Unit II---

Theory of Full Employment and Income : Classical

Income and employment theory, a body of economic analysis concerned with the relative
levels of output, employment, and prices in an economy. By defining the inter-relation of these
macroeconomic factors, Governments try to create policies that contribute to economic
stability .

Classical Theory of Income and Employment

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

(i) An economy, as a whole, always functions at the level of full employment

(a)Full employment level of output of goods and services is the largest output that the
economy is capable of producing when all its resources are fully employed. Full employment
is regarded as a normal situation, yet there could be a temporary unemployment.

(b)If at all there is unemployment, it must be a temporary one and it will be cured automatically
through free play of economic forces. Classical behave that aggregate supply would always
be at full employment level which is based on two assumptions, namely Say’s Law of Market
and Wage-price flexibility as explained below.

(ii) Supply creates its own demand

Classical theory of employment is based on ‘Say’s Law of market’ which states that ‘supply
creates its own demand’. This implies that supply creates a matching demand for it with the
result that the whole of output is sold out. So, there is no deficiency in aggregate demand and
hence no possibility of over-production and unemployment. Thus, equilibrium level of income
and employment is established only at the level of full employment.

Production of Goods Worth ---------------------- Creation of Income by Way

Rs.100 Crores. of Wages, Rent, Interest etc.
to the tune of Rs.100
crores .

Income of Rs.100
Crores becomes the
source of Demand for
Supply of Goods Worth goods worth Rs.100
Rs.100 Crores. Crores
-Assumptions of Say’s Law of Market

1. Whatever income the economy generates is instantaneously spent either on

consumption or on capital good .
2. There is perfect competition in products ,factor and money market.
3. There is no Government intereference in the functioning of the economy.
4. The amount of labour and capital can be raised to any extent in a free enterprise
economy based on price mechanism.
5. New entrants have easy access into the market without dislocating the existing ones.
6. It is a closed laissaize-faire capitalist economy, which implies absence of trade or
financial relationship with other economies.
Implications of Say’s Law of Market
1. The economy under consideration is a two sector economy, household and
business.
2. Unemployed resources profitable to employ and, they pay on their own, economy
operate at full employment level.
3.There is no overproduction .
4.Savings are only a form of investment.
5.The wage flexibility brings about full employment without inflation.
6. The classical theory of employment rules out the possibility of deficient demand and
hence ,involuntary unemployment .
7. Flexible system of prices, interest rates and wages

(a) Price mechanism automatically brings equilibrium between demand and supply in the
market.

(b) Flexibility of interest rates brings about equality between savings and investment.

(c) Flexibility of wage rates brings about full employment equilibrium. As a result, the
aggregate supply is always at full employment level of output.

Criticism:

The Classical theory of income and employment has been severely criticized by J.M.Keynes
and other on the following grounds.

