In this article we will discuss about:- 1. Introduction to Keynesian Theory 2. Features of Keynesian Theory of Employment 3. Assumptions 4. Variables 5. Summary 6. Determination of Equilibrium Level 7. Theory of Income and Output 8. Keynesian Model 9. Policy Implications 10. Criticisms.
Introduction to Keynesian Theory:
Keynes was the first to develop a systematic theory of employment in his book. The General Theory of Employment, Interest and Money (1936). The classical and the neoclassical economists almost neglected the problem of unemployment.
They regarded unemployment as a temporary phenomenon and assumed that there is always a tendency towards full employment. It was Keynes who led a vigorous and systematic attack on the traditional theory of employment and replaced it with a more general and more realistic theory.
Keynes’ main criticism of the classical theory was on the following two grounds:
(a) The classical prediction that full- employment equilibrium will be achieved in the long-run was not acceptable to Keynes, who wanted to solve the short run problem of unemployment. According to Keynes, in the long-run there is no problem; in the long-run, we are all dead.
(b) Keynes criticised the classical assumption of self-regulating economy. The great depression of 1930s led Keynes to believe that full employment equilibrium in the economy was not be automatically achieved in the short period; and that government intervention was necessary to tackle the problem of the economy.
Keynes’ theory of employment is called the effective demand theory of employment. According to this theory, unemployment arises due to the deficiency to effective demand and the method of remove unemployment is to raise effective demand.
Features of Keynesian Theory of Employment:
The following are the main features of the Keynesian theory of employment which determine its basic nature:
(i) It is general theory in the sense that- (a) it deals with all levels of employment, whether it is full employment, widespread unemployment or some intermediate level; (b) it explains inflation as readily as it does unemployment, because basically both situations are a matter of volume of employment, and (c) it relates to changes in the employment and output in the economic system as a whole.
(ii) Keynesian theory of employment is a short-run theory which attempts to analyse the short-run phenomenon of unemployment. He assumed constant all those strategic variables which remain stable and change very little in the short-run.
(iii) Keynesian theory is based on empirical foundations and has important policy implications.
(iv) Keynes did not have much faith in the policy of laissez faire and automatic adjustment of the economic system. On the contrary, he advocated government intervention to reform the capitalist system.
(v) In this theory, Keynes gave money specially an important role in the determination of employment and output in the economic system as a whole.
Assumptions of the Theory:
Keynesian theory of employment is based on the following assumptions:
(i) Keynes confines his analysis to the short-period.
(ii) He assumes that there is perfect competition in the market.
(iii) He carries out his analysis in the closed economy, ignoring the effect of foreign trade.
(iv) His analysis is a macro-economic analysis, i.e., it deals with aggregates.
(v) He assumes the operation of the law of diminishing returns or increasing costs.
(vi) The government is assumed to have no part play either as taxer or a spender, i.e., the fiscal operations of the government is not explicitly recognised.
(vii) He assumes that labour has money illusion. It means that a worker feels better when his wages double even when prices also double, thus leaving his real wage unchanged.
Variables of the Theory:
The variables used by Keynes in his theory can be broadly divided into three groups:
1. Given Elements:
First there are variables which have been assumed as given because they change so slowly that their effects in short run can be ignored. They are- (a) the quality and quantity of labour and capital stock; (b) techniques of production; (c) degree of competition; (d) consumer tastes; (e) the structure of the society.
2. Independent Variables (or Causes):
Independent variables are the behaviour patterns of the society. In other words, they represent the basic functions or relationships.
There are four independent variables:
(i) The consumption function;
(ii) The investment function or the marginal efficiency of investment schedule;
(iii) The liquidity preference function;
(iv) The quantity of money fixed by the monetary authority.
All these variables are stated in wage units.
3. Dependent Variables (or Effects):
The dependent variables of the Keynesian system are- (a) the level of employment, output and income, and (b) the rate of interest. Keynes makes rate of interest an independent variable.
But, according to Hansen, rate of interest is a determinate, and not a determinant. Rate of interest along with national income together are mutually determined by the above mentioned four independent variables.
Summary of Keynesian Theory of Employment:
Keynesian theory of employment, as developed in the General Theory is outlined in Chart-1.
The main propositions of the theory are given below:
(i) Total employment = total output = total income. As employment increases, output and income also increase proportionately.
(ii) Volume of employment depends upon effective demand.
(iii) Effective demand, in turn, is determined by aggregate supply function (representing costs of entrepreneurs) and aggregate demand function (representing receipts of entrepreneurs). It is determined at the point where aggregate demand and aggregate supply are equal.
(iv) Keynes assumed aggregate supply function as given in the short period and regarded aggregate demand as the most important element in his theory.
