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Introduction

  • John Maynard Keynesis often referred to as the father of macroeconomics. His pioneering work “The General Theory of Employment, Interest and Money” published in 1936, provided a completely new approach to the modern study of macroeconomics. It served as a guide for both macroeconomic theory and macroeconomic policy making during the Great Depression and the period later.
  • The General Theorywas a beginning of a new school of thought in macroeconomics which was referred to in later period as Keynesian Revolution in macroeconomic analysis.
  • The notion of “effective demand” and its influence on economic activity was the central theme in Keynes’s Theory of Effective Demand.
  • While refuting the Classical theory which believed in strong general tendency of market mechanism to move output and employment towards full employment, Keynes explained that, in some situations, no strong automatic mechanism moves output and employment towards full employment levels.
  • Keynes was the first economist to advocate the role of government especially fiscal policy, as the primary means of stabilizing the economy.

Keynesian Approach:

According to Keynesian approach, employment depends upon effective demand. Effective demand result output. Output creates income. Income provides employment. Keynes considered all these four components are equal and expressed employment as a function of income.

Effective demand depends upon aggregate supply function (Z), and aggregate demand function (D). Aggregate supply function depends upon technical or physical conditions of production which remains unchanged during short run. As Keynes considered aggregate supply function stable he uses aggregate demand function to fight unemployment and depression. So, employment depends upon aggregate demand which is determined by consumption and investment demand.

According to Keynes, employment can be increased only by enhancing consumption and investment. C = f(Y), i.e., consumption depends on income and thus, consumption also increases along with the increase in level but at a slower rate as compared to increase in income. On the other hand, propensity to consume depends upon psychology, wants, and habits of people which remain constant in this short and because of this reason propensity to consume is stable. Employment thus depends on investment and varies directly with the volume of investment.

On the other hand, rate of interest and MEC influences investment. Marginal efficiency of capital depends on supply price of capital asset and its prospective yield. Another determinant of MEC is expectation of yield on the part of business which is basically a psychological factor. Therefore, there is limited scope for boosting investment by way of raising MEC.

Another determinant of invetmsnet is the rate of interest. Investment and employment can be increased by reducing the rate of interest. Rate of interest is determined by demand and supply of money. On demand side there is LP schedule-which shows higher the value of liquidity preference schedule, higher is rate of interest. People hold money (M) in cash for three purposes: Transaction, Precautionary and Speculative. Transaction and precautionary motives are income elastic. Amount held under these two motives (M1) is a function (L) of level of income, i.e., M1 = L(Y). But money held for speculative motive (M2) is a function of L1 of interest rate(r), i.e., M2 = L1 (r). As the interest rate will be higher, demand for money will be lower and vice versa.

In the figure,

Panel A

Total Demand for money is measured along horizontal axis from M onwards. Transactions and Precautionary demand is given by L curve at OY1 and OY2 level of income. So, at OY1 and OY2 transactions demand will be OM1 and OM2 respectively.

Panel B

L1 curve represents speculative demand for money as a function of rate of interest. When interest rate is OR1 speculative demand for money is MM2.If interest rate reduces to OR speculative demand for Money is MM1.

Panel C

Shows investment as a function of interest rate and MEC. Given MEC, when interest rate is OR1, level of investment is Ol . But when interest rate falls to OR, investment increases to Ol1.

According to Keynesian approach, equilibrium level of employment is obtained where there is equality between saving and investment.

S = f(Y).

Therefore saving is excess of income over consumption n,

i.e., Symbolically S = Y-C

Therefore, we can write, Y = C + S (Expenditure or disposal aspect)

Y = C + I (income aspect)

AS,                                    Income = expenditure

So,                                           C+I = C+S

From above relationship we get, I = S

Panel D

Shows equilibrium level of income where saving equals investment. Here, X- axis represents saving and investment and Y-axis represents income. IE is investment curve which touches S curve at E. Therefore, OY1 is equilibrium level of income and employment. (i.e., under employment equilibrium). If OY2, considered as full employment level of income, then S        = I occurs at E1 where L1E1 investment and Y2E1 saving.

Keynesian theory of income and employment can also be explained by the equality between.

C + I and C + S, i.e, C + I = C + S

As unemployment is outcome of deficiency of aggregate demand. Considering propensity to consume to be stable during short period aggregate demand can be enhanced by increasing level of investment. When investment increases, income as well as employment also increases. Increased income results increased demand for consumption of goods- which increases income and employment in a cumulative manner through multiplier process till equilibrium, as consumption is less than income. It widens the gap between consumption and income, which cannot be filled up due to lack of necessary investment. Full employment level is obtained when volume of investment is increased to fill gap between income and consumption against corresponding full employment level.

In Above Figure

C + I = Aggregate Demand Curve

45o line = Aggregate Supply Curve

E = Equilibrium Point where (C+I) intersects 450 line.

Thus, point E is the point of effective demand where OY1 i.e., equilibrium level of income and employment is determined and known as underemployment equilibrium.

It should be remembered that, there are no automatic forces that create a situation when two curves intersects at full employment level. If the situation occurs it will be rare incident. Thus, Keynes opines that, underemployment equilibrium is a normal case and full employment equilibriums level is an exceptional rare case.

Assume, OYF = Full Employment income level.

C+I shifts to C+I+I1

This new aggregate demand curve which intersects 450 line, i.e., aggregate supply curve at E1 the higher point of effective demand corresponding to full employment income level of OYF It also reveals that to obtain a desired increase in income and employment of Y1YF is the multiplier effect of an increase in investment by I (= l1 in Panel C of Figure) Which causes to an increase in employment and income by Y1YF (i.e., Y1Y2 in Panel D figure) by successive rounds of Consumption.

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