UNIT 1

TOPIC 3: KEYNESIAN THEORY OF

EMPLOYMENT
Before Keynesian theory, there was a classical theory given by classical economists like JS Mill,
Marshall, Pigou, etc. Keynesian theory of employment was based on the criticism of the
classical theory of employment. Keynes had rejected the classic theory of employment
because of its several flaws and then on the basis of those criticisms, he gave his theory.

Classical theory of employment: Full employment is a normal situation. Unemployment will

only be because of certain temporary bottlenecks. They said that there exist automatic
changes in the economy with the changes in the demand and supply and full employment will
always be maintained. Whenever any commodity is produced - it is because somewhere some
person has created the demand for that commodity. There won’t be disequilibrium between
demand and supply and as commodities will be produced, people will be there to purchase
that commodity, so that full employment will be there in economy.

Now, Keynes gave his theory of employment in his book “General Theory of Employment,
Interest and Money” (popularly known was GENERAL THEORY) which was published in 1930s
(at the time of Depression). Mainly Keynes had given his theory of employment at the time of
depression because during those times huge unemployment is there. So, classical theory had
failed during 1930s because it wasn’t able to explain how unemployment shall be reduced.
So, Keynes published the General Theory and in it he gave the Keynesian Theory of
Employment and explained how unemployment can be removed from the capitalist
economy. Keynesian theory was meant for capitalist economy. It is not applicable to less
developed or developing countries. The followers of Keynes included more things in the
Keynesian Theory which may be relevant for other economies also.

Keynesian Theory of Employment:

• Keynes attributed unemployment to a lack of “effective demand”.

The whole theory’s crux is based on effective demand. Effective demand is the core of
the Keynesian theory. Whether the economy will be fully employed or less
employment depends on the “effective demand” in the economy.
An economy which has effective demand has 3 criteria:
1. Desire, 2. Ability, 3. Willingness. Keynes is talking about this effective demand, i.e.,
DAW. Why is effective demand the core of the employment theory?
• Keynes measured the total output of the economy in terms of employment. When
we say total output, we meant total employment. Why? Because total output is the
whole number of goods and services. And who produces them? FOP. As much FOP are
employed, that much total output will be there. So, as the output increases, the
employment also increases. If there is need to increase output, employment will also
increase. Employment here means employment of all FOP, not just labor. TOTAL
 OUTPUT = TOTAL EMPLOYMENT. IF WE INCREASE OUTPUT, EMPLOYMENT WILL
INCREASE. BUT WE CANT INCREASE OUTPUT BECAUSE WE WANT TO INCREASE
EMPLOYMENT. OUTPUT DEPENDS ON EFFECTIVE DEMAND.
• Greater the output, greater the employment. National output depends on effective
demand. A commodity is only produced when there is demand for it in the economy.
• So, national output depends on the effective demand. Who will produce national
output? Producers. But, when will they produce? Only when they see that there is
effective demand. Now what does ED depend on?
• Effective demand comprises of consumption demand and investment demand.
Keynes didn’t talk about government expenditure (3 types – consumer, government,
investment). Consumption demand – expenditure on consumption goods. Investment
demand – expenditure on producer/investment goods. If effective demand has the
power to increase employment, then lack of effective demand means unemployment.
• If employment is governed by effective demand, then unemployment is due to lack
of effective demand. So Keynes said, if at all, employment is governed by ED and we
still see unemployment – this is due to lack of ED in the economy. If you wish to
increase employment in the economy, you must increase the ED.
• Deficiency of effective demand is because when NI increases, national consumption
also increases but by less than the increase in income. Why is this deficiency there in
a capitalist economy? In capitalist economies the Marginal Propensity to Consumer
(MPC) is low, that means, the inclination to consumer more commodities is on a lower
side because most of their demands are met. In general, whenever income of a person
increases, the consumption will also increase but the consumption will increase less
than the increase in income. This is Keynes’ Psychological Law of Consumption. This
law states “as income increases, consumption also increases but it increases by less
than increase in income”. As income goes on increasing, our consumption will also
increase. First, we’ll buy the necessary goods, then we’ll buy the luxury goods but as
the income goes on increasing – we consume some portion of income, we spend some
portion, but we also save some amount of income. This gap goes on widening and has
a cumulative effect on the economy. Till the time there exists a gap between
consumption and income, there will be unemployment in the economy. The gap is the
reason for unemployment.
• This gap between income and consumption can be filled by investment. So, Keynes
said that we can create/increase employment in the economy by filling this gap
between income and consumption. How to fill? Increasing investment in the economy.
Whoever invests – government or private producer. But Keynes was particularly
talking about private investment. Government investment was included later, but not
by Keynes. So, when we save a certain amount – due to which investment lacked –
due to which employment reduced – due to which income reduced – due to which
demand reduced. To fill this gap, invest. This is the reason why TOTAL OUTPUT =
TOTAL EMPLOYMENT = TOTAL EXPENDITURE = TOTAL INCOME.

Keynes had explained how the gap between income and consumption arises? For that, he
explained Effective Demand.

EFFECTIVE DEMAND depends on 2 factors:

• Aggregate Demand Function (ADF):
 It is a schedule of various amounts of money which the entrepreneurs in an economy
expect from the sale of their outputs at varying levels of employment. It is basically the
money that the entrepreneurs expect from the sale of their output. It is the ex-ante
(expected) revenue which the entrepreneurs are seeking. Ex post ante (realized).
It refers to receipts which entrepreneurs expect from the sale of output.
• Aggregate Supply Function (ASF):
It is a schedule of various amounts of money which the entrepreneurs in an economy
MUST receive from the sale of output at varying levels of employment. They must get this
amount to continue in the business. It is the cost which the entrepreneurs are bearing for
producing the output – and this cost they must realize to remain in business.

ASF thus represents COST which accrues to the entrepreneurs for producing certain level
of output. If they don’t get the total cost of production back from the sale of output – they
won’t continue in the business.

THEREFORE –
ASF: COST WHICH THE ENTREPRENEUR MUST GET BACK.
ADF: RECEIPTS WHICH THE ENTREPRENEUR EXPECTS FROM THE SALE OF OUTPUT.

AD and AS function:
Employment (N) Receipts (AD) Costs (AS)
25 250 240
30 260 255
35 270 270
40 280 285
40 290 300

Till 35 units of employment his receipts are more than the costs – so he should continue
employing but after 35 he should stop because now the costs are getting more than the
receipts.
When receipts = costs it is calling break-even point. At 35 units of employment he reaches the
break-even point where r = c, this is the equilibrium level of employment which is there in the
economy.
Suppose he increases the employment to 40 units – he will suffer losses because the cost will
be higher than the receipts.

Now, we don’t know whether at 35 units there is full employment or there are some other
factors of production lying unemployed.