Theory of full employment and

Income

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 Theories of income and employment
Two important theories of income and
employments are :
1. Classical Theory of Income and Employment,
2. Keynesian Theory of Income and Employment

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 Classical Theory
The theory is ascribed to early Classical
economists like Adam Smith, Ricardo, Karl Marx
and Malthus and neo-classical like Marshall,
Pigou and Robbins.

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 Assumptions of Classical Theory
• Free market capitalistic society
• Full employment is a normal situation in a
developed capitalistic economy
• Perfect competition in product and labour market
• Assumption of Laissez-faire policy
• Assumption of closed economy
• Money is only a medium of exchange
• Equality between saving and investment

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 Concept of full employment
According to classical theory, “Full employment is a
normal feature of capitalistic economy”
Full employment refers to that situation in which at
a given level of real wage, demand for labour is
equal to the available supply of labour.
It simply means the situation wherein proper
balance is struck between job givers and job
seekers. But in this equilibrium situation, some kind
of unemployment may be found (natural rate of
unemployment)
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Full employment is consistent with the
following categories of employment:
• Voluntary unemployment
• Frictional unemployment
• Structural unemployment
• Seasonal unemployment
• Technical unemployment

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 Basis of Say’s Law of markets
An important element of classical economics is
Say’s Law of Markets, after J.B. Say, a French
economist who first stated the law in a systematic
form.
According to this, supply creates its own demand
and the problem of overproduction and
unemployment does not arise. Thus there is always
full employment in the economy.
If there is overproduction and unemployment, the
automatic forces of demand and supply in the
market will bring back the full employment level.

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 Say’s Law
Say’s law can be interpreted as identity and as an
equality
1. Say’s identity implies that the money market is
always in equilibrium, for supply of goods would
mean demand for money for the purchase of
other commodities, irrespective of the price
level.
2. Say’s equality implies that a perfectly
competitive economy has an inherent tendency
towards full employment via wage-price
flexibility

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 Criticism of Classical theory of
employment
Keynes strongly criticised the classical theory of
employment for its unrealistic assumptions in his General
Theory. He attacked the classical theory on the following
counts
• Refutation of Say’s Law
• Saving and investment are not interest elastic
• Criticism of flexibility of wages argument
• Supply of labour not a direct function of real wages
• Wrong concept of automatic adjustment
• Employment cannot be increased by general money
cut

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 Criticism of Classical theory of
employment
• Criticism of laissez-faire policy
• It is not based on empirical facts
• Invalidity of quantity theory of money

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 Keynesian Theory of Income and
Employment
Keynes criticised the Classical theory stating that the
assumptions on which the theory is based are wrong and
impractical. For example:
I. In real world situation, an economy often does not
function at the level of full employment; rather it
generally functions at less than full employment level,
II. Supply cannot create its equivalent demand on its own
and, therefore, there is every possibility of general over-
production and unemployment,
III. Similarly, prices, wages and interest rates may not be
flexible due to presence of monopolies and trade unions.

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 Keynesian Theory of Income and
Employment
With this background, Keynes, a British
Economist, propounded his own theory and in
1936, brought out his famous book “General
Theory of Income, Interest and Money” which
brought about a revolution in economic
thought. This led to the emergence of
Macroeconomics as a separate branch of
economics.

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 Assumptions of this theory:
• Theory is applicable in advanced capitalistic economy
• Assumption of short period
• Assumption of perfect competition
• Closed economy in economy have no exports and
imports
• It ignores the role of Government as a spender or a
taxer
• Money also acts as a store of value
• No time lag
• Labour is the only variable factor of production

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 Keynesian Theory
The main point related to starting point of
Keynes theory of employment is the principle of
effective demand. Keynes propounded that the
level of employment in the short run is
dependent on the aggregate effective demand
of products and services.
Effective demand is that level of demand at
which aggregate demand is equal to aggregate
supply.

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 Basic elements of Keyenesian theory
1. Aggregate Supply
2. Aggregate demand
2.1 Consumption expenditure
2.1.1Size of Income
2.1.2 Propensity to consume
2.1.2.1 Average propensity to consume
2.1.2.2 Marginal Propensity to consume
2.2 Investment
2.2.1 Rate of Interest
2.2.2 Marginal efficiency of Capital
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 Keynesian Theory
As per Keynes theory of employment, effective
demand signifies the money spent on the
consumption of goods and services and on
investment. The total expenditure is equal to the
national income, which is equivalent to the national
output. Therefore, effective demand is equal to
total expenditure as well as national income and
national output.
The effective demand can be expressed as follows:
Effective demand = National Income = National Output

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 Features of Keynesian Theory
I. An economy can be in equilibrium even at
less than full employment level
II. Demand creates its own supply
III. Equilibrium level of income and employment
is determined by aggregate demand and
aggregate supply

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An economy can be in equilibrium even at
less than full employment level:
Economic system does not ensure automatic
equality between ‘aggregate demand’ and
‘aggregate supply at full employment’ as
believed by Classical. He proved that an
economy could be in equilibrium even at less
than full employment level. This is the basic
difference between Classical Theory and
Keynesian Theory.

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 Demand creates its own supply:
Aggregate demand for goods and services
directly determines the level of output, income
and employment. If AD increases, level of
output will go up by increasing employment of
resources to meet increased demand and as a
result income will also go up. Thus, demand
creates its own supply.

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Equilibrium level of income and employment is
determined by aggregate demand and
aggregate supply
But this does not mean level of full employment. The
equilibrium level of income maybe at below or above the level
of full employment .In reality, an economy operates very often
at less than full employment equilibrium. Since in the short
run, aggregate supply does not change, it, therefore, changes
in aggregate demand which brings about changes in income
and employment.

This is the gist of Keynesian approach. The core issue of

macroeconomics is the determination of level of income,
employment and output. According to this theory, in an
economy income and employment are in equilibrium at that
level at which Aggregate Demand = Aggregate Supply

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