I. Demand and supply may not be equal.

II. Role of rate of interest expose flexibility and equalizes savings and investment, but
S,I, depend on Income also.
III. Practical Experience: Say’s Law of Market is not supported by facts and practical
experience.
IV. Employment cannot be increased by general money wage cut.
V. Criticism of Laissaize Faires Policy-Role of Government to control and develop
economy through policies- Monetary, Fiscal, Trade, Tax, Industry etc.
Lecture: KEYNESIAN THEORY OF FULL EMPLOYMENT
Keynesian Theory was contrary to Classical Policy of Laissez-faire . He argued that the postulates of the
classical theory are applicable to a special case of full employment only and not to the general case. The
fundamental assumption of full employment condition by classical economists is itself not very realistic,
and hence Keynes regarded it as only a special case.
In his theory, Keynes refers to concepts such as demand, consumption, investment, saving, employment,
income and output in the aggregate sense or as pertaining to the economic system as a whole.
ASSUMPTIONS OF KEYNESIAN THEORY
(1) The Short Period: Keynes was writing about the short period problem of depression. Therefore, he
made the specific assumption of short-period so as to concentrate on the problem at hand. Keynes
assumed that the techniques of production and the amount of fixed capital used remain constant in the
model of his theory. In his view, short period is that in which new investments do not change the
technique, the organization and equipment. This considerably simplified his analysis, for he could
thereby take employment and output as moving together in the same direction.
(2) Perfect Competition: He assumed that there is a fairly high degree of consumption in the markets. Or
if there is some monopoly element somewhere, then its degree remains unchanged.
(3) Fixed Aggregate Price: The aggregate price level remains fixed. This means that all variables are real
variables and all changes are in real terms.
(4) Absence of Governmental part in Economic Activity: The Government is assumed to play no
significant role either as a taxer or as a spender. He ignored the fiscal operations of the government in his
analysis to highlight the causes of and remedies for instability of the pure capitalist economy.
(5) A Closed Economy: Keynes further assumed that the Economy under analysis is a closed one; that is,
he did not explicitly recognize in his analysis the influence of exports and imports. This considerably
simplified his work.
(6) Static Analysis: Keynes states that increase in employment depends on increase in aggregate demand.
Aggregate demand increases though increase in investment, increase in government expenditure and so
on. So, demand is much more important in Keynesian theory. Effective demand is said to exist at the
point where aggregate demand is equal to aggregate supply. According to Keynes, in the short-run, the
determination of the level of employment and income depends upon the effective demand of goods.
(7) Diminishing Marginal Productivity: Diminishing marginal returns is when an advantage is gained in
a factor of production; the marginal productivity will typically diminish as production increases. This
means that the cost advantage usually diminishes for each additional unit of input produced.
EXPLANATION OF KEYNESIAN THEORY
(I)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.
(II)The theory of Keynes was against the belief of classical economists that the market forces in capitalist
economy adjust themselves to attain equilibrium. He has criticized classical theory of employment in his
book. Vie General Theory of Employment, Interest and Money. Keynes not only criticized classical
economists, but also advocated his own theory of employment.

Effective demand represents that aggregate demand or total spending (consumption expenditure and investment expenditure)
which matches with aggregate supply (national income at factor cost).
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 below or above the level of full
employment.
Determinants of Income:
The determinants of effective demand and so of equilibrium level of national income and employment are the aggregate
demand and aggregate supply.
 (1) Aggregate Demand (C+l):
Aggregate demand refers to the sum of expenditure, households, firms and the government is undertaking on consumption
and investment in an economy. The aggregate demand price is the amount of money which the entrepreneurs expect to receive
as a result of the sale of output produced by the employment of certain number of workers. An increase in the level of
employment raises the expected proceeds and a decrease in the level of employment lowers it.
The aggregate demand curve AD (C+I) would be positively sloping signifying that as the level of employment increases, the
