Keynesian Theory of Income and Employment

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 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. His theory was followed by several modern economists. Keynes book was
published post-Great Depression period. The Great Depression had proved that market
forces cannot attain equilibrium themselves; they need an external support for achieving it.
This became a major reason for accepting the Keynes view of employment.
The Keynes theory of employment was based on the view of the short run. In the short run,
he assumed that the factors of production, such as capital goods, supply of labor,
technology, and efficiency of labor, remain unchanged while determining the level of
employment. Therefore, according to Keynes, level of employment is dependent on national
income and output.
In addition, Keynes advocated that if there is an increase in national income, there would be
an increase in level of employment and vice versa. Therefore, Keynes theory of employment
is also known as theory of employment determination and theory of income determination.
Principle of Effective Demand:
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.
According to him, an increase in the aggregate effective demand would increase the level of
employment and vice-versa. Total employment of a country can be determined with the help
of total demand of the country. A decline in total effective demand would lead to
unemployment.
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
Therefore effective demand affects employment level of a country, national income, and
national output. It declines due to the mismatch of income and consumption and this decline
lead to unemployment.
With the increase in the national income the consumption rate also increases, but the
increase in consumption rate is relatively low as compared to the increase in national
income. Low consumption rate leads to a decline in effective demand.
Therefore, the gap between the income and consumption rate should be reduced by
increasing the number of investment opportunities. Consequently, effective demand also
increases, which further helps in reducing unemployment and bringing full employment
condition.
Moreover, effective demand refers to the total expenditure of an economy at a particular
employment level. The total equal to the total supply price of economy (cost of production
of products and services) at a certain level of employment. Therefore, effective demand
refers to the demand of consumption and investment of an economy.
Determination of Effective Demand:
Keynes has used two key terms, namely, aggregate demand price and aggregate supply
price, for determining effective demand. Aggregate demand price and aggregate supply
price together contribute to determine effective demand, which further helps in estimating
the level of employment of an economy at a particular period of time.
In an economy, the employment level depends on the number of workers that are employed,
so that maximum profit can be drawn. Therefore, the employment level of an economy is
dependent on the decisions of organizations related to hiring of employee and placing them.
The level of employment can be determined with the help of aggregate supply price and
aggregate demand price. Let us study these two concepts in detail.
Aggregate Supply Price:
Aggregate supply price refers to the total amount of money that all organizations in an
economy should receive from the sale of output produced by employing a specific number
of workers. In simpler words, aggregate supply price is the cost of production of
products and services at a particular level of employment.
It is the total amount of money paid by organizations to the different factors of production
involved in the production of output. Therefore, organizations would not employ the factors
of production until they can recover the cost of production incurred for employing them.
A certain minimum amount of price is required for inducing employers to offer a specific
amount of employment. According to Dillard, “This minimum price or proceeds, which will
just induce employment on a given scale, is called the aggregate supply price of that amount
of employment.”
If an organization does not get an adequate price so that cost of production is covered, then
it employs less number of workers. Therefore the aggregate supply price varies according to
different number of workers employed. So, aggregate supply price schedule Id Tut can be
prepared as per the total number of workers employed.
Aggregate supply price schedule is a schedule of minimum price required to induce the
different quantities of employment. Thus, higher the price required to induce the different
quantities of employment, greater the level of employment would be. Therefore, the slope of
the aggregate supply curve is upward to the right.
Aggregate Demand Price:
Aggregate demand price is different from demand for products of individual organizations
and industries. The demand for individual organizations or industries refers to a
schedule of quantity purchased at different levels of price of a single product.
On the hand, aggregate demand price is the total amount of money that an organization
expects to receive from the sale of output produced by a specific number of workers. In
other words, the aggregate demand price signifies the expected sale receipts received by the
organization by employing a specific number of workers.
Aggregate demand price schedule refers to the schedule of expected earnings by selling the
product at different level of employment Mo higher the level of employment, greater the
level of output would be.
Consequently, the increase in the employment level would increase the aggregate demand
price. Thus, the slope of aggregate demand curve would be upward to the right. However,
the individual demand curve slopes downward.
The basic difference between the aggregate supply price and aggregate demand price should
be analyzed carefully as both of them seem to be same. In aggregate supply price,
organizations should receive money from the sale of output produced by employing a
specific number of workers.
However, in aggregate demand price, organizations expect to receive from the sale of output
produced by a specific number of workers. Therefore, in aggregate supply price, the amount
of money is the necessary amount that should be received by the organization, while in
aggregate demand price the amount of money may or may not be received.
Determination of Equilibrium Level of Employment:
The aggregate demand price and aggregate supply price help in determining the equilibrium
level of employment.
The aggregate demand (AD) and aggregate supply (AS) curve are used for determining
the equilibrium level of employment, as shown in Figure-3:

