Keynesian Theory of Employment

Introduction
Prior to Keynes, classical economists were of the opinion that there is always full employment in the
economy. In other words, there was always tendency towards full employment in the economy. This
view was based on Say's law of market. They thought that unemployment was a temporary
phenomenon which disappears in the long-run. But the classical theory could not explain the causes and
remedial measures of huge unemployment of labor and other resources during economic depression of
1930s. During this period, many industries were closed. As a result, unemployment, low income, and
low production were created. Thus, the classical theory of full employment was proved to be empirically
wrong. In this context, J.M. Keynes challenged the validity of classical theory of employment in his book
'General Theory of Employment, Interest and Money' published in 1936. In this book he did not only
criticize classical theory of employment, but also presented new theory of income and employment,
which is known as the Keynesian Theory of Income and Employment. This theory has more systematic
and realistic analysis of determinants of employment in the developed or advanced capitalist
economies.
The principle of effective demand is basic to Keynes' general theory of employment. Effective demand,
which is the sole determinant of employment, is the logical point of Keynes' theory of employment.
Employment depends upon effective demand and unemployment is the result of deficiency of effective
demand. As employment increases, output and real income also increases. A fundamental principle is
that as the real income increases, consumption also increases, but by less than the increase in income.
Therefore, in order to have sufficient demand to sustain an increase in employment, there must be an
increase in investment equal to the gap between income and consumption demand out of that income.
In other words, employment cannot increase unless investment increases. This is the core of the
principle of effective demand.
Principle of Effective Demand
The principle of effective demand is the heart of the Keynes general theory of employment.
Effective demand is related with the capacity of purchasing goods and services. According to
Keynes, the employment level depends upon the effective demand for goods and services
produced for consumption and investment. The problem of unemployment arises due to the
decrease in effective demand. Therefore, Keynesian theory of employment is also known as the
"Demand Deficiency Theory". Again, effective demand means the amount of money which all
people of the country spend for consumption and investment in a given period of time. Thus, in
a monetary system, effective demand is influenced by the amount of expenditure. The increase
in the effective demand will result in higher aggregate effective demand, higher will be the
volume of employ and vice versa. Effective demand depends upon aggregate demand function
(ADF)and aggregate supply function (ASF). Effective demand is attained that point where
aggregate demand function is equal to the aggregate supply function (i.e. ADF = ASF).
Assumptions
 There is existence of closed economy, ignoring the effect of foreign trade.
 There is operation of the law of diminishing returns.
  Perfect competition exists in market.
 He assumes that labor 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.
 The government is assumed to have no part play either as taxer or a spender, i.e. the
fiscal operations of the government are not explicitly recognized.
 Less than full employment equilibrium is possible in short period.
Determinants of Effective Demand
Aggregate Demand Function (ADF)
The aggregate proceeds expected from a given amount of employment is called aggregate
demand price of the output of that amount of employment. Aggregate demand price refers to
the amount of maximum sales revenue expected from the total output produced at a particular
level of employment in the economy. Aggregate demand function (AD F) is a schedule of the
various amounts of money which the entrepreneurs in an economy expect from the sale of
their output at varying levels of employment. In a capitalist economy, total expenditure of the
economy comprises of total consumption expenditure (C) and total investment expenditure (I).
Thus, aggregate demand is equal to total consumption expenditure plus total investment
expenditure. Aggregate demand curve slopes upwards to the right and bends to the x axis
reflecting that aggregate demand price increases at a diminishing rate as the amount of
employment increases.
Aggregate Supply Function (ASF)
Another important aspect of Keynesian theory of employment is aggregate supply. Aggregate
supply function (or aggregate supply price) is the relationship between the level of employment
and the minimum amount of proceeds (money income) required to induce that level of
employment. Profit maximization is the main objective of business enterprises. So, level of
employment depends upon the level of profit. In order to provide employment, certain
minimum amount of proceeds (money receipts) will be required. In the absence of such
minimum proceeds, economic activities will not take place and there is no further employment
opportunity. Thus, aggregate supply function is a schedule of the various minimum amounts of
the proceeds which the entrepreneurs must receive from the sale of output resulting at
different levels of employment.
Determination of Level of Employment
The equilibrium level of employment and income in an economy is determined by the point of
intersection between aggregate demand function (or curve) and aggregate supply function. This
is also the point of effective demand. The determination of effective demand and level of
employment can be explained with the help of given seclude and diagram.
Aggregate Demand Price (ADP) and Aggregate Supply Price (ASP)
Level of Employment Aggregate Demand Price Aggregate Supply Price Condition
(in thousands) (in crore) (in crore)
10 5 1 ADP> ASP
20 10 7 ADP > ASP
 30 13 13 ADP = ASP
40 15 19 ADP < ASP
50 16 25 ADP < ASP
Diagrammatic Representation of ADF and ASF

