Keynesian Theory of Income and Employment

Introduction:

In the Keynesian theory, employment depends upon effective demand. Effective demand results in output. Output creates income. Income provides employment. Since Keynes assumes all these four quantities, viz., effective demand (ED), output (Q), income (Y) and employment (N) equal to each other, he regards employment as a function of income. 

Effective demand is determined by two factors, the aggregate supply function and the aggregate demand function. The aggregate supply function depends on physical or technical conditions of production, which do not change in the short run. Since Keynes assumes the aggregate supply function to be stable, he concentrates his entire attention upon the aggregate demand function to fight depression and unemployment. Thus employment depends on aggregate demand, which in turn is determined by consumption demand and investment demand. 

According to Keynes, employment can be increased by increasing consumption and/or investment. Consumption depends on income C(Y), and when income rises, consumption also rises but not as much as income. In other words, as income rises, saving rises. Thus, consumption can be increased by raising the propensity to consume to increase income and employment. But the propensity to consume depends upon the psychology of the people, their tastes, habits, wants, and the social structure which determines the distribution of income. All these elements remain constant during the short run. Therefore, the propensity to consume is stable.

Employment thus depends on investment, and it varies in the same direction as the volume of investment. Investment, in turn, depends on the rate of interest and the marginal efficiency of capital (MEC). Investment can be increased by a fall in the interest rate and/or a rise in the MEC. The MEC depends on the supply price of capital assets and their prospective yield. It can be raised when the supply price of capital assets falls or their prospective yield increases. The second determinant of MEC is the prospective yield of capital assets which depends on the expectations of yields on the part of businessmen. Again, it is a psychological factor that cannot be depended upon to increase the MEC to raise investment. Thus there is little scope for increasing investment by raising the MEC. The other determinant of investment is the rate of interest. Investment and employment can be increased by lowering the rate of interest. The rate of interest is determined by the demand for money and the supply of money. 

The relation between interest rate, MEC and investment is shown in figure 1, wherein Panels (A) and (B) the total demand for money is measured along the horizontal axis from M onward. The transactions (and precautionary) demand is given by the  curve at  and  levels of income in Panel (A) of the figure. In Panel (B), the  curve represents the speculative demand for money as a function of the rate of interest. Finally, panel (C) shows investment as a function of the rate of interest and the MEC. 

In the Keynesian analysis, the equilibrium level of employment and income is determined at the point of equality between saving and investment. Saving is a function of income, i.e. S = f (Y). It is defined as the excess of income over consumption, S = Y - C and income equal consumption plus investment. 

Thus, Y = C + I    and    Y = C + S

    or,  Y - C = I  or,     Y - C = S

Therefore, I = S

So the equilibrium level of income is established where saving equals investment. This is shown in Panel (D) of Figure 1, where the horizontal axis from O toward the right represents investment and saving, and the OY axis represents income. S is the saving curve.

The Keynesian theory of employment and income is also explained in terms of the equality of aggregate supply (C + S) and aggregate demand (C + I). Since unemployment results from the deficiency of aggregate demand, employment and income can be increased by increasing aggregate demand. Aggregate demand can be increased by increasing investment if the propensity to consume is stable during the short run. Once investment increases, employment and income increase. Increased income leads to a rise in the demand for consumption goods, leading to a further increase in employment and income.

The 45° line is the aggregate supply curve. At point E, the economy is in equilibrium where the aggregate demand curves C + I intersects the 45° line. This is the point of effective demand where the equilibrium level of income and employment  is determined. This is the level of under-employment equilibrium and not of full employment. Keynes regarded the under-employment equilibrium level as normal and the full employment income level as special cases.

Suppose  is the full employment income level. To reach this level, autonomous investment is increased by  so that the C + I curve shifts upward as , curve. This is the new aggregate demand curve which intersects the 45° line (the aggregate supply curve) at , the higher point of effective demand corresponding to the full employment income level . This also reveals that to get the desired increase in employment and income of , it is the multiplier effect of an increase in investment by  which leads to an increase in employment and income by  through successive rounds of investment.

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