An outline of Keynesian Theory of

Employment

Dr. Gopalakrishna B.V.

Faculty in MBA,
SDM, Mangalore.

J. M. Keynes

 John Maynard Keynes was the greatest and the most eminent
economist of the mid-twentieth century.
During the period 1929-33 - Great Depression in the
capitalist countries which caused huge unemployment, low
income and low production.
His famous book General Theory of employment, interest
and money published in 1936 challenged the validity of
the classical theory of employment.
He is not only criticized the classical theory of income and
wealth but also - propounded new theory of employment and
output Keynesian Revolution
This book gives a systematic treatment to the theory of
employment, explaining the real causes of unemployment.
He tries to provide that under employment equilibrium is the
normal features of capitalist economy.
Keynes advocated many concepts like Propensity to Consume,
Multiplier, Marginal Efficiency of Capital and Liquidity
Preference.

Keynesian theory of income and employment

Keynesian theory of income and employment is a - short
period where the stock of capital techniques of production,
efficiency of labour, size of population have been assumed to
remain constant.
In this theory, the amount of employment depends upon the
level of national income and output.
This is because, given the amount of capital, technology and
labour efficiency increase in income and output can be
obtained by employment of more labour.
Unemployment causes due to lack of effective
demand/deficiency of outlay on consumption and investment
function.
The level of income and employment in an economy at any
given time depends upon the effective aggregate demand.

 The Keynesian theory of employment touches all

aspects of the economy as a whole and hence his
theory can be called macro economics.
According to him, national income determined the
level of employment greater the national income,
higher will be the level of employment and lower the
level of national income, the lower the amount of
employment.
He strongly argues that Government intervention
must be required at time of depression where level
of income, employment and output at the lower level
lack of aggregate demand.

Keynesian concepts
1.
2.
3.
4.

Fundamental Equation
Principle of Effective Demand
Consumption Function
Marginal Efficiency of Capital (MEC) and
rate of interest
5. Multiplier
6. Trade Cycle
7. Fiscal Policy

1. Fundamental Equation
The fundamental equation of Keynes is
Y=C+I
Y = National Income
C = Consumption
I = Investment
According to Keynes, the level of national income
determines the level of employment.
If NI increases the level of employment could also
be increased.
So that, increasing the level of NI employment also
increases and thereby the economy should be move
from the under-employment to full employment
condition.

 According to Keynes the three constituents of national income

are consumption, investment and expenditure
Government expenditure plays a dominant role and according
to Keynes formula
Y=C+I+G
Y = National Income
C = Consumption
I = Investment
G = Government Expenditure.
Keynes total income depends on total employment this
depends on effective demand in the economy.
Effective demand depends on consumption expenditure and
investment expenditure.
Consumption depends on income and propensity to consume
Investment depends on Marginal Efficiency of Capital (MEC)
and rate of interest.

Level of Employment and Income

Level of Effective Demand

Consumption

Investment

Government Expenditure

MEC
Size of
Income

Propensity to
Consume
Liquidity
Preference

Transaction
Motives

Rate of Interest

Supply of
Money

Precautionary
Motives

Expectation of
Profit

Speculative
Motives

Replacement
cost

2. Principle of Effective Demand

The level of income and employment in a country at
any given time depends on effective demand.
An increase in effective demand will lead to an
increase in production and income and it leads to
increases in employment.
A decrease in effective demand will result in
contraction of production and income and in the level
of employment.
Effective demand is the point at which aggregate
demand will be equal to aggregate supply.
It is the equilibrium point determined by the equality
of aggregate demand function and aggregate supply
function.
According to Keynes, effective demand is equal to
the total volume of output available in the economy

 The aggregate demand function includes consumer

and capital goods.
Keynesian theory of employment related to short
period where technique of production as
unchanged.
Therefore, an increase in the output of the economy is
possible only if there is an increase in employment.
Thus according to Keynes effective demand = total
output = employment = total income = consumption
expenditure + investment expenditure.
Consumption expenditure is determined by two
factors level of income and the propensity to
consume.
Investment expenditure depends upon the marginal
efficiency of capital (MEC) and rate of interest.

 Deficiency of effective demand means when increases in the

national
income,
consumption
is
not
increasing
proportionately, thereby creating gap between income and
consumption (MPC < 1).
This gap should be covered by an increase in investment.
Therefore Y = C + S
Y=C+S
S=I
Therefore, level of employment in the economy at any time
depends on the volume of effective demand.
These effective demand determined by aggregate demand
function (ADF) and aggregate supply function (ASF) where
both ADF & ASF intersect each other that point is called as
equilibrium.
This equilibrium point is known as fully employment
equilibrium

3. The Propensity to Consume

Consumption function or propensity to consume
forms a vital part of Keynesian analysis.
As we studied that effective demand depends on
consumption and investment in the economy.
Consumption is one of the important determinants of
level of employment.
According to Keynes, consumption depends on two
factors size of income and propensity to consume.
The amount of income which is spent on
consumption out of a given total income is known as
propensity to consume.

