Income and Employment Theory, A Body of

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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
interrelation of these macroeconomic factors, governments try to create policies that
contribute to economic stability.
Modern interest in income and employment theory was triggered by the severity of
the Great Depression of the 1930s in the United States and Europe. In its failure to
explain the persistent high levels of unemployment and the low levels of business
productivity, the prevailing school of classical economics lacked solutions for the
problems of that era.
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John Maynard Keynes offered new thinking on income and employment theory with
the publication of General Theory of Employment, Interest and Money (1936).
Building on his theory, Keynesians have stressed the relationship between income,
output, and expenditure. Since transactions are two-sided—in that one person’s
income is another person’s expenditure—the relationship could be expressed in the
form of a simple equation: Y = O = D, where Y is the national income (i.e.,
purchasing power), O is the value of the national output, and D is national
https://www.britannica.com/science/income-and-employment-theory 1/6
expenditure. What this equation means is that effective demand is equal to income
as well as to output. Since consumers can either spend or save their income, Y = C +
S, where C is consumption and S is savings.
Similarly, on the output side, production is either sold to final customers or invested
in inventory or new capital equipment, (such as production plants or machinery). So
O = C + I, where C represents sales to final customers and I investment. Thus, C + S
= C + I and, therefore, S = I. However, while savings and investment may thus be
equated from an accounting standpoint, in fact, actual planned savings and planned
investment may differ in real life. Keynesians say that economic instability stems
from this discrepancy between savings and investment.
Suppose, for example, that in a given period savings rise above their previous levels.
The effect will be a reduction in present demand with a prospect of increased future
demand. If, by coincidence, additional capital formation (investment, such as in
inventory) rises by the same amount, productive resources will continue to operate
at capacity; there will be no change in the level of activity, and the economy will
remain in equilibrium. However, if capital formation does not rise, then the demand
for labour will fall and, assuming that wages do not fall, some workers will become
unemployed and lose some of their current income.
The fall in incomes further reduces consumer demand while also reducing the rate of
savings. Provided manufacturers do not alter their investment plans, equilibrium
will be established at a lower level of income. In reality, then, it is not savings that
are unstable but the level of investment: a fall in investment and an increase in
savings will both produce a dampening effect on the economy. Conversely, a rise in
investment or an increase in consumer spending will tend to stimulate the economy.
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This example illustrates how changes in savings or investment will affect changes in
national income, but it does not show the extent of those changes. The actual degree
of change is determined by what Keynes called the “consumption function” (that is,
the level of spending that is based on disposable income). Keynes’s primary aim in
developing his theory was to show that, under certain conditions the economy could
become stuck in a disequilibrium, with productive resources in surplus (i.e., high
level of unemployment) but income and output unable to rise sufficiently to reach an
equilibrium. Put simply, Keynes argued that, when business was unwilling or unable
to increase investment because of low demand, additional government spending
could spur new spending and eventually pull the economy out of disequilibrium.
Keynesians believe that fiscal policy—such as an increase in government expenditure
or a reduction in taxation—is the most effective way to offset the lack of private
demand.
A competing theory of income and employment, the monetarist approach, places the
quantity of money in the controlling role. The analysis of the effects of increasing or
decreasing the money supply is approximately parallel to that of the consumption-

and-savings relation. The rules of thumb derived from the two theories may, in fact,
be combined: an excess demand for goods or an excess supply of money (the two
may be seen as aspects of the same phenomenon) will be associated with rising
income; similarly, an excess supply of goods or an excess demand for money will be
associated with falling income. Monetarists, such as Milton Friedman, have
advocated monetary policy as the proper countercyclical tool of government.
Both the Keynesian and the monetarist theories have two notable shortcomings.
First, both are demand-side theories and are therefore incapable of contributing
toward the long-term considerations of economic growth. Second, both assume that
people can be fooled over and over again; in reality, as they learn to anticipate
government policies based on the monetarist or Keynesian models, people act in
ways to offset these policies and thus negate the government actions.
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Written by Daniel E. Palmer
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economic rationality, conceptions of rationality used in economic theory.

Although there is no single notion of rationality appealed to by all economic theories,
there is a core conception that forms the basis of much economic theorizing. That
view, termed the neoclassical conception of economic rationality, takes rationality to
consist primarily of the maximization of subjective utility—that is, the maximization
of one’s own personal desires. Although it is sometimes assumed that subjective
utility is equivalent to self-interest (concern for getting one’s own wants and needs
met exclusive of the effects on others), these are not identical, because the notion of
subjective utility allows that one might have preferences that are not purely
motivated by self-interest.
The neoclassical conception of economic rationality has been subjected to different

criticisms, some of which are ethical in nature. For example, some critics contend
that in failing to provide any ethical criterion for the selection of basic goals or ends,
economic rationality fails to discriminate between legitimate and illegitimate
pursuits on the part of individuals. Without such criteria, some economists consider
the theory incomplete but not necessarily false. Other critics note that economists
often view economic rationality as a normative concept (that is, it can be applied to a
wide variety of people and situations), and economically rational people would thus
be required to maximize their individual interests or utility, which could lead them to
violate the interests and rights of others. . However, not all economists support that
view. Some defenders of the neoclassical conception argue that the drive to maximize
one’s individual interests often leads to cooperation with others and, through the
“invisible hand” (the idea that self-interested acts drive social welfare) of the market,
to the ultimate common good of all.
Daniel E. Palmer
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