In Figure-3, AD represents the aggregate demand curve, while AS represents the aggregate
supply curve. It can be interpreted from Figure-3 that although the aggregate demand and
aggregate supply curve are moving in the same direction, but they are not alike. There are
different aggregate demand price and aggregate supply price for different levels of
employment.
For example, in Figure-3, at AS curve, the organization would employ ON 1 number of
workers, when they receive OC amount of sales receipts. Similarly, in case of AD curve, the
organization would employ ON 1 number of workers with the expectation that they would
produce OH amount of sales receipt for them.
The aggregate demand price exceeds the aggregate supply price or vice versa at some levels
of employment. For example, at ON 1 employment level, the aggregate demand price (OH) is
greater than the aggregate supply price (OC). However, at certain level of employment, the
aggregate demand price and aggregate supply price become equal.
At this point, aggregate demand and aggregate supply curve intersect each other. This point
of intersection is termed as the equilibrium level of employment. In Figure-3, point E
represents the equilibrium level of employment because at this point, the aggregate demand
curve and aggregate supply curve intersect each other.
In Figure-3, initially, there is a slow movement in the AS curve, but after a certain point of
time it shows a sharp rise. This implies that when a number of workers increases initially,
the cost incurred for production also increases but at a slow rate. However, when the amount
of sales receipt increases, the organization starts employing more and more workers. In
Figure-3, the ON 1 numbers of workers are employed, when OT amount of sales receipts are
received by the organization.
On the other hand, the AD curve shows a rapid increase initially, but after some time it gets
flattened. This means that the expected sales receipts increase with an increase in the
number of workers. As a result, the expectations of the organization to earn more profit
increases. As a result, the organization start employing more workers. However, after a
certain level, the increase in employment level would not show an increase in the amount of
sales receipts.
In Figure-3, before reaching the employment level of ON 2, the employment level keeps on
increasing as the organizations want to higher more and more workers to get the maximum
profit. However, when the employment level crosses the ON 21 level, the AD curve is below
the AS curve, which shows that the aggregate supply price exceeds the aggregate demand
price. As a result, the organization would start incurring losses; therefore would reduce the
employment rate.
Thus, the economy would be in equilibrium when the aggregate supply price and aggregate
demand price become equal. In other words, equilibrium can be achieved when the amount
of sales receipt necessary and the amount of sales receipt expected to be received by the
organization at a specified level of employment are equal.
Under employment Equilibrium: The Problem of Demand Deficiency
The equilibrium level of employment is determined in an economy by using the concept of
effective demand. The level of employment in an economy is determined at that point where
the aggregate supply price equals the aggregate demand price. In other words, the
intersection of the aggregate supply function with the aggregate demand function determines
the volume of income and employment in an economy.
It is, thus, clear that so long as expected sales receipts of the entrepreneur (i.e.,
aggregate demand schedule) exceed costs (i.e., aggregate supply schedule), the level of
employment should be increasing and the process will continue until expected receipts equal
costs or aggregate demand curve intersects aggregate supply curve.
The AS curve starts from the origin. If aggregate receipts (i.e., GNP) are zero,
entrepreneurs would not hire workers. Likewise, AD curve also starts from the origin. The
equilibrium level of employment is determined by the intersection of the AS and AD curves.
This is the point of effective demand— point E in Fig. 3.4. Corresponding to this point,
OLE workers are employed. At the OL 1 level of employment, expected receipts exceed nec-
essary costs by the amount RC. Entrepreneurs will now go on hiring more labour till
OLE level of employment is reached.
 At this level of employment, entrepreneurs’ expectations of profits are maximised.
Employment beyond OL E is unprofitable because costs exceed revenue. Thus, actual
employment (OL E) falls short of full employment (OL F). Keynesian system shows two kinds
of equilibria - actual employment equilibrium determined by AD and AS curves and
underemployment equilibrium.
Fig. 3.4 shows the situation of equilibrium at less than full employment level. Actual
equilibrium, OL E, is short of full employment equilibrium, OL E. Thus, the distance OL F –
OLE measures unemployment. This is called involuntary unemployment—a situation at
which people are willing to work but do not find jobs.
This unemployment, according to Keynes, is due to the deficiency of aggregate
demand. This unemployment can be removed by stimulating aggregate demand. Aggregate
demand is the sum total of consumption and investment demand or expenditures in the
economy. By raising consumption expenditure, level of employment can be raised.
But there is a limit to consumption expenditure. So what is needed is the raising of
(private) investment demand. Anyway, an increase in consumption demand and investment
demand will raise the level of employment in the economy. The point of effective demand
has been changed because of the shifting of AD curve from AD to AD 1New effective
demand is now given by E 1 Corresponding to this point, equilibrium level of employment is
OLF—the level of full employment.
Thus, in Keynes’ theory, unemployment is due to the deficiency of effective demand.
Only by stimulating effective demand can a higher level of employment be achieved.
However, Keynes goes on arguing that equilibrium level of employment will not necessarily
be at full employment.
A capitalist economy will always experience underemployment equilibrium—an
equilibrium situation less than full employment. Full employment, according to Keynes, can
never be achieved. In Keynes’ scheme of things, both consumption and investment cannot
be raised enough to employ more work force. Therefore, he recommends government to
come forward and take appropriate action to cure unemployment problem.
This means that aggregate demand is now the sum total of all consumption,
investment and government expenditures. It is because of the multiplier effect of both pri-
vate investment expenditure and government expenditure, that there will be larger income,
output and employment. But equilibrium in the economy will be established at less than full
employment situation because of (i) wage rigidity, (ii) interest inelasticity of investment,
and (iii) liquidity trap.

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