School of studies of Management,

Jiwaji university Gwalior (M.P.)

Bba 4Th Sem.
Subject: Macro Economics
Unit-4th

Keynesian Theory of Income and Employment:

Definition and Explanation:

John May nard Keynes was the main critic of the classical macro economics. He in his book 'General
Theory of Employment, Interest and Money' out-rightly rejected theSay's Law of Market that supply
creates its own demand. He severely criticized A.C. Pigou's version that cuts in real wages help in
promoting employment in theeconomy. He also opposed the idea that saving and investment can be
brought about through changes in the rate of interest. In addition to this, the assumption of full
employment in the economy is not realistic.
So long as the economy was operating smoothly, the classical analysis of aggregate economy met no
serious opposition. However, Great Depression of 1930's created problems of increasing unemployment,
reducing national income, declining prices and failing firms increased in intensity. The classical model
miserably failed to explain and provide a workable solution for how to escape the depression.

It was at that time when J. M. Keynes wrote his famous book 'General Theory'. In it he 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".

What is Effective Demand?

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 signification of the equilibrium between aggregate demand (C+I)
and aggregate supply (C+S). This equilibrium position (effective demand) indicates that the entrepreneurs
neither have a tendency to increase production nor a tendency to decrease production. It implies that the
national income and employment which correspond to the effective demand are equilibrium levels of
national income and employment.

Unlike classical theory of income and employment, Keynesian theory of income and employment
emphasizes that the equilibrium level of employment would not necessarily be full employment. It can be
below or above the level of full employment.

Determinants of Income:
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 (C+l):

Aggregate demand refers to the sum of expenditure, households, firms and the government is
undertaking on consumption and investment in an economy. The aggregate demand price is the amount
of money which the entrepreneurs expect to receive as a result of the sale of output produced by the
employment of certain number of workers. An increase in the level of employment raises the expected
proceeds and a decrease in the level of employment lowers it.

The aggregate demand curve AD (C+I) would be positively sloping signifying that as the level of
employment increases, the level of output also increases, thereby increasing of aggregate demand (C+l)
for goods. The aggregate demand (C+l), thus, depends directly on the level of real national income and
indirectly on the level of employment.

(2) Aggregate Supply (C+S):

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 entrepreneurs must
receive to cover the costs of output produced by the employment of certain number of workers.
The aggregate supply is denoted by (OS) because a part of this is consumed (C) and the other part is
saved (S) in the form of inventories of unsold output. The aggregate supply curve, (C+S) is positively
sloped indicating that as the level of employment increases, the level of output also increases, thereby,
increasing the aggregate, supply. Thus, the aggregate supply (C+S) depends upon the level of
employment through4he 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 as is shown in the curve below.

Diagram/Figure:

In figure (32.3), the aggregate demand curve (C+l), intersects the aggregate supply curve (OS) at point
E1 which is an effective demand point. At point E1, the equilibrium of national income is OY1. Let us
assume that in the generation 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 the government, the
aggregate demand curve (C+I+G) rises. As a result of this, the 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 the economy.

Thus government spending can help to achieve full employment. In case the equilibrium level of national
income is above the level of full employment, this means that the output has increased in money terms
only. The value of the output is just the same to the national income at full employment level.

Importance of Effective Demand:

The principle of effective demand is the most important contribution of J.M. Keynes.Its importance in
macro economics, in brief, is as under:

(i) Determinant of employment. Effective demand determines the level of employment in the country. As
effective demand increases employment also increases. When effective demand falls, the level of
employment also decreases.

(ii) Say's Law falsified. It is with the help of the principle of effective demand that Says Law of Market
has been falsified. According to the concept of effective demand whatever is produced in the economy is
not automatically consumed. It is partly saved. As a result, the existence of full employment is not
possible.

(iii) Role of investment. The principle of effective demand explains that for achieving full employment
level, real investment must equal to the gap between income and consumption. In other words,
employment cannot expand, unless investment expands. Therein lies the importance of the concept of
effective demand.

(iv) Capitalistic economy. The principle of effective demand makes clear that in a rich community, the
gap between income and expenditure is large. If required investment is not made to fill this gap, it will lead
to deficiency of effective demand resulting in unemployment.

Criticism on Keynesian Theory:

From mid 1970 onward, the Keynesian theory of employment came under sharp criticism from the
monetarists. Milton Frsadman, the Chief advocate of monetarists rejected the Keynesianism as a whole.
The monetarists returned back to the old classical theory for the explanation of the rise in general price
level and stated that inflation is always and every where a monetary phenomenon.
The monetarists are of the view that J. M. Keynes laid more emphasis on the determinants of aggregate
demand and to a greater extent ignored the determinants of aggregate supply. The monetarists
encouraged the supply side policy and thus favored free enterprise economy for solving the problems of
unemployment and inflation.

J. R. Hicks describes Keyne's 'General Theory' as depression economics.

Further, the 'General Theory' of Keynes is applicable to the developed economies. The Keynesians
concepts are not very useful for policy purposes in less developed countries.

