Keynes’ Theory of Employment

– Principle of Effective Demand

Dr. Akshay Dhume

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Readings
 04A. Keynes’ Theory of Employment

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Prelude: The Classical Approach
 Primary Thesis
◦ There is always full employment or tendency towards full employment in
the economy
◦ In the event of unemployment, market forces through operation of price
mechanism will automatically restore full-employment in the economy

 Based on the following basic assumptions

◦ There is always enough expenditure or aggregate demand to purchase the
total output at full-employment level or resources
◦ Deficiency in aggregate demand is eliminated and full employment
equilibrium is restored due to flexibility in prices, wages and interest
◦ Wage = Marginal Product of Labor
◦ Money: medium of exchange

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Prelude:
The Classical Approach – 2 Basic Notions
 Say’s Law:
◦ Supply Creates Its Own Demand
 Source of demand for goods is the income earned by factor inputs
 Unemployed factors of production, when employed create demand for output
produced
 Any savings that may occur are invested thus increasing expenditure or demand
 No leakages and hence Say’s Law holds
◦ No problem of overproduction
◦ No possibility of lack of aggregate demand

 Digression: What makes Savings = Investment?

◦ Rate of Interest makes Savings = Investment
◦ If Savings Interest Rate Investment Savings become equal to
Investment

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Prelude:
The Classical Approach – 2 Basic Notions
 Wage Price Flexibility:
◦ Flexibility in prices ensure equilibrium in product market
 Amount of production does not only depend on aggregate demand, but
also on price level
 Aggregate demand for goods and services due to fall in investment
Prices aggregate demand equilibrium is restored at full-employment
level
◦ Flexibility in wages ensure equilibrium in labor market
 Aggregate demand for goods and services due to fall in investment
Prices
 Question: To what extent will producers tolerate price decline?
 Aggregate demand for goods and services demand for labor wages
demand for labor full employment is restored
 Labor that is not willing to work at lower wages will leave the labor force
– no involuntary unemployment
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Prelude:
The Classical Approach – 2 Basic Notions
 Wage-Price Flexibility: The Great Depression and
Pigou’s Solution
◦ Pigou suggested cut in wage rates to remove unemployment
◦ Cause of Depression: Government and trade unions were
preventing flexibility in wages and the wages were held at high
levels (artificially)
◦ Wage rate cuts stimulate demand for labor
◦ Pigou Effect or Real Balance Effect
 Unemployment Wages Prices Consumption Demand for labor
Employment
◦ Problem:
 Wage cuts reduced ability to purchase as a result of which
aggregate would reduce and unemployment would increase
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Keynes’ Theory of Employment: Principle
of Effective Demand

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Introduction
 Keynes theory is a short-run theory – “In the long-run we are all
dead”
 Keynes’ criticized Classical Theory
◦ Full employment need not always prevail – not a normal feature of advanced
capitalist economy
◦ Underemployment equilibrium is a normal feature
◦ Unemployment may not disappear automatically
 Proposed a more systematic and realistic theory
 Introduced new concepts
◦ Propensity of consume
◦ Multiplier
◦ Marginal Efficiency of Capital
◦ Liquidity Preference

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Assumptions
 Short-run theory
◦ Stock of capital, population and size of labor force,
technology, efficiency of labor, etc. does not change
◦ Hence, employment depends on level of national income
and production – higher level of national income, higher is
the employment and vice versa

 Prices and money wages are fixed and not flexible –

cannot adjust quickly to balance demand and supply

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Building Blocks:
Aggregate Supply Price, Function and Curve
 Aggregate supply price refers to the proceeds from the sale of
output at each level of employment and there are dif­ferent
aggregate supply prices for different levels of employment

 This information expressed in a tabular form, gives “ag­gregate

supply price schedule” or aggregate supply function

 Aggregate supply func­tion is a schedule of the minimum amounts

of proceeds required to induce varying quanti­ties of employment

 Plotting this information graphi­cally, we obtain aggregate supply

curve

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Building Blocks:
Aggregate Demand Price, Function and Curve
 Aggregate demand price is the amount of money or price which all entrepreneurs
expect to receive from the sale of output produced by a given number of workers
employed

