The world economic crisis, originating from the housing bubble of 2007, also reminds us of Keynes. (Foreign trade is ignored.) The premise of full employment runs throughout the whole structure of this theory. It is to this concept that we turn now. However, to keep our analysis simple, we will focus on the determinants of employment and the causes(s) of unemployment. By contrast, Keynes pointed out that unemployment occurs due to inadequate aggregate effective demand. In Keynes’s demand-determined model various factors together determine the equilibrium level of employment. Thus, if wages are sticky or inflexible downward, there will be the problem of involuntary unemployment. However in this essay we will see it from another perspective: Keynes mentioned several subjective and objective factors which determine consumption of a society. Such expectations—waves of optimism and pessimism and called by Keynes ‘the animal spirits of capitalism’—are highly uncertain. ii) The three-sector model consisting of household, business and government sectors. The Keynesian Theory Keynes's theory of the determination of equilibrium real GDP, employment, and prices focuses on the relationship between aggregate income and expenditure. This curve is upward sloping initially and ultimately becomes vertical as soon as the economy reaches the state of full employment (when the number of workers employed is LF, as shown on the horizontal axis). When aggregate demand falls, there is widespread pessimism and MEC falls. In short, once full employment is reached, an increase in aggregate demand will lead to demand pull inflation. If income increases, consumption also increases, though not proportionately. Firstly, monetary policy can be used. Moreover, high wages reduce the rate of labour turnover. When people start demanding another product in place of a product temporarily, unemployment would increase due to a fall in total demand, it shall be of an irregular nature. And the depression got intensified due to the inability of the Fed to take timely actions for preventing bank failures. If the desire to save from their particular income is more than the desire for substitution expenditure has become a reverse relationship, demand, and employment increase i.e., when the desire to save, among people is lesser than the substitution expenditure in the society, demand, and employment increases. Due to rigidity of nominal wage, L1L2 = GH workers become involuntarily unemployed. So the labour market reaches equilibrium at point E in Fig. 1,000 to Rs. As a result the level of employment will increase. Since income and employment are inseparably linked up with each other, the Keynesian theory of income determination is also known as the Keynesian theory of income and employment. For all these reasons Keynes postulated that the level of employment depends on the volume of production. Keynesian Theory of Unemployment: Economists, since time immemorial, have always struggled with the issue of unemployment. As a result the aggregate demand curve shown in panel (b) shifts downward exactly by the amount by which investment falls (ΔI). Most of the modern economists agree with the concept of Keynes. According to Keynes, an economy reaches full-employment when aggregate effective demand is adequate to support the economy’s potential (full-employment) level of output. He was not much concerned about price level changes (i.e., inflation and deflation). And if the current tax revenue of the government is not sufficient to cover this extra expenditure the government can incur a deficit in the budget and borrow money from the central bank—its own bank. This leads to a fall in investment and in aggregate effective demand. Keynesian Theory of Income and Employment: Definition and Explanation: John Maynard Keynes was the main critic of the classical macro economics. Two simple examples will make the concept clear. This is because the real cost of labour has increased. Workers accept a fall in real wage caused by a rise in prices of wage goods (or essential commodities) but they do not accept a cut-in money wage. At the same time the aggregate price level falls from P0 to P1. Central to Keynesian economics is an analysis of the determinants of effective demand. In an advanced capitalist country, the level of employment depends on aggregate effective demand. As we know,in a two-sector economy, aggregate effective demand has two components, viz., (household) consumption and (private business) investment. The equilibrium of national income occurs where AD is equal to AS. According to keynes, “ In the short period, level of national income and so of employment is determined by aggregate demand and aggregate supply in the country. Keynes pointed out that during depression the Say’s law does not work. In the money market, the demand for capital shall be more even during the period of high rates of interest, if in view of the investors, capital is more efficient. The equilibrium level of income determined by the equality of AD and AS does not necessarily indicate the full employment level. His theory of employment is widely accepted by modern economists. If at a particular level of employment AD is equal to AS, then that level of aggregate demand is called effective (and not notional) demand. Unemployment occurs due to deficiency of demand. The equilibrium level of employment is 0L2. 