THEORY OF INCOME AND EMPLOYMENT

Q) What are the assumptions of Classical theory?

ANS - 1. There is the existence of full employment without inflation.

2. There is a laissez-faire capitalist economy without government interference.

3. It is a closed economy without foreign trade.

4. There is perfect competition in labour and product markets.

5. Labour is homogeneous.

6. Total output of the economy is divided between consumption and investment expenditures.

Q) State and explain Say’s Law of market with suitable examples.

ANS- Say's Law of Markets is theory from classical economics arguing that the ability to
purchase something depends on the ability to produce and thereby generate income.Say
reasoned that to have the means to buy, a buyer must first have produced something to sell.
Thus, the source of demand is production, not money itself. Say’s Law implies that
production is the key to economic growth and prosperity and the government policy should
encourage (but not control) production rather than promoting consumption.

Q) Briefly explain Pigou’s concept of wage- price flexibility. How does it solve the
problem of unemployment?

ANS- The Pigou effect, also known as the wealth effect, was propounded by A.C. Pigou in
1943 to counter Keynes’ argument that wage-price deflation cannot lead to automatic full
employment. Pigou fully recognised that interest-rate effect of Keynes that wage-price
deflation raises investment and income through a reduction in the interest rate. But he did not
agree that the real income cannot be raised to the level of full employment due to liquidity
trap.

According to Pigou, a wage-price deflation will generate automatic full employment via an
increase in the level of consumption. He argued that when money wages are cut, prices fall
and the value of money rises. The rise in the value of money means a rise in the real value of
assets such as stocks, shares, bank deposits, government securities, bonds, etc.For example, if
prices fall by 50 per cent, the real value of each rupee will be doubled because it will
purchase twice as much as it did before. The increase in the real value of fixed assets will
make their owners feel richer than before.They will, therefore, save less out of their current
income and spend more on consumption. This will increase aggregate demand and output,
and will generate automatic full employment in the economy. As a result of the Pigou effect,
the consumption function will shift upward (or the saving function will shift downward). In
terms of the IS function, it means a rightward shift of the IS curve.

The important point in Pigou effect is that it is based on the assumptions of flexible wage and
price levels, and a constant stock of money. Therefore, it is only the IS curve that shifts to the
right with increase in consumption or reduction in saving when the real value of fixed assets
increases. The LM curve is assumed to be given because of the assumption of a constant
stock of money. This is because the analysis of Pigou effect runs strictly in terms of static
analysis.

According to Prof. Pigou the employment, which exists at any time, is because of the fact that
changes in demand conditions are continually taking place and that frictional resistances
prevent the appropriate wage adjustment from being made instantaneously. Thus, according
to the classical theory there could be a small amount of frictional unemployment attended on
changing from one job to another. But there could be involuntary unemployment for a long
period of time. All people who sought employment would fairly quickly find it, if the wage
rate is perfectly elastic. If all people seeking job at the current wage rate would be bid down.
a decrease in wage rate would reduce the cost of shifting individual product supply curves to
the right there by lowering the prices of product with given demand curves a large quantity
would be purchased at lower prices then more people would be employed to produce the
larger out put. In short, Pigou applied to the labor market what Says said about the
commodity market.

Thus, according to classical analysis if people were unemployed wages would fall until all
seeking employment, were in fact employed. Involuntary unemployment could be found at
the time of depression was because of fact that wages are kept too high by the action of
labour union and government. Therefore, Professor pigou advanced that a general cut in
money wages at the time of depression would increase employment and would ensure full
employment of labour.

Q) Define saving- investment equality.

ANS- According to Keynes, in a functional sense, thus, the equality between investment and
saving is a consequence of changes in the level of income. To him, the equality between the
saving and investment functions is an indispensable condition of equilibrium.

No level of national income can be sustained without the equality of aggregate saving and
aggregate investment. And, he stressed the point that income is the functional variable that
brings about equality between saving and investment.

It may be noted here that classical economists had also visualised the functional equality
between saving and investment but they believed that it was brought about by the rate of
interest.

Q) Write a short note on Criticisms of Classical Theory of Employment.

