THE KEYNESIAN CRITIQUE OF THE CLASSICAL

SYSTEM
 Adam smith, credited by many as the founder of classical
economics believed the government should intervene in
economic affairs as little as possible
John Maynard Keynes asked, “If supply creates its
own demand, why are we having a worldwide
depression?”

 John Maynard Keynes advocated massive government

intervention to bring an end to the Great Depression
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
11-30
KEYNESIAN ECONOMICS
The Great Depression of the 1930s
Keynes and Keynesian Economics
 Keynes (1936), General Theory of Employment, Interest and
Money
 the capitalist economy is inherently unstable and likely to
achieve equilibrium with considerable unemployment or severe
inflation, and the possibility of persistent unemployment

C O P Y R I G H T  2 0 0 4 M C G R AW- H I L L A U S T R A L I A P T Y LT D
P P T S T / A M A C R O E C O N O M I C S 7 / E B Y J A C K S O N A N D M C I V E R
S L I D E S P R E PA R E D B Y M U N I P E R U M A L , U N I V E R S I T Y O F C A N B E R R A , A U S T R A L I A
 EFFECTIVE DEMAND
PRINCIPLE OF EFFECTIVE DEMAND is the pillar
of keynesian theory of employment
effective demand is that level of aggregate demand at
which it is equal to aggregate supply.
effective demand is expressed by aggregate
expenditure of an economy
ad refers to aggregate demand expenditure in an
economy.
it refers to the amount that all the people of an
economy may spend on buying goods produced at a
given level of employment.
 WHAT IS EFFECTIVE DEMAND?

In other words, effective demand is the signification of the

equilibrium between aggregate demand (C+I) and aggregate supply
(C+S).
This equilibrium position (effective demand) indicates that the
entrepreneurs neither have a tendency to increase production nor a
tendency to decrease production.
It implies that the national income and employment which
correspond to the effective demand are equilibrium levels of national
income and employment.

Unlike classical theory of income and employment, Keynesian theory

of income and employment emphasizes that the equilibrium level of
employment would not necessarily be full employment. It can be
 Monetary
Policy Output(GDP)
Fiscal Policy

Other Aggregate Demand

Factors Employment
Interaction
of Aggregate and
Supply and Unempoyment
Price leveland Demand
Costs
Potentila Prices and
Output Inflation
Capital, Aggregate Supply
Labour,
Technology
Foreign Trade
ADF
Aggregate Demand Schedule or Aggregate Demand Function: It refers to
the entire table showing producer’s maximum expected receipts from the
sale of their output corresponding to various levels of employment.
AD=f(N)

Level of Employment (in Aggregate demand price

Lakh) (ADP) in crore rs.

0 100
10 360
20 420
30 480
40 540
50 600
60 660
ADC
Aggregate Demand Curve (ADC):
It is a curve which expresses relationship between aggregate demand price and
employment.

Y
Expected Receipts

AD

O X
Employment
 AGGREGATE SUPPLY (C+S):

In other words, the aggregate supply is the value of final output valued at
factor cost.
The aggregate supply price is the minimum amount of money which the
entrepreneurs must receive to cover the costs of output produced by
the employment of certain number of workers.
The aggregate supply curve, (C+S) is positively sloped indicating that as
the level of employment increases, the level of output also increases,
thereby, increasing the aggregate, supply. Thus, the aggregate supply
(C+S) depends upon the level of employment through the economy's
aggregate production function.
Aggregate Supply Schedule /Aggregate Supply Function (ADF):
It is a schedule/Table which shows various amount of money which all the
producers must receive from the sale of output at varying levels of
employment.

Level of Employment Aggregate Supply Price (crore

rs)
0 0
10 120
20 240
30 360
40 480
50 600
60 720
Y
Aggregate Supply Curve
AS=f(N)

Y
ASC

Proceeds
Minimum Expected

Employment X
 DETERMINATION OF EFFECTIVE DEMAND

Effective Demand
Employ AD AS Equilibri
ment (crore rs) (crore um
rs) Y
AS

Expected Receipts
0 100 0 Disequi
10 360 120 AD>AS AD
20 420 240 AD>AS
E
30 480 360 AD>AS
40 540 480 AD>AS
50 600 600 ED
60 660 720 AD<AS
O X
Employment
 AGGREGATE DEMAND EXCEEDS AGGREGATE
SUPPLY

When aggregate demand exceeds aggregate

supply the economy is in disequilibrium
 Output is increased in response
 Eventually, the economy approaches full capacity
followed by price increases
It appears that there are two ways to raise
aggregate supply
 By increasing output
 By increasing prices
By doing this, aggregate supply is raised relative
to aggregate demand and equilibrium is
restored
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
11-43
 AGGREGATE SUPPLY EXCEEDS AGGREGATE
DEMAND

When aggregate supply exceeds aggregate

demand the economy is in disequilibrium
 Inventories rise and output is decreased
 Workers are laid off, further depressing aggregate
demand as these workers cut back on their consumption
 Eventually, inventories are sufficiently depleted
In the meantime, aggregate supply has fallen
back into equilibrium with aggregate demand

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

11-44
Determination of Level of Employment and Income:

According to Keynes, the equilibrium levels of national income and employment are
determined by the interaction of aggregate demand curve (AD) and aggregate
supply curve (AS). The equilibrium level of income determined by the equality
of AD and AS does not necessarily indicate the full employment level. The
equilibrium position between aggregate demand and aggregate supply can be
below or above the level of full employment as is shown in the curve below.
Diagram/Figure:
KEYNESIAN THEORY
Effective
demand

Aggregate
Supply Aggregate
Demand

Consumption Investment
Government
Function Function
expenditure

Size of Propensity to Rate of Autonomous

MEC
Income consume interest Investment