(v) Aggregate demand function is governed by consumption expenditure and investment expenditure.
(vi) Consumption expenditure depends upon the size of income and the propensity of consume. Consumption expenditure is fairly stable in the short-period because propensity to consume does not change quickly.
(vii) Investment expenditure is governed by marginal efficiency of capital (i.e., profitability of capital) and the rate of interest. Unlike consumption expenditure, investment expenditure is highly unstable.
(viii) The marginal efficiency of capital is determined by the supply price of capital assets on the one hand and the prospective yield on the other. Prospective yield, in turn, depends upon future expectations. This explains why the marginal efficiency of capital and hence investment expenditure fluctuates.
(ix) Rate of interest is a monetary phenomenon and is determined by the demand for money (liquidity preference) and the quantity of money. Liquidity preference depends upon three motives- transaction motive, precautionary motive, and speculative motive. Quantity of money is regulated by the monetary authority.
(x) The essence of the whole theory of employment is that employment (= output = income) depends upon effective demand. Effective demand expresses itself in the whole of total spending of the community, i.e., consumption expenditure and investment expenditure.
A fundamental principle is that as income of the community increases, consumption will increase, but by less than the increase in income. Thus, in order to increase the level of employment, investment must be increased. Investment must be high enough to fill the gap between income and consumption.
(xi) Original Keynesian analysis considers private consumption and private investment expenditure only and does not take into account government expenditure. But, in modem times, government expenditure is also a significant determinant of effective demand. Government expenditure is considered the most effective weapon to fight unemployment.
Determination of Equilibrium Level of Employment:
The central problem of the General Theory is- What determines the level of employment? Keynes’ answer is- effective demand. Effective demand is the logical starting point of Keynes’ theory of employment. Effective demand means desire plus ability and willingness to buy, i.e., actual expenditure. Effective demand depends upon aggregate demand function and aggregate supply function.
Aggregate demand function represents different amounts of money which the entrepreneurs expect to get from the sale of output at varying levels of employment. Or, to put it differently, aggregate demand function reveals planned or intended expenditure at different levels of income.
Aggregate demand schedule (AD curve in Figure – 7) slopes upward to the right, indicating that as the expected sale proceeds increase, greater number of workers will be employed. The AD curve flattens at the later stages of employment because marginal propensity to consume declines as income increases.
Aggregate supply function represents different amounts of money which the entrepreneurs must get from the sale of output at varying levels of employment. Or stated in a different way, aggregate supply function represents different levels of income (and thus output and employment) which the entrepreneurs will supply at different levels of expenditures.
Aggregate supply schedule (AS curve in Figure-7) also slopes upwards to the right, indicating that at higher levels of employment expected minimum sale proceeds increase. After the full employment level is reached (i.e., after point F), AS curve becomes perfectly inelastic (a vertical straight line) which shows that employment cannot increase further even if minimum expected sale proceeds increase.
The equilibrium level of employment is determined at the point of intersection between aggregate demand function and aggregate supply function. This is also the point of effective demand. Aggregate supply represents costs, while aggregate demand represents expected receipts of the entrepreneurs.
So long as receipts are greater than costs, the employment will continue to increase. This process will go on till receipts become equal to costs. No employment will be offered to the workers if costs are greater than receipts.
In Figure-7, point E is the point of effective demand where AD curve and AS curve intersect each other. ON is the equilibrium level of employment. At this level, aggregate demand (receipts) is equal to aggregate supply (costs). At ON employment level, the entrepreneurs maximise their profits and have no tendency either to increase or decrease employment. At no other level of employment, the economy will be in equilibrium.
For example, at ON1 level of employment, the expected receipts are greater than the expected costs (AN1 > BN1). This will induce entrepreneurs to increase employment. Similarly, at ONf employment level, expected costs exceed expected receipts (FNf > GNf). Such a level of employment will not be offered, because it will involve losses.
(i) The equilibrium level of employment as represented by the point of effective demand (point E) does not necessarily indicate a full-employment equilibrium. As is clear from
Figure- 7, there exists NNf amount of unemployment at E point of effective demand. Keynes’ main contribution is the demonstration that less- than-full employment equilibrium is possible and, in a capitalist economy, this is normal situation. In such an economy, investment is generally inadequate to fill the gap between income and consumption.
(ii) Aggregate supply function (being given in the short period) cannot be manipulated and thus is not of much practical significance. In order to attain full-employment level of ONf (or to remove unemployment NNf), aggregate demand must be raised from AD curve to AD1 curve. Thus, the Keynesian theory of employment may be more properly called the aggregate demand theory of employment.
The Keynesian theory of employment is also called the theory of income and output. The point of effective demand, which gives the equilibrium level of employment, also indicates the equilibrium level of national income and output.