ANS- The classical theory of employment has been severely criticized by Keynes. According
to Keynes, the classical theory was perfectly logical. But the difficulty with this theory is that
it is incapable of solving the actual economic problems. It is misleading and disastrous if we
attempt to apply it to the facts of experience.

The main points of criticism of the classified theory are as follows:

1) Under-Employment Equilibrium:

Keynes’ foremost attack was on the classical assumption of full employment. According to
the classical economists, full employment was a normal feature and involuntary
unemployment was an impossibility.
Flexibility of wages always tends to maintain full-employment equilibrium. Keynes, on the
other hand has shown that the possibility of under-employment, and not full employment, is a
normal phenomenon in the real capitalist world.

2. Repudiation of Say’s Law:

Keynes raises a severe attack on Say’s law of markets. According to Say’s law, an increase in
employment increases income, the whole of which is automatically spent either on consumer
goods or on investment goods. According to Keynes, a part of the increased income is spent
on consumer goods and the other saved.
But, there is no guarantee that the saved part of income will be spent on investment goods.
Thus, if investment does not increase when employment increases, there will appear a
deficiency of demand. This implies that supply docs not create its own demand.

3. Rejection of Pigou’s View:

Keynes has criticised Pigou’s formulation of Say’s law on both theoretical as well as practical
grounds:

(i) On the theoretical side, Keynes rejected the Pigovian wage-adjustment mechanism.
According to Pigou, reduction in money wages, through its downward effect on cost of
production and prices, tends to increase employment. Keynes, on the other hand pointed out
that wages are a double-edged weapon.
They are not only costs of production, but also form the incomes of labourers. A reduction in
wages, if on the one hand produces favourable effect on employment through reduction in
costs and prices, also, on the other hand, reduces income which, in turn, decreases aggregate
demand and hence employment.
(ii) On the practical side, it is difficult to reduce wages because- (a) the workers, due to
money illusion, often oppose such a cut; (b) trade unions, which are now an integral part of
the modern industrial system, oppose a wage-cut policy; and (c) there is labour legislation
regarding minimum wages, unemployment insurance, etc. in a welfare state.

4. No Automatic Adjustment:

Keynes rejected the classical belief that economic system is automatic and self-adjusting in
character.
He mentioned three cases when the economic system does not remain self-adjusting:

(i) When liquidity preference schedule becomes perfectly elastic (i.e., liquidity trap) as a
result of the investors’ expectation that the rate of interest cannot fall further.
(ii) When investment function becomes interest inelastic.
(iii) When, due to money illusion, money wages become rigid downwards.

5. Government Intervention:

Keynes analysis leads to the practical conclusions- (a) that the economy does not
automatically reach full employment equilibrium; (b) that the policy of laissez-faire is not a
reliable policy; and (c) that active government intervention is required if the objective of full
employment is to be achieved.
Keynes did not believe in the self- adjusting mechanism of the competitive system and
recommended government expenditure in public works in order to save the economy from
uncertainties of private investment. He also suggested a number of fiscal and monetary
measures to fight unemployment.

6. Saving-Investment Equality:

Keynes also criticised the classical version of saving-investment equality. According to the
classical economists, saving and investment are equal and this equality is maintained by the
interest rate adjustment mechanism. According to Keynes, income, and not rate of interest, is
the equilibrating force between saving and investment.
Whenever saving exceeds investment, aggregate demand decreases and income level
declines. As a result, saving falls and. becomes equal to investment. Similarly, if investment
exceeds saving, income level rises, saving increases and becomes equal to investment.

7. Role of Money:

For the classical economists, money is only a veil and its main function is to act as a medium
of exchange. Keynes, on the other hand, emphasised the store of value function of money.
According to Keynes, when there is unemployment of resources, an increase in the quantity
of money increases output and employment, and prices rise very little and that too only
indirectly.

8. Long-Run Analysis:

The classical economists provided long-run analysis. According to them, there may be
temporary imbalances (e.g. unemployment) in the economy, but these imbalances will
disappear in the long run. According to Keynes, actual problems are short-run problems and
they must be given greater importance.

Q) Define the following concepts: a) aggregate demand b) aggregate supply c) effective

demand d) Accelerator e) Multiplier f) under employment equilibrium.

