Keynesian Theory of

Income and EmploymentIncome and Employment

Keynesian Theory of Income and Employment

� John Maynard Keynes

� General Theory of Employment, Interest and Money (1936)

� attacked the major postulates of classical theory.

Classical Theory of Income and Employment

� Existence of full employment without inflation

� Closed laissez faire capitalist economy without foreign trade

� Homogeneous labour

� Y = C + I

� The quantity of Money is Given, MV = PT� The quantity of Money is Given, MV = PT

� Wages and prices are flexible

� Money wages and real wages are directly related and proportional

� Capital stock and technological knowledge are given

� Say’s law of Markets

Say’s law of Markets

� J.B Say

� ‘Supply creates its own demand’

� There is no general over production since,

� SS = DD ,

� S = I

� Equilibrium: adjustment through rate of interest ‘r’ � Equilibrium: adjustment through rate of interest ‘r’

� [S and I = f (r)]

� ↑ ‘r’ ⇒ ↑ saving

� ↓ ‘r’ ⇒ ↑ demand for investments

Say’s law of Markets

� If over production,

Labours leave.

Short run� Short run

Quantity Theory of Money

� MV = PT

M = Supply of Money

V = Velocity of Money

P = Price level

T = Volume of TransactionsT = Volume of Transactions

� Money Supply (MV) = Total Value of Output (PT)

� M causes proportional change in P

� Ms is Neutral

Summary of Classical Model

� Level of Employment⇒ Labour market

Demand for and Supply of Labour, f (w/p)

� Total Output⇒ Goods Market

Employment (N), Capital Stock (K) and

Technical Knowledge (T)Technical Knowledge (T)

� Price Level⇒ Money Market ⇒ MV = PT

� Great depression

Criticisms Against Classical Theory

� Keynes rejected the assumption of full employment

� Rejected Say’s Law

� Laissez faire is not self adjusting

� Capitalist system not self adjusting

� S = I is not valid since S = f (y and not r)� S = I is not valid since S = f (y and not r)

� In Classical, Money transaction and precautionary only not Speculative

� Neutrality of Money

� Keynes integrated monetary and real sectrors of the economy.

Keynesian Theory of Employment, Interest and Money

� J. M Keynes

� General theory of employment, Interest and Money (1936)

� Short run theory (amount of capital, labour force, technology, etc

does not change)

Keynesian Theory of Employment

� Effective Demand

� Level of employment in short run is determined by effective

demand

� Aggregate Demand (Price) = Aggregate Supply (Price)

Aggregate Demand

� the amount of goods and services people wish to purchase at the existing price level

� Expected receipts when a given volume of employment is offered to workers.

� ⇑ Number of workers ⇑ Output

� Varies at different levels of employment b’coz, � Varies at different levels of employment b’coz,

� ∆ employment ∆ income ∆ consumption

� Components:

� Consumption (C) + Investment (I) + Govt. Expenditure (G) & Net Exports (X-M)

Aggregate Supply

� the amount of final goods and services produced in an economy at the existing price level

� Minimum sales proceeds…..total cost of production at a given level of employment

� Z = φ (N)

� ⇑ Employment ⇑ Aggregate supply price of the output

� Slopes upward from left to right; when economy reaches full employment the AS curve becomes vertical.

Effective Demand

AS

ES2P

rice

lev

el

Point of

Effective

Demand

AD

E

o Out put, Income

D2

Pri

ce l

evel

Importance of Effective Demand

� Rejection of Say’s Law - All income is not invested.

� Refutes Pigou’s Wage Cut theory –

� Pigou: cut in money wage increase employment

� But, ↓↓↓↓ Money wage ↓↓↓↓ Consumption ↓↓↓↓ Employment

� Importance of Investment – investment increases employment and incomeincome

� Determines Employment

� Emphasis on Demand side

� Explaining Paradox of poverty –

� Poverty in the midst of plenty – Unemployment in Capitalism

� Psychological Law – ↑↑↑↑ income ↑↑↑↑consumption but less than proportionally

� Gap between income and consumption not filled by investment

Keynes Theory of Employment and Income

� Consumption

� Saving

� Investment

� Govt. Expenditure

� Net exports� Net exports

Consumption Function

� C = f (Y) , where, Y = Real Current National Income

� Average Propensity to Consume (APC)

� Proportion of whole income which is spend on consumption.

IncomeTotal

nConsumptioTotalAPC ====

Y

C=

� Average Propensity to Save (APS) = 1 – APC

� Marginal Propensity to Consume (MPC)

� Ratio of change in consumption due to a change in income

� Marginal Propensity to Save = 1 – MPC

IncomeTotal

IncomeinChange

nConsumptioinChangeMPC =

Y

Y

C

∆∆

=

Psychological Law of Consumption

� Men are disposed as a rule and on the average to increase in

their consumption as their income increases but not by as

much as the increase in their income.

� Hence MPC is always less than 1.

Investment Function

� Real investment - Increment in Capital goods

� Financial Investment – purchase of stocks of existing companies, doesn’t increase productive capacity of the economy.

� I depends on MEC, should be higher than rate of interest (r).

� MEC and ‘r’ are inversely related� MEC and ‘r’ are inversely related

� MEC is the expected rate of return (discounted) over cost of a new capital good.

� Induced investment – profit or income motivated

� Autonomous Investment – independent of level of income, influenced by exogenous factors

Keynesian Theory

� Total Output = National Income

� National Income ⇒ Level of Employment ,

Y = f (N)

� Employment ⇒ Effective Demand

N = f (ED)N = f (ED)

Effective Demand

Aggregate Supply (g) Aggregate Demand

Consumption Investment

Size of ‘Y’ APC/MPC MEC r

Prospective SupplyProspective

Yield

Supply

PriceDD

Money

SS

Money(g)

Transactionary

Motive

Precautionary

MotiveSpeculative

Motive

Determination of National Income

� Aggregate Demand = Aggregate Supply

� Aggregate Demand = C + I

� Aggregate Supply: total monetary value of goods and services

produced in an economy

� Y = f (N,K^,T^)� Y = f (N,K^,T^)

� Planned output 450 line

Determination of National Income

AS

C+I+G Z

C+I

E

CC

o Y Y =NI

National Income: Change in Investment

C+I+G Z

C+I+I’

Full Employment F

C+I

CE

O Y YF NI

I∆∆∆∆

Y∆

E

Multiplier (K)

� Change in Income (Y), as a result of Change in Investment (I) at a

given propensity to Consume.

� ∆ Y = K. ∆ I

MPSor

MPCK

1

1

1

−=

� If MPC = 0.75, Multiplier = = 4

MPSMPC1−

Inflationary Gap

� The amount by which the actual aggregate demand

exceeds the level of national income corresponding

to full employment is known as inflationary gap

because this excess aggregate demand causes because this excess aggregate demand causes

inflation or rise in prices.

� C + I + G > the full employment GNP level

Inflationary Gap

C+I+G Inflationary Gap

Z

C+I+G’

H

T C+I+G

E

Full Employment Output

O YF YX NI

Deflationary Gap

� Deflationary Gap represents the difference between

the actual aggregate demand and the aggregate

demand which is required to establish the equilibrium

at full employment level of Income. (Causes

Depression)Depression)

Deflationary Gap

C+I+G Deflationary Gap

Z

C+I+G

E

C+I+G’

HH

Q

Full Employment Output

O YX YF NI

Thank you……………………..Thank you……………………..