Effective demand manifests itself in spending of income or the flow of total expenditure in the economy. The flow of expenditure determines the flow of income because one man’s expenditure is another man’s income.
The flow of expenditure also represents the value of total output because total price of national output is just the same thing as the total expenditure made and the total income received by the community.
Total expenditure, which represents total demand for goods and services, comprises of consumption expenditure and investment expenditure. To meet this demand, workers are employed to produce consumer goods and investment goods.
Thus, effective demand (E.D.)
= total employment (N)
= total output (O)
= total income (Y)
= expenditure on consumption goods (C) + expenditure on investment goods (I)
or ED = N = O = Y = C + I
Thus the level of effective demand determines the general level of income, output and employment in a capitalist economy. At the point of effective demand, aggregate supply [i.e., total value of all final goods and services produced (Y)] is equal to aggregate demand [i.e., total planned expenditures on final goods and services (C+I)].
At this equilibrium level, the economy as a whole produces that level of output, generates that level of income and employs that quantity of labour which is the most profitable. This most profitable level of output, income and employment depends primarily on aggregate demand. Aggregate supply adjusts itself to aggregate demand. Thus, the important implication of the Keynesian theory is that demand creates its own supply. This is just the reverse of Say’ law of markets which states that supply creates its own demand.
Thus, the point of effective demand represents the economy’s general equilibrium level at which –
(i) aggregate supply (total income) = aggregate demand (total expenditure)
Y = C + I … (1)
(ii) total saving = total investment
S = I … (2)
(Since total saying is equal to total income minus total consumption (S = Y – C), therefore, Y = C + I can be written as Y – C = I or S = I)
Figure-8 illustrates the determination of equilibrium level of income (or output or employment). C-line represents consumption function. Consumption is an increasing function of income, i.e., C = f (Y). C + I line represents aggregate demand or consumption plus investment expenditure. Keynes believed that a considerable amount of investment is autonomous (i.e., independent of income).
Therefore, C + I line is parallel to C- line, the difference indicates the investment expenditure. SS (45° line) is the aggregate supply schedule which indicates that at a given level of expected total expenditure (C + I), exactly equal level of income (Y) will be offered. That is why SS line represents Y = C + I and the equilibrium lies on this line. Economy’s equilibrium is at point E, which is also the point of effective demand. At this equilibrium point
(i) Total income = total expenditure
Y = C + I
or (OY = CY + EC)
(ii) Total saving = total investment
S = I
or (EC = EC)
Keynes’ theory of employment can be summed up in terms of an equational model as developed by D. Oscar Lange.
The basic equation of the model is:
M = L (i, Y) … (1)
The amount of money which people hold (M) is a function (L) of rate of interest (i) and income (Y). There is an inverse relationship between i and M, but Y and M move in the same direction. L represents liquidity preference function.
C = F (Y, i) … (2)
Consumption (C) is a function (F) of income (Y) and the rate of interest (i). C and Y rise and fall together. About the relationship between C and i, Keynes was not certain.
I = F (i, C) …(3)
Investment (I) is a function (F) of the rate of interest (i) and consumption (C). Given the marginal efficiency of capital, I rises as the rate of interest (i) falls, and falls as the rate of interest rises. Again, given the state of expectations, the marginal efficiency of capital rises as C rises, and falls as C falls. F signifies investment function.
Y = C + I … (4)
Income (Y) is equal to consumption (C) plus investment (I)
M can be taken as given, since it is determined by the monetary authorities of a country. Thus, we are left with four unknowns (Y, C, I and i) and an equal number of equations. The system is then, determinate i.e., the value of all the unknowns can be understood with the help of the following four diagrams in Figure-9.
Let us start with the initial equilibrium position when income is Y0 (Rs. 6000), the amount of money M0 (Rs. 3000) and the rate of interest is i0 (3%). Y0 curve is the liquidity preference schedule at Y0 income level (Figure-9A). With the rate of interest 3% and income Rs. 6000, consumption will be Co (Rs. 4000). The i0 is the consumption function at 3% rate of interest (Figure-9B).
With consumption Rs. 4000 and the rate of interest 3%, investment will be I0 (Rs. 2000). C0 curve is the investment function at consumption level Rs. 4000 (Figure-9C). Figure -9D shows that the economy is in equilibrium, i.e., income (Rs. 6000) is equal to consumption (Rs. 4000) plus investment (Rs. 2000). The 45° line shows Y = C + I.
If, for example C+I is not Rs. 6000 but Rs. 8000, then income will rise to Rs. 8000. How would the system behave in order to reach a new equilibrium position? With income Rs. 8000, liquidity preference function rises to Y1 and, given the quantity of money Rs. 3000, the rate of interest rises to i1 (4%) in Figure- 9A. With the rate of interest 4%, consumption function falls to i1; but because of higher income (Rs. 8000), consumption rises to C1 (Rs 4500) in Figure-9B.