1,000 to Rs. 909 due to 10% inflation in the economy. The propensity to consume, in turn, depends on several factors — both subjective such as the desire to save, the desire to emulate consumption pattern of others and objective such as the general price level, fiscal (tax) policy of the government and monetary policy of the central bank (which affects the rate of interest). The reason is that more workers are now willing to work at the new real wage (W0/P0). In panel (a) we see that due to a fall in MEC, the investment demand schedule shifts to the left from I0 to I1). Keynes used his income‐expenditure model to argue that the economy's equilibrium level of output or real GDP may not corresPond to the natural level of real GDP. Keynes' approach was a stark contrast to the aggregate supply -focused classical economics that preceded his book. In this context, we introduce a new concept, viz., aggregate supply price (ASP). So any change in wage in the interim period is not possible, even if there is excess supply or demand for labour. Due to this depression, unemployment spread in all independent capitalist economies. A cut in taxes is likely to stimulate household consumption expenditure. These unemployed people are willing to work at the prevailing market wage but do not get jobs due to lack of aggregate effective demand. It works in reverse direction during depression. The truth is that both monetary policy and fiscal policy are to be adopted to stimulate investment and promote faster economic growth. It shows that when the number of workers employed is 0L1, the aggregate demand price is 0A and when the number of workers employed is 0L2, the aggregate demand price is 0C. Determinants of Autonomous Investment: Since investment is independent of national income or its rate of change, it must depend on other factors. Keynesian Theory of Income determination . In his view, however low the interest rate may be, new investment is unlikely to take place, if MEC is very low. Workers who get higher than the prevailing market wage do not want to leave their existing enterprises and try to get jobs elsewhere. Underemployment Equilibrium due to Demand Deficiency and Other Details. The converse is also true. As the income of a person increases, his tendency to consume comparatively reduces. 5.3 where the AD and AS curves intersect. And the labour market could not be cleared due to downward rigidity of nominal wage. Government spending will add to private spending in increasing aggregate effective demand and lifting the economy out of depression. First we present Keynes’s view and then the monetarists’ view on the same issue. In this case workers will not be unhappy. The Post Keynesian model of employment confronted here with the data from the United States is derived from Weintraub (198142) and Davidson (1998).1 In this model the primary Such an unemployment lasts for a short period due to too high a real wage. Keynesian economics developed during and after the Great Depression from the ideas presented by Keynes in his 1936 book, The General Theory of Employment, Interest and Money. Importance of Investment Fluctuations: According to Keynes investment depends mainly on the MEC (because interest rate remains constant in the short run). However, due to frequent changes in these variables and the resultant change in the expected profits of firms MEC fluctuates. In Fig. According to this theory, since the demand for goods and services does not meet the total actual resources that may be utilized, unemployment arises. According to Keynes MEC itself depends on business firms’ estimates of current and future demand for consumer goods, tax policy of the government and the expectations about technological change (i.e., whether technology is expected to improve or deteriorate over time). Effective demand results in output. In several countries governments fix minimum wage for industrial workers. 5.6, we see that aggregate demand falls. If aggregate demand increases and the aggregate demand curve shifts upward, then more output can be produced by employing more workers to meet the extra demand for goods. If MEC suddenly increases due to improved profit prospects, new investment will take place. Even during depression, an increase in the money supply causes a fall in interest rate because the liquidity preference curve is downward sloping and not horizontal. So the solution to the problem lies in increasing aggregate effective demand. However, Keynes was not very sure about the effectiveness of monetary policy in raising investment. So the aggregate demand curve slopes upward from left to right. So aggregate demand increases if consumption increases and consumption increases if employment increases. (ii) The supply price (or the replacement cost) of capital goods (such as machines or equipment). Macroeconomics, Employment, Theories, Keynesian Theory of Employment, © 2017 MacroEconomicsNotes - All rights reserved Terms of Service Privacy Policy Contact Us, © 2017 MacroEconomicsNotes - All rights reserved, Copyright infringement