 Each level of employment is associated with a particular aggregate demand price

and there are different aggregate demand prices for different levels of employment

 This information expressed in a tabular form, gives “ag­gregate demand price

schedule” or aggregate demand function

 Aggregate demand schedule shows the aggregate demand price for each possible
level of employment

 Plotting the aggregate demand schedule we obtain aggregate demand curve

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Factors Determining Aggregate Supply
Function (ASF)
 Physical and Technical Conditions of
Production – fixed in the short-run
 Level of output increased by
increase in level employment of
labor
 As output increases due to increase
in employment, cost of production
increases
 More workers are employed if
greater revenue is expected that will
cover higher costs
 Hence, Higher Receipts lead to
Higher Employment – ASC is
upward sloping

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Factors Determining Aggregate Supply
Function (ASF)
 Slope of ASC depends on
physical and technical conditions
 If technical conditions are such
that
◦ MC does not increase – ASC is a
straight line
◦ Diminishing returns – MC rises –
ASC slope increases with increase in
employment
 If wage rate rises with increase in
employment, slope of ASC increases
with increase in employment
 However, if huge unemployment –
wage rate remains constant even
with increase in employment
 Assume that MC is rising
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Factors Determining Aggregate Supply
Function (ASF)
 As quantity and quality of inputs
and technology change ASC
changes

 In short-run ASC remains constant

 Hence, in times of depression –

main problem is how to employ
idle resources to increase
production

 Therefore, Keynes paid greater

attention to factors determining AD

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Factors Determining Aggregate Supply
Function (ASF)
 At Full Employment
given the resources and
technology, increase in
employment cannot
increase output further.
 Results in inflation
 ASC

◦ Initially rises slowly

◦ Then rises rapidly
◦ At full employment
becomes vertical

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Aggregate Demand Function (ADF)
 Plays important role in determination of employment

 ADC shows for each possible level of employment the total proceeds which all
firms in the economy actually expect to receive from sale of output produced by
these workers

 Different levels of employment – Different levels of income are generated

 Different levels of income – Different levels of expenditure are generated –

especially consumption expenditure

 AD = C + I + G + NX

 Focus on C and I

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Factors Determining Aggregate Demand
Function (ADF)
 Consumption depend on
◦ Propensity to consume
 Depends on subjective factors like willingness to pay,
desire to imitate others
 Price level
 Taxation policy
 Rate of interest

 Given these factors, higher disposable income will

lead to higher consumption expenditure

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Factors Determining Aggregate Demand
Function (ADF)
 Investment depends on
◦ Rate of interest – more or less sticky
◦ Marginal Efficiency of Capital (i.e. Expected Rate of Return) –
causes frequent changes in inducement to invest
 Business confidence is high prospects of making gains are high
investment
 Business confidence is low prospects of making gains are low
investment
 Factors Determining Business expectations
 Estimates of consumer demand for goods and services
 Taxation policy
 Expectations about change in technology
◦ Investment demand volatile due to frequent changes in
expectations
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Factors Determining Aggregate Demand
Function (ADF)
 Investment
◦ Recall: AD = C + I + G + NX
◦ Pessimistic Business Expectations
Lowers Investment Lower
Aggregate Demand
◦ Optimistic Business Expectations
Higer Investment Higher Aggregate
Demand

 Recall: Consumption Demand and

Income are positively related

 Depiction of ADC showing

relationship between aggregate
demand price and employment
level is upward sloping
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Determination of Equilibrium
 ASC: minimum revenue that must  Opportunities to make profits do
be received by entrepreneurs to not exist if aggregate demand
provide various levels of price is less than aggregate supply
employment to difference price
 ADC: receipts that the  Equilibrium is at the point of
entrepreneurs expect to receive at intersection
different levels of employment
 Given perfect competition,
employment as long as profit
making opportunities exist
 Opportunities to make profits exist
if aggregate demand price is
greater than aggregate supply
price

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About the Equilibrium
 Effective demand is the
volume of total expenditure at
(short-run) equilibrium
 Not necessary the equilibrium
is at full-employment level –
contrary to Classical thesis
 Only way to increase
employment in short-run is by
increasing effective demand
 Unemployment will be
removed and full-employment
will be achieved by C and I

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