Keynesian Theory of Income and Employment

Keynesian Theory of Income and Employment

John Maynard Keynes General Theory of Employment, Interest and Money (1936) attacked the major postulates of classical theory.

Classical Theory of Income and Employment

Existence of full employment without inflation Closed laissez faire capitalist economy without foreign trade Homogeneous labour Y=C+I The quantity of Money is Given, MV = PT Wages and prices are flexible Money wages and real wages are directly related and proportional Capital stock and technological knowledge are given Says law of Markets

Says law of Markets

J.B Say Supply creates its own demand There is no general over production since, SS = DD , S=I Equilibrium: adjustment through rate of interest r [S and I = f (r)] r saving r demand for investments

Says law of Markets

If over production, Labours leave. Short run

Quantity Theory of Money

MV = PT M = Supply of Money V = Velocity of Money P = Price level T = Volume of Transactions Money Supply (MV) = Total Value of Output (PT) M causes proportional change in P Ms is Neutral

Summary of Classical Model

Level of Employment Labour market Demand for and Supply of Labour, f (w/p) Total Output Goods Market Employment (N), Capital Stock (K) and Technical Knowledge (T) Price Level Money Market MV = PT Great depression

Criticisms Against Classical Theory

Keynes rejected the assumption of full employment Rejected Says Law Laissez faire is not self adjusting Capitalist system not self adjusting S = I is not valid since S = f (y and not r) In Classical, Money transaction and precautionary only not Speculative Neutrality of Money Keynes integrated monetary and real sectrors of the economy.

Keynesian Theory of Employment, Interest and Money

J. M Keynes General theory of employment, Interest and Money (1936) Short run theory (amount of capital, labour force, technology, etc does not change)

Keynesian Theory of Employment

Effective Demand Level of employment in short run is determined by effective demand Aggregate Demand (Price) = Aggregate Supply (Price)

Aggregate Demand
the amount of goods and services people wish to purchase at the existing price level Expected receipts when a given volume of employment is offered to workers. Number of workers Output Varies at different levels of employment bcoz, employment income consumption Components: Consumption (C) + Investment (I) + Govt. Expenditure (G) & Net Exports (X-M)

Aggregate Supply
the amount of final goods and services produced in an economy at the existing price level Minimum sales proceeds..total cost of production at a given level of employment Z = (N) Employment Aggregate supply price of the output Slopes upward from left to right; when economy reaches full employment the AS curve becomes vertical.

Effective Demand
AS Point of Effective Demand

Price level

S2

D2 AD

Out put, Income

Importance of Effective Demand

Rejection of Says Law - All income is not invested. Refutes Pigous Wage Cut theory Pigou: cut in money wage increase employment But, Money wage Consumption Employment Importance of Investment investment increases employment and income Determines Employment Emphasis on Demand side Explaining Paradox of poverty Poverty in the midst of plenty Unemployment in Capitalism Psychological Law income consumption but less than proportionally Gap between income and consumption not filled by investment

Keynes Theory of Employment and Income

Consumption Saving Investment Govt. Expenditure Net exports

Consumption Function
C = f (Y) , where, Y = Real Current National Income Average Propensity to Consume (APC) Proportion of whole income which is spend on consumption.

Total Consumptio n APC = Total Income

C = Y

Average Propensity to Save (APS) = 1 APC Marginal Propensity to Consume (MPC) Ratio of change in consumption due to a change in income

Change in Consumption C MPC = = Change in Income Y

Marginal Propensity to Save = 1 MPC

Psychological Law of Consumption

Men are disposed as a rule and on the average to increase in their consumption as their income increases but not by as much as the increase in their income. Hence MPC is always less than 1.

Investment Function
Real investment - Increment in Capital goods Financial Investment purchase of stocks of existing companies, doesnt increase productive capacity of the economy. I depends on MEC, should be higher than rate of interest (r). MEC and r are inversely related MEC is the expected rate of return (discounted) over cost of a new capital good. Induced investment profit or income motivated Autonomous Investment independent of level of income, influenced by exogenous factors

Keynesian Theory
Total Output = National Income National Income Level of Employment , Y = f (N) Employment Effective Demand N = f (ED)

Effective Demand Aggregate Supply (g) Consumption Size of Y APC/MPC Prospective Yield MEC Aggregate Demand Investment r Supply DD SS Price Money Money(g) Precautionary Motive

Transactionary Motive

Speculative Motive

Determination of National Income

Aggregate Demand = Aggregate Supply Aggregate Demand = C + I Aggregate Supply: total monetary value of goods and services produced in an economy Y = f (N,K^,T^) Planned output 450 line

Determination of National Income

AS C+I+G E C Z C+I

Y =NI

National Income: Change in Investment

C+I+G Full Employment F
E

Z C+I+I C+I C

Y
O Y YF NI

Multiplier (K)
Change in Income (Y), as a result of Change in Investment (I) at a given propensity to Consume. Y = K. I

1 K= or 1 1 MPC
If MPC = 0.75, Multiplier = = 4

1 MPS

Inflationary Gap

The amount by which the actual aggregate demand exceeds the level of national income corresponding to full employment is known as inflationary gap because this excess aggregate demand causes inflation or rise in prices. C + I + G > the full employment GNP level

Inflationary Gap
C+I+G Inflationary Gap Z C+I+G H T E Full Employment Output C+I+G

YF

YX

NI

Deflationary Gap Deflationary Gap represents the difference between the actual aggregate demand and the aggregate demand which is required to establish the equilibrium at full employment level of Income. (Causes

Depression)

Deflationary Gap
C+I+G Deflationary Gap Z C+I+G E C+I+G H Q Full Employment Output

YX

YF

NI

Thank you..