takedown notification policy, Copyright infringement takedown notification template, Keynes and the Classicists Views on Inflation | Macroeconomics, Keynes’s Monetary Theory | Macroeconomics, How to Reduce, Eliminate and Stop Poverty in India ? Keynes assumed that in the short run the AS curve will remain unchanged due to constant supply of capital and unchanged technology. In short, with downward rigidity of money wage rate and flexible price level, a fall in aggregate demand results in involuntary unemployment. And the central bank will make loan to the government by printing currency notes. Workers suffer from money illusion for two main reasons: When there is a cut in wage in one industry or sector such as automobiles, auto workers feel that their relative position has deteriorated. 3. So the aggregate demand curve shifts to the left from AD0 to AD1. (Compare points E and F). 5.8. In such a situation the actual sales revenue of the entrepreneurs is equal to their expected sales revenue (i.e., the revenue they receive by selling the output produced by using the variable factor labour). One is deficiency of demand. This refers to infinite elasticity of demand for money. And employers are under the legal obligation to pay minimum wage even if there is excess supply of labour or unemployment. In the Keynesian theory, employment depends upon effective demand. So fiscal policy has to be used to stimulate the economy. This happens in times of full-employment boom (or the period of maximum prosperity) when actual output or GDP is equal to potential (full-employment) output. It is determined by the demand for and the supply of money. A decline in total effective demand would lead to unemployment. Thus whatever may be the magnitude (or rate) of increase in the money supply, it will be absorbed by the people in the form of liquid (cash) balance. Keynes believed that in times of depression and unemployment, nominal wage would remain constant. A fall in the level of employment and a consequent fall in GNP or national income implies that the economy under consideration is in deep depression. Profit prospects become bleak due to widespread business pessimism. In the short run the amount of capital, the size of the labour force, and the state of technology remain constant. According to Keynes, the three main reasons for the spreading of unemployment are: Pingback: Macro Economics - Importance, Limitations and Difficulties - Exam Notes, Good explanation about Keynesian Theory of Employment. 5.3 we present both the AS and AD curve to find out macroeconomic equilibrium. Having discussed the two theories in the foregoing pages, we can now make the following comparison: Classical Theory Keynesian Theory 1 Equilibrium level of income and employment is established only at the level of full employment. Monetarist Theory: The monetarist theory is an economic concept which contends that changes in the money supply are the most significant determinants of the … In this case, there is movement along the same consumption function. Sorry, your blog cannot share posts by email. Criticisms. Such unemployment is likely to persist for some time and is likely to disappear, if the government adopts measures to stimulate aggregate effective demand. According to Keynes equilibrium level of national income does not always occur at full employment. So, if more workers are employed, the variable cost of production will increase proportionately. iii) The four-sector model consisting of household, business, government and foreign sectors Q.No.2. According to Keynes there are three reasons for money-wage rigidity: Workers suffer from money illusion. There are two ways of doing it. The other is downward rigidity of nominal wage. In a competitive market economy, profit-seeking firms will go on employing extra workers so long as aggregate demand price exceeds aggregate supply price. When aggregate demand price is lower than aggregate supply price, firms will reduce the number of workers hired. In Fig. Point E in Fig. Consider Table 5.1. Keynes was concerned with the short-run problem of the capitalist economy which is characterised by periodic fluctuations in output, employment and income. So what is the way out? Keynesian Theory of Unemployment Keynesian economics provides an alternative theory of unemployment. So even if the demand for labour increases, the wage rate will not rise. If MEC falls, there will be an immediate fall in investment and this will lead to a sharp fall in employment, output and income through the multiplier. In 1933 about 25% of the US labour force was involuntarily unemployed. By comparison, if the level of employment exceeds OL2, firms will incur losses by employing extra workers. 5.3 together determine the level of employment in the economy. Thus the aggregate supply curve shown in Fig 5.1 is upward sloping from left to right. Since unemployment is a logical possibility in times of economic downturn, an economy may get stuck at underemployment equilibrium, i.e., equilibrium at less-than-full employment. The Post Keynesian theory is based on the "Principle of Effective Demand" discussed in chapter 3 of Keynes' General Theory. 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