level of output also increases, thereby increasing of aggregate demand (C+l) for goods.
The aggregate demand (C+l), thus, depends directly on the level of real national income and indirectly on the level of
employment.
(2) Aggregate Supply (C+S):
The aggregate supply refers to the flow of output produced by the employment of workers in an economy during a short
period. 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 cost.
The aggregate supply is denoted by (AS) because a part of this is consumed (C) and the other part is saved (S) in the form of
inventories of unsold output. 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
.
Propensity to consume , is the proportion of total income or of an increase in income that consumers tend to spend on goods
and services rather than to save. It is of two types:
(1) Average Propensity to Consume (APC):
Average propensity to consume refers to the ratio of consumption expenditure to the corresponding level of income.
APC = Consumption (C) / Income (Y)
2. Marginal Propensity to Consume (MPC):
Marginal propensity to consume refers to the ratio of change in consumption expenditure to change in total income. MPC
explains what proportion of change in income is spent on consumption.
MPC = Change in Consumption (∆C) / Change in Income (∆Y)
Investment refers to that expenditure which leads to addition to the total stock of capital assets.
DETERMINATION OF EMPLOYMENT
Aggregate Demand Function
Aggregate demand is the amount of total receipts which all the firms expect to receive from the sale of output produced by a
given number of workers employed. Aggregate demand increases with increase in the number of workers employed. The
aggregate demand function curve is a rising curve as shown in Fig. 1.
Figure.: Aggregate Demand Function
It can be seen that total expected receipts is D 1L1 at OL1 level of employment. Total expected receipts increase to D 2L2 with
increase in the level of employment to OL 2. OLf is the full employment level. Initially the aggregate demand function (ADF)
rises sharply as increase in the number of employment leads to increase in society's expenditure, thereby, increasing
producer's expected sales receipts.
There is no much increase in employment, income, expenditure and therefore producer's expected sales receipts as the
economy reaches near full-employment. The ADF curve becomes perfectly elastic (horizontal) as the economy reaches near
full-employment.
Aggregate Demand In Keynes’ theory of income determination is society’s planned expenditure. In a laissez-faire economy it
consists of consumption expenditure (C)and investment expenditure (I).
Thus AD = Planned Expenditure = C + I
Aggregate Supply Function
Aggregate supply is determined by physical and technical conditions of production. However, these conditions remain
constant in the short run. As such, given the technical conditions, output in the short run can be increases only by increasing
employment of labor.
Aggregate supply is the amount of total receipts which all the firms must expect to receive from the sale of output produced by
a given number of workers employed. In other words, aggregate supply price is the total cost of production incurred by
producers by employing a certain given number of workers. Obviously, aggregate supply price increases with increase in the
number of workers employed. The aggregate supply function curve is a rising curve and at full employment (OL f) it becomes
perfectly inelastic (vertical).
Aggregate Supply Function
It can be seen that aggregate supply price or the cost of production is S 1L1 at OL1 level of employment. It increases to S 2L2 with
increase in the level of employment to OL 2. Initially, the aggregate supply function (ASF) rises slowly as labor is abundant
thereby leading to slow increase in the cost of production. Labor cost rises sharply as the economy reaches near full-
employment. The ASF therefore rises sharply and at full employment (OLf) it becomes perfectly inelastic (vertical).
DETERMINATION OF EQUILIBRIUM LEVEL OF EMPLOYMENT
According to Keynes equilibrium level of
employment (income) in the short run is determined by the level of effective demand. The higher the level of effective demand,
the greater would be the level of income and employment and vice versa. ADF and ASF together . As discussed above the ADF
shows the amount of total receipts which all the firms expect to receive from the sale of output produced by a given number of
workers employed and the ASF shows the amount of total receipts which all the firms must expect to receive from the sale of
output produced by a given number of workers employed .Entrepreneurs expand output as long as there are opportunities to
make profits.
Determination of Equilibrium Employment