ANS- A) AGGREGATE DEMAND- Aggregate demand is an economic measurement of the

total amount of demand for all finished goods and services produced in an economy.
Aggregate demand is expressed as the total amount of money exchanged for those goods and
services at a specific price level and point in time.

B) AGGREGATE SUPPLY- Aggregate supply, also known as total output, is the total supply
of goods and services produced within an economy at a given overall price in a given period.
It is represented by the aggregate supply curve, which describes the relationship
between price levels and the quantity of output that firms are willing to provide. Typically,
there is a positive relationship between aggregate supply and the price level.

C) EFFECTIVE DEMAND- Effective demand refers to the willingness and ability of

consumers to purchase goods at different prices. It shows the amount of goods that
consumers are actually buying – supported by their ability to pay.Effective demand excludes
latent demand – where the willingness to purchase goods may be limited by the inability to
afford it or lack of knowledge.

D) ACCELERATOR- The multiplier and the accelerator are not rivals: they are parallel
concepts. While multiplier shows the effect of changes in investment on changes in income
(and employment), the accelerator shows the effect of a change in consumption on private
investment.

E) MULTIPLIER- In economics, a multiplier broadly refers to an economic factor that, when

increased or changed, causes increases or changes in many other related economic variables.
In terms of gross domestic product, the multiplier effect causes gains in total output to be
greater than the change in spending that caused it.

The term multiplier is usually used in reference to the relationship between government
spending and total national income. Multipliers are also used in explaining fractional reserve
banking, known as the deposit multiplier.

F) UNDER-EMPLOYMENT EQUILIBRIUM- Under-employment equilibrium means

equality between aggregate demand and ‘aggregate supply but at less than full employment’.
It is a state of equilibrium where level of demand is less than full employment level of
output’. In other words, in producing the output, economy’s all resources are not fully
employed, i.e. some resources are underemployed.

7) Critically examine the Keynesian Theory of income and employment.

In the Keynesian theory, employment depends upon effective demand. Effective demand
results in output. Output creates income. Income provides employment. Since Keynes
assumes all these four quantities, viz., effective demand (ED), output (Q), income (Y) and
employment (N) equal to each other, he regards employment as a function of income.

1. Does not provide comprehensive solution of unemployment:

Keynes theory does provide solution of all types of unemployment. It deals with only cyclical
unemployment.
Keynes did not attempt to solve frictional, technological unemployment and chronic
unemployment of under-developed countries.

Keynes did not elaborate how to secure fair employment. A complete theory should explain
how to get both full and fair employment.

2. Unrealistic assumption of perfect competition:

In real business world imperfect competition is found instead of perfect competition even in
capitalist economics. Therefore, it is not applicable in advanced economies.

3. No determinate functional relationship between effective demand and employment:

Critics point out that there cannot be a definite functional relationship between ED and
employment. Keynes did not provide any evidence of this functional relationship.

There is no direct relationship between ED and level of employment. In fact everything

depends upon the complex interrelationship of wage rates, prices and money supply.

4. Wholly aggregative in nature:

It is highly aggregative because it deals with aggregate concepts such as aggregate
consumption, total investment and total output.

These aggregate concepts may be misleading because these do not explain the economic
problems of individual economic units like firm, industry and individual consumption.

It is not the size of investment alone that determines employment but the character of
investment also affects production and employment.

5. Undue importance to inducement to invest:

Keynes theories solely rely on investment to increase employment. Critiques point out that
other determinants of employment were ignored by Keynes.

6. Keynes ignores long-run problem:

Keynes assumes that ASF is given. Thus, it is a short-run theory and provide solution to
short-run employment problem.

7. Keynes theory is not general:

Keynes theory is not applicable anywhere and everywhere. Its application, as best, is limited
to industrially advanced countries and it has little relevance to the problems of under-
developed countries like India.

8. Keynes ignored accelerator effect:

Accelerator and multiplier work simultaneously. Multiplier describes the effect of investment
on consumption and the accelerator shows the effect of consumption on investment. But
Keynes ignored the accelerator effect completely.

