» Two important theories of income and employments are : » 1. Classical Theory of Income and Employment, » 2. Keynesian Theory of Income and Employment! aCLASSICAL THEORY » The theory is ascribed to early Classical economists like Adam Smith, Ricardo, and Malthus and neo-classical like Marshall, Pigou and Robbins. They believe that; » An economy, as a whole, always functions at the level of full employment i.e., full employment of labour and other resources . » Full employment level of output of goods and services is the largest output that the economy is capable of producing when all its resources are fully employed. Full employment is regarded as a normal situation a>», yet there could be a_ temporary unemployment , it must be a temporary one and it will be cured automatically through free play of economic forces either by government or private monoplly itself. » Classical behave that aggregate supply would always be at full employment level which is based on two assumptions, > 1) Law of Market and 2) Wage-price flexibility explained above: aSupply creates its own demand or law of market » Classical theory of employment is based on ‘ Law of market’ which states that ‘supply creates its own demand’. This implies that supply creates a matching demand for it with the result that the whole of output is sold out. So, there is no deficiency in aggregate demand and hence no possibility of over-production and unemployment. Thus, equilibrium level of income and employment is established only at the level of full employment.Flexible system of prices, interest rates and wages » (a) Price mechanism automatically brings equilibrium between demand and supply in the market, » (b) Flexibility of interest rates brings about equality between savings and investment, » (c) Flexibility of wage rates brings about full employment equilibrium. As a result, the aggregate supply is always at full employment level of output. aKEYNESIAN vs CLASSICAL THEORY '. According to classical economists, money is demanded for transaction motive alone. On the contrary, keynes maintained that money is demanded for transaction motive as well as speculative motive . i. According to classical economists, supply of labourers depends on real wage (W/P). On the contrary keynes believes that it depends on money wage. ui. In classical theory saving is a function of rate of interest and keynes is of view the saving is a function of an income. aWHY THERE IS NEED OF kEYNESIAN THEORY » During the Great Depression of the 1930s, existing economic theory was unable either to explain the causes of the severe worldwide economic collapse or to provide an adequate public policy solution to remove unemployment. akey points: » According to lord keynes, full employment is not a normal feature of a developed capitalist economy, there can be unemployment in every economy. » The main reason for this unemployment is deficiency of aggregate demand. » Unemployment can be removed by increasing the aggregate demand. » Many countries like: America, france etc adopted all such measures failed to remove unemployment as were recommended by classical theory of unemployment,ie reduction of money-wage, fall in rate of interest etc. aWhat is Aggregate Supply and Aggregate Demand » Aggregate supply refers to the schedule showing aggregate supply received at different levels of employment. Aggregate supply price received to the total amount that all the producers must receive by selling the output produced at a_ given level of employment. » Aggregate demand refers to a _ schedule showing aggregate demand price received at different level of employment. »Keynesian theory » Lord keynes analyzed deeply the problem of unemployment and concluded that main cause of unemployment was deficiency of effective demand. Effective demand refers to that level of aggregate demand where it is equal to aggregate supply. He _ therefore suggested that unemployment could be removed by increasing the effective demand. a» According to him aggregate demand comprised of demand for two type of goods: Demand for consumption goods» Lord keynes was of the opinion that to remove unemployment and to achieve full employment , government interfernce in the economy is imperative. Prior to lord keynes, famous classical economist Malthus had also opined that the main cause of fall in employment was deficiency of effective demand. But Malthus could not explain the reason behind deficiency of effective demand. aAssumptions of keynesian theory + Short period | -Closed economy - Labour is the only factor of production | Se-Under-employment equilibrium - Saving and investment function «Labour has a money illusionFurther explanation of theory of income and employment » The basic concept of keynesion theory is that level of employment in a country is determined by the aggregate demand and aggregate supply. Effective demand refers to that level of aggregate demand at which it is equal to aggregate supply. Example: by employing one lakh labourer in a country at any given time the aggregate supply is worth rs 100 cr. And the aggregate demand at the very time period is also rs 100 cr, then in that situation aggregate demand price will be equal to aggregate supply price.Y=f(N) N=F(ED) ~~ ED=»(AD=AS) [National income or output (¥) Is. function) OF level of employment N) evel of employment nt (N) Is a function of jemand(ED) expresses equality ence orem ‘demand and aggregate ‘supplyConsumption expenditure » Consumption expenditure is an important constituent of aggregate demand. Increase in consumption expenditure leads to increase in total income. Consumption expenditure depends mainly on 2 factors: _ propensity to consume _— national incomeInvestment » It refers to that expenditure which leads to addition in the total stock of capital assets. It is an important constituent of aggregate demand. According to keynes, investment mainly depends upon 2 factors: » - rate of interest » - marginal effeciency of capitalDetermination of employment » Under perfect competition, employment will be determined at that level of aggregate demand at which is equal to aggregate supply. This level is called equilibrium level or effective demand. According to keynes, “ the volume of employment is given by the point of intersection between the aggregate demand function and aggregate supply function’. » in short period aggregate supply remains constant, as such, effective demand and level of employment can be increased by changing aggregate demand. ain a closed economy, aggregate demand depends upon: 1 L 2 J | 3 =consumption = National + Propensity to income consume» Propensity to consume is the ratio of consumption expenditure to different value of income. » National income depends upon consumption based on the — subjective and objective factors which remain constant in the short period. It is therefore not possible to increase consumption in the short period. » Investment the other determinant of a aggregate depend is investment. It depends upon the: -rate of interest - marginal efficiency of capital. a» Rate of interest is determined by the interaction of the demand for and supply of money. Demand for money is reflected in liquidity preference ie. Preference to hold the wealth is called liquidity preference. People hold their wealth in liquid form for three motives: (1) transaction motive (2) precautionary motive (3) speculative motive Demand for cash for transaction and precautionary motives depend upon the level of income while that for speculative motive depends upon the rate of interest.» At the high rate of interest people will be willin to give more money on loan and at low rate o interest they will send less. Marginal efficiency of capital refers to rate of profit. It is governed by two factors 1) supply price of capital asset and 2) prospective yield. An entrepreneur compares rate of interest with marginal efficiency of capital before making investment. » Where MEC> Rate of interest , investment is made otherwise not if MEC< Rate of interest no investment is made. In short period investment can be made by lowering the rate if interest. a» SO To increase the aggregate demand there should be an increase in consumption and investment. In short period consumption cannot be increased but investment can be increased so employment will increase. aAchievement of full employment » In an economy even with unemployment and achieving full employment it is essential to increase aggregate demand, it is an under- employment equilibrium. Qo y % Employment and Income Fig.2» WHERE, » Y= INCOME » C= CONSUMPTION » Cg= AUTONOMOUS CONSUMPTION » b= MARGINAL PROPENSITY TO CONSUME » Y= INCOME IN INTIAL STAGE » l= AUTONOMOUS INVESTMENT aKeynesian model > Y=f(N) , (OUTPUT (y) is the direct function of employment (N), OUTPUT depends on employment. Total output with increase in employment.) > NS=f(W), (Supply of labour (NS) IS the direct function of money wage(W). It means supply of labour increases with increase in money wages.) > ND = f(W/P) _, (Demand for labour (ND) is the inverse function of real wagew/P). It means demand for labour increases as his real wage falls and decreases as his real wage rises. Hence according to keynes, increase in employment will lead to fall in real wages.)» Qa a Qa a Labour market will be in equilibrium when demand for labour is equal to its supply, NS=ND According to keynes, money market will be in equilibrium when demand for money is equal to supply of money, ie MS= MD KEYNES believed that MD=L,¢Y) +L,(r) | = S, KEYNES also assumed that in equilibrium, investment and saving will be equal. l= f(r) , investment is an inverse function of rate of interest (r) S=f (Y), saving is a direct function (f ) of income. Saving increases with increase in income.» These equations tell that to increase employment in the short run, rate of interest should be lowered and to increase demand for labour, real wages should also be lowered. For this purpose, price- level should be raised and money wages not to be changed. aCriticism of keynesian theory v The concept of equilibrium is self- contradictory v Keynesian economics is mainly static v It has ignored the long period equilibrium v Unrealistic assumption of perfect competition v Keynesian theory is not a general theory v Based on the assumption of closed economy v Keynesian analysis is not so empirical v It ignores the cost-push inflation. aReferences » www.investopedia.com » http://www.economicsdiscussion.net/theori es /two-important-theories—of-income- and-employment-micro-economics/687 » Principals of economics a