

stm

ent

National Income

Ia

Y

O Y

Savings and Investments Keynes in his famous work “General Theory of employment,

interest and money” – saving and investment are always equal. This gave rise to a severe controversy in economics as to

whether saving and investment are always equal or unequal. The modern economists argues that concepts of saving and

investment in two different senses. Savings and investment are always equal – at equilibrium position. Savings and investments are not equal under disequilibrium position.

Aggregate investment is always equal to aggregate savings. National output consists of two types goods – consumption

goods and investment goods.O = C + I O = National OutputC = Consumption goodsI = Investment goods

• Similarly national income is divided under two heads – consumption and savings

Y = C + SY = national incomeC = Consumption

S = Savings

• National output is always equal to national income O = Y

C + S = C + I Investment = SavingsS = I

• As long as S and I are equal aggregate income Y will be constant and the level of employment will also be constant.

• But in practice S & I need not be equal as the saver group and investing group are different and their objectives is differ.

• This leads to divergence between savings and investments.• If there is excess of savings over investment – it will bring

about depression in business – an excess of investment over savings is responsible for business boom.

Multiplier• The concept of multiplier is an important tool of

analysis in the Keynesian theory of income and employment.

• This was first introduced by R.F. Kahn – with reference to employment. Manifold increase in employment as a result of initial increment in investment.

• Keynes propounded the concept of investment multiplier with reference to the much large increase in total income direct as well as indirect, as a result of original increase in investment.

• Keynesian multiplier is also known as investment or income multiplier.

• The essence of multiplier is that increase in income, output, or employment is manifold the original increase in investment.

• For example – if investment equal to Rs.100 crores is made, then the income will increased by multiple of Rs.300 or 400 crores it can be says that multiplier 3 or 4.

• Thus ratio of increment in income to the increment in investment

• Multiplier k = MPC = Y

I

K = multiplier

Y = changes of income

I = changes in investment

O X

Y

C

C + I

C + I 1

E

National IncomeY1 Y2

Z

Agg

rega

te D

eman

d

Y

I

450