9. Liquidity preference theory of interest is indeterminate:

This is an incomplete theory as it considers interest a purely monetary phenomenon. But rate
of interest is not determined by monetary factor alone. Real factors also affect the rate of
interest.

Q) What is Consumption function? Explain its determinants.

The consumption function, or Keynesian consumption function, is an economic formula that

represents the functional relationship between total consumption and gross national income.
It was introduced by British economist John Maynard Keynes, who argued the function,
could be used to track and predict total aggregate consumption expenditures.

The consumption function is represented as:

C= A + MD

Where,

C= Consumer spending

A= Autonomous spending

M= Marginal propensity to consume

D= real disposable income

There are a number of determinants/factors both subjective and objective which determine

the position of consumption function. The factors or causes of shifts in consumption function
are :

(1) Subjective Factors:

 
(i) Psychological Characteristics of Human Nature: The subjective factors affecting
propensity to consume are internal to the economic system. The subjective factors include
characteristics of human nature, social practices which lead households to refrain or activate
to appending out of their income.
 
For example, religious belief of the people towards spending, their foresight attitude towards
life, level of education, etc. etc., directly affect propensity to consume or determine the slope
and position of the consumptions curve. The subjective factors do not undergo a material
change over a short period of time. These remain constant in the short run.
 
(2) Objective Factors:
 
The objective factors are external to economic system. The undergo rapid changes and bring
market in the consumption function. The main objective factors are as under:
 
(i) Real Income: Real income is the basic factor which determines community’s propensity to
consume. When real income of the community increases, consumption expenditure also
increases but by a smaller amount. The consumption function shifts upward.
 
(ii) Distribution of wealth: If there is unequal distribution of wealth in a country, the
consumption function will also be unequal. People with low income group have high
propensity to consume and rich people low propensity to consume. An equal distribution of
wealth raises the propensity to consume.
 
(iii) Expectation Change in Price: If people expect prices are going to rise in near future, they
hasten to spend large sum out of a given income just after the promulgation of first Martial
Law in our country. So we can say that when prices are expected to be high in future, the
propensity to consume increases or the consumption function shifts upward. When they are
expected to be low, the propensity to consume decreases or the consumption function shifts
downward.
 
(iv) Changes in Fiscal Policy: Taxes also play an important part in influencing the propensity
to consume. If the nature of taxes is such that they directly affect the poor people and reduce
their income, then the propensity to consume is high and if rich persons are not taxed at a
progressive rate and they accumulate more wealth, then the propensity to consume is low.
 
(v) Change in the Rate of Interest: A change in the rate of interest exercises influence on the
propensity to consume. When the interest rate is raised, it generally induces people to
decrease expenditure and save more for lending purposes. On the other hand, when the
interest rate is reduced, it usually encourages expenditure as lending then becomes less
attractive. So we conclude that an increase in the rate of interest generally reduces propensity
to consume or shifts the consumption function downward and a fall in the rate of interest
usually helps to the increase of propensity to consume or shifts the consumption function
upward.
 
(vi) Availability of Goods: Propensity to consume is also affected by the availability of
consumption goods. If the goods are available in abundance, then the propensity to consume
increases. If they are scarce and are priced very high, then the propensity to consume will
decline.
 
(vii) Credit Facilities: cheap credit facilities are available in the country, the consumption
function will move upward.
 
(viii) Higher Living Standard: If the real income of the people increases in the country and
people adopt the use of new produce like television, washing machines, refrigerators, care,
etc., etc., the consumption function is high.

9) Write a short note on psychological Law of consumption?

The concept of consumption function stems from the basic psychological law of consumption
which states that generally, people tend to spend more on consumption when there is an
increase in their income level. However, the rise in the spending behaviour is not to the same
extent as the rise in income because a part of the income is saved as well. The psychological
law of consumption shows the relationship between income and consumption pattern that
exists among the household sectors in an economy.
Q) Define investment functions. What are its determinants?

The investment function refers to investment -interest rate relationship. There is a functional
and inverse relationship between rate of interest and investment. The investment function
slopes downward.