What is Consumption Function (Propensity to Consume)?

The functional relationship between consumption and national income is known as Consumption Function.
It was introduced by John Maynard Keynes and represents the willingness of households to purchase
goods and services at a given income level during a given period of time. It is represented as C = f(Y);
where C = Consumption, Y = National Income and f = Functional Relationship. The consumption function is
a psychological concept that shows consumption levels at different income levels in an economy. Besides,
it is influenced by subjective factors like consumer habits, preferences, etc.
Consumption Function is based on the Psychological Law of Consumption introduced by Keynes. The
Psychological Law of Consumption states three main things:
 Even at zero income level, there is minimum consumption, i.e., autonomous consumption which is
required for the survival needs of people.
 Consumption increases with the increase in income.
  The rate at which income increases is more than the rate of increase in consumption.
Let’s understand the concept of Consumption Function with the help of the following consumption schedule
and consumption curve.

The above schedule shows consumption at different income levels.

In the above graph, X-axis represents National Income, and Y-axis represents Consumption Expenditure.
Observation:
1. Starting Point: The consumption curve (CC) starts from point C and not from point O, which means that

even at a zero level of national income, there is autonomous consumption of OC.

2. Slope of Consumption Curve: The slope of the consumption curve CC is positive, which means that
with an increase in income, consumption also increases. However, the rate at which consumption increases
is less than the rate of increase in income because the consumer saves a part of his income and spends
the rest.
3. Income is less than Consumption: As seen in the above table and graph, income is less than
consumption at income levels less than ₹200 Crores and OM, respectively. This gap between consumption
and income level is covered by dissavings. Dissavings is the previous savings of the consumer. In the

above graph, dissavings is the shaded area .

4. Break-even Point; i.e., C = Y: Break-even point is the point at which consumption is equal to income. In
the above graph, the break-even point is achieved at point E with OM income level; i.e., at the income of
₹200 Crores. Also, at the break-even point, savings is zero.
5. Income is more than Consumption: As seen in the above table and graph, income is more than
consumption at income levels more than ₹200 Crores and the points to the right of Point E, respectively.
This excess income results in savings. It means that the gap after point E between the 45° line and the CC
line represents positive savings.
Note: The 45° line is drawn to indicate whether the consumption is less than, equal to, or more than the
income level.
Consumption is not the same as Consumption Function
Consumption is the amount of income spent on the purchase of goods and services at a given income
level. However, Consumption Function is the schedule which shows the consumption expenditures at
different income levels.
Types of Propensities to Consume
The two types of Propensities to Consume are Average Propensity to Consume (APC) and Marginal
Propensity to Consume (MPC).
1. Average Propensity to Consume (APC):
It is the ratio of consumption expenditure to the corresponding income level. The formula to determine
Average Propensity to Consume (APC) is:
APC can be equal to one, less than one, and more than one, but can never be zero. According to the
formula, APC can be zero when the consumption level is zero, which is not possible at any income level

because even at zero income level, there is autonomous consumption .

2. Marginal Propensity to Consume (MPC):
It is the ratio of the change in consumption expenditure to the change in total income. In simple terms, MPC
explains the proportion of change income that is spent on consumption. The formula to determine Marginal
Propensity to Consume (MPC) is as follows:

The value of MPC varies between 0 and 1. Besides, the Marginal Propensity to Consume (MPC) of the
poor is more than the MPC of the rich. It is because the poor spend most of their increased income on
consumption as most of their basic needs are not yet fulfilled. However, rich people spend less of their
increased income on consumption as they are already enjoying a high living standard.
Equation of Consumption Function
The consumption function consists of two parts:
 Even at zero level of national income (Y), there is some minimum consumption; i.e., autonomous

consumption . Autonomous consumption is always positive.

 With an increase in income, the consumption level also increases. But the rate at which the
consumption level increases is less than the rate of increase in income. The Marginal propensity to
Consume (MPC) or b shows how the consumption expenditure (C) changes when there is a
change in income. This part of consumption is Induced Consumption, and is equal to MPC x
Income; i.e., b(Y).
Hence, the equation of Consumption Function will be:

Where,
C = Consumption

= Autonomous Consumption
b = MPC
Y = Income
In the above equation, a change in income does not have any impact on autonomous consumption
expenditure; however, it affects the induced consumption expenditure. Also, as the given equation is a

straight line with intercept and slope ‘b’, it is a case of the linear consumption function. Therefore,
a higher value of b will result in a more slope of the linear consumption function.
The equation of the consumption function can be used to prepare the consumption curve by calculating
consumption expenditure at different income levels if the value of (\bar{c}) ; i.e., autonomous consumption
and b; i.e., MPS is given. For example, If the value of (\bar{c}) and b are ₹50 Crores and 0.80,
respectively, then the Saving Expenditure at income level ₹100 crores will be

C = 50 + 0.80(100)
= 50 + 80
= ₹130 Crores

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