 Propensity to consume expresses a relationship

between income and consumption.
When income increases, consumption are also
increases not as much of income increases a part of
income is likely to be saved. So consumption will be
less than income.
An individual/family/community will spend a part of
the income on consumption it may be 70% - 80% of
the income and the rest may be saved.
The propensity to consume depends on various
factors such as price level, interest rate, stock of
wealth and several subjective factors remains
constant (short period).
Thus Keynesian consumption function depends on
level of income.

C = a + bY
ab = constant
C = consumption represents MPC
Y = level of income
C+Y
R

Consumption

C2
C1

Y1
Income

Y2

 The propensity to consume higher in the lower income level

and lower in high income level (poor and rich)
Propensity to consume is fairly stable during short period as
the consumption habits of the community will not change.
Propensity to consume two types
Average propensity to consume (APC) refers to the total
amount of consumption expenditure divided by a given total
income at a particular period.
APC =

Total Consumption
Total Income

C
APC
Y

Marginal propensity to consume (MPC) refers to the additional changes in

consumption as result of changes in income
MPC = C
Y

4. Marginal Efficiency of Capital (MEC)

Keynesian effective demand consists of two major components
consumption and investment.
Consumption function more or less stable in the short period.
Therefore investment function has the vital role in determination of
effective demand.
The level of investment depends upon two important factors
marginal efficiency of capital and rate of interest.
MEC refers to the expected profitability of an additional capital
asset.
It may be defined as the highest rate of return over cost expected
from the marginal or additional unit of capital asset.
For example, suppose a plant costs Rs. 10.000 to an entrepreneur
and the expected yield from the plant is Rs. 500 per annum.
Then the marginal efficiency of the plant would be 500 X 100 = 5%
10.000
Q3
____
+ Q2
+ .. Qn
+
(1 + r)
(1+r)2 (1=r)3
(1+r)n

Q1

5. Rate of Interest
The rate of interest is determined on the
liquidity preference of the people.
Liquidity preference is governed by
transaction motive, precautionary motives and
speculative motives.
The supply of money and the liquidity
preference together determine the rate of
interest.

Investment function
Investment function is the crucial factor in the
determination of effective demand.
Investment demand depends upon two factors MEC
and rate of interest.
Rate of interest is comparatively stable and does not
frequently change in the short run. Therefore, the
fluctuations in the level of investment depends on
MEC.
Higher the MEC higher will be the level of
investment and vice-versa.
During the period of depression the prospects of
profit will become little and they may not be
increased by the economy.

 Investment has two types

1. Induced investment and
2. Autonomous investment.
Autonomous investment is an investment which does not
change with the changes in the income level independent of
income.
Keynes thought that the level of investment depends upon
MEC and rate of interest therefore, changes in income level
will not affect investment.
Autonomous investment generally takes place in houses,
roads, public undertakings and in other types of economic
infrastructure such as power, transport and communication.
This autonomous investment depends more on population
growth and technical progress than on the level of income.
Most of the autonomous investment undertaken by
government at time of depression enhancing aggregate
demand.

Y
Ia

Investment

Ia

National Income

Savings and Investments

Keynes in his famous work General Theory of employment,
interest and money saving and investment are always equal.
This gave rise to a severe controversy in economics as to
whether saving and investment are always equal or unequal.
The modern economists argues that concepts of saving and
investment in two different senses.
Savings and investment are always equal at equilibrium position.
Savings and investments are not equal under disequilibrium position.

Aggregate investment is always equal to aggregate savings.

National output consists of two types goods consumption
goods and investment goods.
O=C+I
O = National Output
C = Consumption goods
I = Investment goods

 Similarly national income is divided under two heads

consumption and savings
Y=C+S
Y = national income
C = Consumption
S = Savings

National output is always equal to national income

O=Y
C+S=C+I
S=I

Investment = Savings

As long as S and I are equal aggregate income Y will be

constant and the level of employment will also be constant.
But in practice S & I need not be equal as the saver group and
investing group are different and their objectives is differ.
This leads to divergence between savings and investments.
If there is excess of savings over investment it will bring
about depression in business an excess of investment over
savings is responsible for business boom.

Multiplier
The concept of multiplier is an important tool of
analysis in the Keynesian theory of income and
employment.
This was first introduced by R.F. Kahn with
reference to employment. Manifold increase in
employment as a result of initial increment in
investment.
Keynes propounded the concept of investment
multiplier with reference to the much large increase
in total income direct as well as indirect, as a result of
original increase in investment.
Keynesian multiplier is also known as investment or
income multiplier.
The essence of multiplier is that increase in income,
output, or employment is manifold the original
increase in investment.

 For example if investment equal to Rs.100

crores is made, then the income will increased
by multiple of Rs.300 or 400 crores it can be
says that multiplier 3 or 4.
Thus ratio of increment in income to the
increment in investment
Multiplier k = MPC = Y
I
K = multiplier
Y = changes of income
I = changes in investment

Z
Y

C+I1
C+I

Aggregate Demand

450
O

National Income

Y1

Y2