Wednesday, August 26, 2009

Keynesian's Theory of Employment

In his General Theory Keynes presented an explanation of the Great Depression of 1930’s and suggested measures for the solution. He also presented his own theory of income and employment. According to Keynes, in the short period, level of national income and so of employment is determined by aggregate demand and aggregate supply in the country. The equilibrium of national income occurs where aggregate demand is equal to aggregate supply. This equilibrium is also called effective demand point.

Effective demand represents that aggregate demand or total spending (consumption expenditure and investment expenditure) which matches with aggregate supply (national income at factor cost). In other words effective demand is the signi factor of the equilibrium between aggregate demand (C + I) and aggregate supply (C + S). This equilibrium position (effective demand) indicates that the entrepreneur neither have tendency to increase production. It implies that the national income and employment which correspond to the effective demand are equilibrium levels of national income and employment. Keynesian theory of income and employment emphasises that the equilibrium level of employment would not necessarily be full employment. It can be below or above the level of full employment.

The determinants of effective demand and so of equilibrium level of national income and employment are the aggregate demand and aggregate supply.

1. AGGREGATE DEMAND:

Aggregate demand refers to sum of expenditure, households, firms and the government is undertaking on consumption and investment in economy. The aggregate demand price is the amount of money which the entrepreneurs expect to receive as a result of the sale of output produce by the employment of certain number of workers. As increase in the level of employment lowers it the aggregate demand curve AD would be positively slopping signifying that as the level of employment increases the level of output also increases, thereby increasing of aggregate demand for goods. The aggregate demand thus depends directly on the level of real national income and indirectly on the level of employment.

2. AGGREGATE SUPPLY:

The aggregate supply refers to the flow of output produced by the employment of workers in an economy during a short period. In other words the aggregate supply is the value of final output valued at factor cost. The aggregate supply price is the minimum amount of money which the entrepreneur must receive to cover the costs of output produced by the employment of certain number of workers. The aggregate supply is denoted by (C + S) because a part of this is consumed (c) and other part is saved (S) in the form of inventories of unsold output. The aggregate supply curve (C + S) is positively slopped indicating that as the level of employment increases the level of output also increases, thereby increasing the aggregate supply. Thus aggregate supply (C + S) depends upon the level of employment through the economy’s aggregate production function.

DETERMINATION OF LEVEL OF EMPLOYMENT AND INCOME:

According to Keynes, the equilibrium levels of national income and employment are determined by the interaction of aggregate demand curve (AD) and aggregate supply curve (AS). The equilibrium level of income determined by the equality of AD and AS does not necessarily indicate the full employment level. The equilibrium position between aggregate demand and aggregate supply can be below or above the level of full employment.

In above figure the aggregate demand curve (C + I) intersects the aggregate supply curve (C + S) at point E1 which is an effective demand point. At point E' the equilibrium of national income is OY1. Let us assume that in generating of OY1 level of income some of the workers willing to work have not been absorbed. It means that E1 (effective demand point) is an under employment equilibrium and OY1 is under employment level of income.

The unemployed workers can be absorbed if the level of output can be increased from OY1 to OY2 which we assume is the full employment level. We further assume that due to spending by government the aggregate demand curve (C + I + G) rises. As a result of this economy moves from lower equilibrium point E1 to higher equilibrium point E2. The OY is now the new equilibrium level of income along with full employment. Thus E2 denotes full employment equilibrium position of economy. Thus government spending can help to achieve the full employment.

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