Main Ideas of Keynesian Theory

 Total employment = total output = total income. As employment increases, output and
income also increase proportionately.
 Effective demand is the key determinant of volume of employment. In other words,
deficiency in effective demand (ie. the gap between income and consumption) results
unemployment. Hence, effective demand has to be increased to achieve high level of
employment.
 Effective demand is a point at which aggregate demand function (expected receipts of
entrepreneurs) and aggregate supply of function (cost of entrepreneurs) are equal.
 Keynes assumed aggregate supply function as given in the short period and regarded
aggregate demand as the most important element in his theory.
 Aggregate demand function is the sum of consumption expenditure and investment
expenditure.
 Consumption expenditure depends upon the psychological and objective factors;
however, the main determinants are size of income and propensity to consume. It is
fairly stable in the short-period because propensity to consume does not change
quickly.
 Investment expenditure depends upon marginal efficiency of capital and the rate of
interest unlike consumption expenditure, investment expenditure is highly unstable.
The marginal efficiency of capital is determined by a supply price of capital asset and
their prospective yields. Rate of interest is a monetary phenomenon and remains
constant in short period. Hence, the main determinant of effective demand is the
prospective yield.
Importance of Effective Demand
 Keynes proposed that the government spend more money and cut taxes to turn a
budget deficit, which would increase consumer demand in the economy. This would, in
turn, lead to an increase in overall economic activity and a reduction in unemployment.
 Keynes also criticized the idea of excessive saving, unless it was for a specific purpose
such as retirement or education. He saw it as dangerous for the economy because the
more money sitting stagnant, the less money is in the economy stimulating growth. This
was another of Keynes’ theories geared toward preventing deep economic depressions.
 Many economists have criticized Keynes’ approach. They argue that businesses
responding to economic incentives will tend to return the economy to a state of
equilibrium unless the government prevents them from doing so by interfering with
prices and wages, making it appear as though the market is self-regulating.
 On the other hand, Keynes, who was writing while the world was mired in a period of
deep economic depression, was not as optimistic about the natural equilibrium of the
market. He believed that the government was in a better position than market forces
when it came to creating a robust economy.
 The principle of effective demand highlights the significant role of investment in
determining the level of employment in the economy. The two determinants of
effective demand are the consumption and investment expenditures. When income
increases consumption expenditure also increases but by less than the increase in
income. Thus, there arises a gap between income and consumption which leads to
decline in the volume of employment. This gap can be bridged by an increase in either
consumption expenditure or investment expenditure in order to achieve full
employment level of effective demand in the economy. Since the propensity to
consume is stable during the short-run, it is not possible to raise the consumption
expenditure. Therefore, the level of effective demand and hence of employment can be
raised by an increase in investment.
 In contrast to the classical emphasis on supply side. Keynes laid more emphasis on
demand side and traced fluctuations in output and employment to changes in aggregate
demand. Aggregate supply is assumed to be given in the short period.
Criticisms
Not a complete theory
Keynesian theory is not complete theory of employment in the sense that it does not provide
any comprehensive treatment of unemployment. It deals only with cyclical unemployment and
ignores other forms of unemployment, such as frictional unemployment, technological
unemployment, etc. It also does not tell us how to secure full and fair employment.
Based on the unrealistic assumption of perfect competition
Keynesian theory of employment is based on the assumption of perfect competition but this is
not a very realistic assumption. He completely ignores the problem of monopoly and other
imperfect competitions.
No direct relationship between unemployment level and effective demand
There exists no direct relationship between effective demand and volume of employment. It all
depends upon the relationship between wage rate, price and money supply.
Short-run analysis
Keynesian theory deals with short-run phenomenon paying no attention to the long-run
problems of the dynamic economies.
Ignores microeconomic problems
Being a purely macro-economic analysis, Keynesian theory completely neglects micro economic
issues like problems of individual firms and industries.
Static in nature
Keynesian economics is static in nature. It ignores the time lags in the behavior of economic
variables. This gap has been filled up by post Keynesian economists by providing dynamic
analysis.
Assumption of closed economy
Keynes assumes a closed economy model for the sake of simplicity. But at present, almost all
the countries are involving in international trade. By excluding the foreign trade (exports &
imports), none of one truly determine the country's level of income and employment in the
present context of globalization and WTO.
A depression economics
Keynesian economics is the product of great depression of 1930s and attempts to suggest
measures to solve problem of unemployment. It pays little attention to deal with the
inflationary situation.
Capitalistic theory
Keynesian theory is a capitalistic theory. It examines the determinants of employment in a free
capitalist economy. However, Keynes has suggested government intervention and controlled
capitalism. This theory fails to deal with the inflationary situation.
Not applicable in the developing countries
Keynesian theory is more applicable in developed countries. But it is not applicable to
underdeveloped countries like Nepal. Keynes considers with the problems of cyclical
unemployment but in underdeveloped countries, there is problem of chronic and disguised
unemployment. Keynesian theory of employment does not mention any measure to break the
vicious circle of poverty facing by most developed countries.
Superiority of Keynesian Theory to the Classical Theory
Emphasis on short run
The classical economists consider that in the long run, there will be equilibrium condition and full
employment situation will be restored. So, government should not intervene in the economy. But
Keynes emphasizes that short run is more important than long run because in the long run we all are
dead.
Applicable to all Economic Situation
The classical theory is applicable where the economy is operating at full employment level. But
Keynesian theory applies to the all economic situation whether full employment or under full
employment/less than full employment.
Practical Reality
The classical theory assumes that wage is flexible and it should be low if there is excess supply of labor.
But in real life, it is not possible to cut or lowering the wage rate because of existence of strong trade
union and the provision of several protection mechanisms in labor regulation. Keynes also suggests that
reduction of wage is neither possible due to social structure nor morally advisable Keynes further
identifies that reduction of wage will reduce the effective demand and economy will further fall in less
than unemployment with more unemployed people.
Role of Investment
According to classical theory, employment can be increased by reducing the wage rate. But by reducing
the wage rate, we cannot increase the level of employment. According to Keynes, level of
unemployment can be reduced by increasing the investment. So, Keynes has given more importance to t
he investment which seems more realistic.
Based on Macro-Economics
The classical theory of employment is based on micro economic analysis whereas Keynesian theory is
based on macro-economic analysis. To understand the over all aspects of a country's economy
macroeconomics is more important than micro economics. Thus, Keynesian theory in superior than the
classical theory of employment.
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