With consumption Rs. 4500, the investment function shifts upward to C1. At consumption Rs. 4500 and the rate of interest 4%, investment is I1 (Rs. 3500) in Figure-9C. Thus, the economy reaches a new and higher equilibrium level because income (Rs. 8000) = consumption (Rs. 4500) + investment (Rs. 3500) in Figure-9D.
Thus, if one knows the shape of the functions (i.e., liquidity preference function, consumption function and investment function) and the value of any one of the dependent variables (M, C, I, and i), then the changes in the whole system as a result of a change in one variable can be worked out.
Keynesian theory of employment has the following policy implications:
I. Reform of Capitalism:
Keynesian theory has demonstrated that in a capitalist’s economy, unemployment, and not full employment, is a normal situation. But as a remedial measure, Keynes did not suggest a complete reconstruction of the capitalist society on socialistic pattern. He wanted to preserve and reform capitalism, rather than lo replace capitalism by socialism.
II. Government Intervention:
Keynes has no faith in the policy of laissez-faire and has shown that the state of full employment is not automatically achieved. He recommended state intervention to raise effective demand in order to increase the level of employment in the economy.
In order to increase the volume of employment, effective demand, i.e., consumption and investment expenditures must be increased. Keynes suggested that propensity to consume can be raised by redistribution of income from the rich (with low propensity to consume) to the poor (with high propensity to consume). Such a redistribution of income can be achieved through progressive taxation.
IV. Monetary Policy not Reliable:
Employment can be increased by increasing the quantity of money (i.e., cheap money policy) because it will reduce rate of interest and increase private investment. But Keynes did not consider cheap money policy as a reliable policy to promote private investment in a situation of depression and unemployment.
After all, the monetary authorities can only make money available to a businessman at a cheaper rate, but cannot compel him to increase investment if he is pessimistic about the future prospects of the business.
V. Public Works Programme:
Keynes laid maximum emphasis on the public investment because of the unstable nature of private investment. He suggested that government can remove unemployment by starting public works and utilising the unemployed people there. Employment in this case will increase many times because of the operation of the multiplier.
VI. Objective of Full Employment:
The present-day popularity of the objective of full employment is also attributed to Keynes. There is hardly any nation, planned or unplanned, which has not accepted full employment as the ultimate goal of its economic policy.
Though Keynes has revolutionised the modern economic thinking, his analysis has some inherent weakness:
(i) Keynesian theory is not a complete theory of employment in the sense that it does not provide a comprehensive treatment of unemployment, (a) It deals only with cyclical unemployment and ignores other forms of unemployment, such as, frictional unemployment, technological unemployment, etc. (b) It does not tell us how to secure full and fair employment.
(ii) There exists no direct and determinable relationship between effective demand and volume of employment. It all depends upon the relationship between wage rate, prices and money supply. Moreover, in modern times, most countries are facing the problem of stagflation (i.e., unemployment with inflation).
(iii) Keynesian theory assumes perfect competition which is not a very realistic assumption. He completely ignored the problems of monopoly.
(iv) Keynesian theory deals with short-run phenomenon. It pays no attention in the long-run problems of the dynamic economy.
(v) Keynesian economics is static in nature. It ignores the time lags in the behaviour of economic variables. However, the post-Keynesians have filled this gap by providing truly dynamic analysis.
(vi) Keynesian theory is purely macro-economic theory which deals with aggregates. Micro-economic problems have been completely ignored.
(vii) Keynes assumes a closed economy. In this way, his analysis does not take into account the impact of international trade on the growth of employment and income of the economy.
(viii) Keynesian economics is, by and large, a depression economics. It is the product of Great Depression of 1930s and attempts to suggest measures to solve the problems of unemployment. It pays little attention to deal with the inflationary situation.
(ix) It is basically a capitalistic theory. It examines the determinants of employment in a free enterprise economy. Though Keynes has suggested government intervention and controlled capitalism, his theory fails to deal socialist economic system.
(x) Keynesian theory is not applicable in underdeveloped countries. Keynes deals with the problem of cyclical unemployment, whereas the underdeveloped countries face the problems of chronic unemployment and disguised unemployment.
As a remedial measure, Keynes suggested expansion of aggregate demand and discouragement to saving, while the underdeveloped countries need curbs on spending, and increases in saving for capital formation and for large-scale investment to break the vicious circle of poverty.
In short, the Keynesian theory is not general; it is not applicable in all places and at all times. As Harris has remarked- “Those who seek universal truths, applicable in all places at all times had better not waste their time on the General Theory.”