I = f (r)

I= Investment (Dependent variable)

r = Rate of interest (Independent variable)

The level of investment in an economy tends to vary by a greater extent than other
components of aggregate demand. This is because the underlying determinants also have a
tendency to change.

The main determinants of investment are:

1) The expected return on the investment

Investment is a sacrifice, which involves taking risks. This means that businesses,
entrepreneurs, and capital owners will require a return on their investment in order to cover
this risk, and earn a reward. In terms of the whole economy, the amount of business profits is
a good indication of the potential reward for investment.

2) Business confidence
Similarly, changes in business confidence can have a considerable influence on investment
decisions. Uncertainty about the future can reduce confidence, and means that firms may
postpone their investment decisions until confidence returns.

3) Changes in national income

Changes in national income create an accelerator effect. Economic theory suggests that, at the
macro-economic level, small changes in national income can trigger much larger changes in
investment levels.

4) Interest rates

Investment is inversely related to interest rates, which are the cost of borrowing and the
reward to lending. Investment is inversely related to interest rates for two main reasons.

1. Firstly, if interest rates rise, the opportunity cost of investment rises. This means that a
rise in interest rates increases the return on funds deposited in an interest-bearing
account, or from making a loan, which reduces the attractiveness of investment
relative to lending. Hence, investment decisions may be postponed until interest rates
return to lower levels.
2. Secondly, if interest rates rise, firms may anticipate that consumers will reduce their
spending, and the benefit of investing will be lost. Investing to expand requires that
 consumers at least maintain their current spending. Therefore, a predicted fall is likely
to discourage firms from investing and force them to postpone their investment
decisions.

5) General expectations
Because investment is a high-risk activity, general expectations about the future will
influence a firm’s investment appraisal and eventual decision-making. Any indication of a
downturn in the economy, a possible change of government, war or a rise in oil or other
commodity prices may reduce the expected benefit or increase the expected cost of
investment.

6) Corporation tax
Firms pay corporation tax on their profits, so a reduction in tax increases the profits they
retain after tax is paid, and this acts as an incentive to invest. There current rate of 20% will
fall to 19% in 2017, and then to 18% in 2020.

7) The level of savings

Household and corporate savings provides a flow of funds into the financial sector, which
means that funds are available for investment. Increased saving may reduce interest rates and
stimulate corporate borrowing and investment.

8) The accelerator effect

Small changes in household income and spending can trigger much larger changes in
investment. This is because firms often expect new sales and orders  to be sustained into the
long run, and purchase larger quantities of capital goods than they need in the short run.

In addition, machinery is generally indivisible which means it cannot be broken into small
amounts and bought separately. Even small increases in demand can trigger the need to buy
complete new machines or build entirely new factories and premises, even though the
increase in demand may be relatively small.

Q) Write a short note on the working of a multiplier.

ANS- The concept of ‘Multiplier’ occupies an important place in Keynesian theory of

income, output and employment. It is an important tool of income propagation and business
cycle analysis. According to Keynes, employment depends upon effective demand, which in
turn, depends upon consumption and investment (Y = C + I). Consumption function, as we
have known, is stable in the short-run and MPC is less than unity.

Therefore, all the increases in income do not go to increase consumption to the extent of
increment in income, with the result, that a gap comes to exist between the incomes (output)
produced and consumed which must be made up by investment. Keynes believed that the
initial increment in investment increases the final income by many times to this relationship
between an initial increase in investment and the final increase in aggregate income. Keynes
gave the name of ‘Investment Multiplier’, also called ‘Income Multiplier’ by others.

Q) Write a short note on the working of an accelerator.

The Principle of Acceleration states that if the demand for consumption goods rises, there
will be an increase in the demand for the equipment, say machines, which produce these
goods. But the demand for the machines will increase at a faster rate than the increase in
demand for the product.

The accelerator, therefore, makes the level of investment a function of the rate of change in
consumption and not of the level of consumption. In other words, the accelerator measures
the changes in investment goods industries as a result of long-term changes in demand in
consumption goods industries.

The idea underlying the accelerator is of a functional relationship between the demand for
consumption goods and the demand for machines which make them. The acceleration
coefficient is the ratio between induced investments to a given net change in consumption
expenditures.