keynes theory

8/6/2019 Keynes Theory

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KEYNES THEORY OF INCOMEAND EMPLOYMENT


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According to the classical economist, the economy

normally operates at the level of full employment without inflation in the long period.

They assumed that wages and prices of goods wereflexible and the competitive market existed in the

economy.


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Says Law of Market Says Law of Market states that ,supply creates its own

demand

Explanation:-When goods are produced by firms in the

economy, they pay reward factors of production.Thehouseholds after receiving rewards of factors of

production spend the amount on the purchase ofgoods and services.


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GREAT DEPRESSIONy The Great Depressionwas a severe worldwideeconomic depression in the decade precedingWorldWar II. The timing of the Great Depression

varied across nations, but in most countries itstarted in about 1929 and lasted until the late 1930sor early 1940s. The Great Depression haddevastating effects in virtually every country, rich

and poor. Personal income, tax revenue, profits andprices dropped while international trade plungedby to. Unemployment in the U.S. rose to 25%,and in some countries rose as high as 33%.


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Not a general theory.

Instead of micro economics, macro economicanalysis is required.

Saving investment equality.It is the income not the rate of interest which is the

equilibrium force between saving and investment.

Monopoly element.

It is the imperfect completion which in practice

prevails in the product and factor market.


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Role ofTrade union.The trade union bargain with the employers for

the fixation of wages. The state also fixes

minimum wages in certain industries.

Short run economics.

The lenth of long run is not clear in Says law.


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Keynes theory of Income and

Employmenty John Maynard Keynes wrote his esteemed book

General Theoryof Employment in 1936.

y Definition:-

In short period, level of national income and so ofemployment is determined by aggregate demand andaggregate supply in the country.

Volume of employment depends on the level of national

income and output. Increase in national income meansincrease in employment


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Effective DemandyAccording to Keynes, the equilibrium of national

income occurs where aggregate demand is equal to

aggregate supply. This equilibrium is also calledeffective demand point.

Effective demand = national income = national output


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Effective Demand (con,td)yAccording to Keynes, the level of employment in

effective demand depends on two factors:

(a) Aggregate Demand (c + I)

(b)Aggregate Supply (c + s)


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Aggregate Demandy Aggregate demand refers to the sum of expenditure,

households, firms and government is undertaking onconsumption and investment in an economy.

The aggregate demand price is the amount of money which

the entrepreneur expects to receive as a result of sale ofoutput produced by the employment of certain number ofworkers.

The aggregate demand curve AD (c + I )would be positivelysloping signifying that when a level of employment

increases, the level of output also increases.Thereare two components of aggregate demand:

1- Consumption expenditure

2-Investment expenditure (I)


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Aggregate Supplyy The aggregate supply is the value of final output valued atfactor cost.

y Aggregate supply is equal to national income at market price.

y The aggregate supply is denoted byAS (C + S ) because a partof is consumed ( C ) and the other part is saved ( S )

y The aggregate supply curve (c + s) is positively slopedindicating that as the level of employment increases, thelevel of output also increases, thereby increases the aggregatesupply.

AS = C + S


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Effective Demandy DIAGRAME

0100 200 300

100

200

300

400

500600

45 P R

E

E1

(C + S)

(C + I )

( c + I )

INCOME

Cons.inv

Aggregate demand = c + I

Aggregate Supply = c + S


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Importance ofEffective Demandy Determinant of employment

y Says Lays falsified

y Role of Investmenty Capitalistic economy


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Keynes theory relate National

Incomey Equilibrium of level of national income takes place where

aggregate demand is equal to aggregate supply.

y

The equilibrium level of national income may be at fullemployment, may be at above full employment and maybe at below full employment.

y Full employment represents the maximum level of outputwhich could be obtained by utilizing all the natural and

human resources of the economy.


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Determination oflevel of employment and incomey Diagram:-

AS = Y OR(C=S)

AD= (C+I+G+ (X-M))

National incom

AS,AD$

0 Ye

E

Effective demand

45*


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The components ofAD are:

- Consumption(C)- Investment(I)

- Government Expenditure (G)

- Net Exports (X-M)

The Components of AS are:

- Consumption (C)- Savings (S)


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Explanationy On the level of full employment, aggregate demand is equal to aggregte

supply, and the equilibrium level of employment will maintain at fullemployment.

y If at the level of full employment , aggregate demand is greater thenthe aggregate supply, the equilibrium level of national income will take

place at above full employment.y If at the level of full employment , aggregate demand is grter then

aggregate supply, the equilibrium level of NI will take place at bellowfull employment.


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Significance of Keynes theoryy Macro-approach:-Keynes has given a new approach, i.e., Macro-approach to the field of

economics. His theory has several names: theory of income andemployment, demand-side theory, consumption theory, and macro-

economic theory.

y Completely demolished the idea of full-employment:-

He states that employment level in the economy can only beincreased by increasing investment.

yNew economic tools and techniques :-

Keynes have enabled the todays economists to draw correctconclusions on the economic situation of a country. Such tools areconsumption function, multiplier, investment function, liquiditypreference, etc.


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y integrated the theory of money with the theory of value andoutput.

. Keynes has integrated the theory of money with the theory of value

and output.y Inflationary and deflationary gap analysis.

. He also states the reasons of excess or deficiency of aggregatedemand through inflationary and deflationary gap analysis.

y Emphasised on suitable fiscal policy .

. Keynes has emphasised on suitable fiscal policy as an instrumentfor checking inflation and for increasing aggregate demand in acountry. He advocated extensive public work programmes as anintegral part of government programmes in all countries for expandingemployment.


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y Rejected the theory of wage-cut :-He rejected the theory of wage-cut as a means of promoting full-employment.


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Criticism on Keynes TheoryyKeynesian theory has ignored microanalysis

yShort-term analysis

y the Keynesianapproach isindustry-oriented

yComparative statics


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Relevance of Keynes Theory to

Less-Developed Countries

y In the short-term analysis, Keynes assumes that

capital equipment, technology, organisation,labour and their efficiency remains constant.

But the problem in case of LDCs is to increase capitalequipment, to improve technology and labour

efficiency. Solving thisproblem will take a longprocess; it cannot be solved in short-run.


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yMost of the LDCs are agriculturists and theKeynesian approach is industry-oriented. Therefore, increase in nationalincome by deficit spending will lead to

increase in demand for food. This will raisethe prices of food grains. Therefore, heavyreliance on Keynesian approach couldmislead the economists, and can plunge theeconomy into inflationary spiral.


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ySuppose new investments are made in the

country, increased investment will lead tothe establishment of new factories, workers

will get employed, income will increase,

demand will increase, but it does notguarantee the increase in the supply ofgoods because there is no excess capacity,and the supply of productive factors is not

elastic. Increased income will be absorbedin high prices.

keynes theory

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