It can be seen that up to OL level of employment, aggregate demand price is greater than aggregate supply price (AD > AS).
Producers expect greater returns than the cost of production. As such, producers expand output up to OL level of
employment. Thus at any level of employment up to OL, there would be expansionary tendency in the economy and therefore
rise in the level of employment.
Beyond OL level of employment, aggregate demand price is less than aggregate supply price (AD< AS). Producers expect less
return than the cost of production. Thus at any level of employment beyond OL, there would be contractionary tendency in
the economy and therefore fall in the level of employment. At OL level of employment aggregate demand price equals
aggregate supply price (AD = AS). Thus OL is the equilibrium level of employment. Point 'E' is called the point of effective
demand. It represents that level of aggregate demand price that is equal to aggregate supply price and thus reaches short run
equilibrium position.
It can be seen that equilibrium point 'E' is established at less-than-full employment equilibrium and there is LLf amount of
involuntary unemployment in the economy.
VI.DIFFERENCE BETWEEN CLASSICAL THEORY AND KEYNESIAN THEORY
1. Money Supply: Increase in the supply of money under classical system may create inflationary tendencies,
due to the assumption of automatic full employment.
However in the Keynesian analysis, increase in money supply will increase output and employment. Inflation
will arise only after full employment has been achieved.
2. Money wages: The classical economists further believe that in case the economy departs from full
employment, equilibrium would be restored through cut in money wages.
Keynes, however, considered this belief as unrealistic and theoretically unsound. He suggested that lowering of
wages in a particular industry might raise employment in that industry, but if wages are reduced everywhere, it
would reduce income, output and employment levels.
3. Saving Investment Analysis : With classical economists, the saving investment analysis is a tool to explain
the determination of the rate of interest. Any change in prevailing rate of interest creates disparity between
savings and investment. In other words saving is brought into equilibrium with investment through variation in
the rate of interest.
Keynes, on the other hand, treats saving investment analysis as a device to determine the level of income and
employment. If saving exceeds investment, there is less consumption expenditure. Consequently, demand
declines. This will result in over production and fall in saving, investment, income, employment and output. A
low rate of interest will not increase investment, when business expectations are poor. Thus equilibrium
between saving and investment is achieved through changes in the level of income. That is why, Keynesian
theory is more or less and useful to explain economic growth.
4. Time Period: Classical theory works only in the long run.
Keynes questions the usefulness of such analysis and give the theory that works in the short run.
5. Change in economic activity: The classical economists believe that any change in the level of economic
activity can be brought about by the changes in the quantity of money and the rate of interest. They advocate the
use of monetary policy (increase in the supply of money and reduction in the rate of interest) to control
unemployment, business depreciation etc.
Keynes, on the other hand, relies on physical policy (public expenditure, deficit financing etc.) to overcome
such problems.
6. Treatment of Supply: The classical theory lays more emphasis on ‘supply’ as determinant of the
equilibrium level of income and employment in the economy. It assumes that supply creates its own demand,
i.e. a flow usage of the variable.
Keynes, on the other hand, treats supply (the level of national output)as given and leaves the demand to bring
about equilibrium in the economy. That is, supply is a stock variable in the Keynesian analysis.
7. Rate of Interest: In the classical theory, savings and investment decisions are made by the same group of
people. Hence, saving and investment tend to be equal. Any inequality between the two is restore through the
rate of interest. The rate of interest, thus, occupies an important place under the classical system. Even equality
of aggregate demand and aggregate supply is brought about by the rate of interest.
Keynes however, regards interest as a reward for parting with liquidity and gives less importance to the rate of
interest. In his view, changes in the economy are the result of the changes in the level of income and
expenditure and not the rate of interest. Further, saving and investment would only be equal when the economy
is in equilibrium, as saving and investment functions are performed by different groups of people with different
motives.
8. Theory of Money and Value: The classical thinkers suggested two separate sets of theories, one for money
and other for value and output.
Keynes has, however, integrated the theory of money with the theory of value and output. According to him, the
two theories cannot be segregated as money supply affects income, output and employment.
9. Equilibrium: The classical thinkers assume that economy invariably attains stable equilibrium at full
employment. Thus, the classical theory exclusively deals with the specific situation of full employment and
rules out the possibility of general unemployment.
On the contrary Keynesian theory is a general theory and explains the working of an economy in all sorts of
situations, namely full employment, near full employment, under employment, unemployment, etc. According
to Keynes, full employment equilibrium occurs only rarely and generally an economy is in equilibrium at a
level short of full employment.
VII.CRITICISM OF KEYNESIAN THEORY
1. Does not provide comprehensive solution of unemployment: Keynes theory does provide solution of all
types of unemployment. It deals with only cyclical unemployment. Keynes did not attempt to solve
unemployment of under-developed countries.
2. Unrealistic assumption of perfect competition : In real business world imperfect competition is found
instead of perfect competition even in capitalist economics. Therefore, it is not applicable in advanced
economies.
3. No determinate functional relationship between effective demand and employment: Keynes said there is
no direct relationship between ED and level of employment. In fact everything depends upon the complex inter-
relationship of wage rates, prices and money supply.
4. Wholly aggregative in nature: It is highly aggregative because it deals with aggregate concepts such as
aggregate consumption, total investment and total output.
5. Undue importance to inducement to invest: Keynes theories solely rely on investment to increase
employment. Critiques point out that other determinants of employment were ignored by Keynes.
6. Criticism of consumption function: Everybody knows that when income increases, consumption also
increases. Thus, consumption function is a truism.
7. Keynes ignores long-run problem: Keynes assumes that ASF is given. Thus, it is a short-run theory and
provide solution to short-run employment problem. Keynes himself said, “In future we are all dead.”
8. Keynes theory is not general: Keynes theory is not applicable anywhere and everywhere. Its application, as
best, is limited to industrially advanced countries and it has little relevance to the problems of underdeveloped
countries like India.
9. Keynes ignored accelerator effect: Accelerator and multiplier work simultaneously. Multiplier describes the
effect of investment on consumption and the accelerator shows the effect of consumption on investment. But
Keynes ignored the accelerator effect completely.
10. No explanation of partial equilibrium: Keynes theory offers no solution to the problem of depression in
an individual or particular industry.