Keynes’s Theory of Employment: THE PRINCIPLE OF EFFECTIVE DEMAND: AGGREGATE DEMAND AND AGGREGATE SUPPLY

Keynes was the first to develop a systematic theory of employment in his book, “General Theory of Employment. Interest and Money” published in 1936.

The classical and the neoclassical economists in other words, aggregate supply price is the total cost of production incurred by employing a certain given number of labors. Almost neglected the problem of unemployment. They regarded unemployment as a temporary phenomenon and assumed that there is always a tendency towards full employment. According to them, when there is unemployment in the economy, then certain economic forces in the free capital economy automatically operate in such a way that the condition of full employment is restored.

Keynes challenged the validity of the classical theory of employment as during the period 1929- 33, there occurred great depression in the capitalist countries which caused huge unemployment and low income.

He presented a new theory of income and employment in which he states that the level of employment depends upon the level of aggregate effective demand, the greater the level of effective demand, the greater the amount of employment in the economy.

Features of Keynesian Theory of Employment:

  • Keynes tried to prove that full employment is not a normal feature of a capitalist economy and underemployment equilibrium is its normal feature.
  • Keynesian theory of income and employment is a short-run theory. According to him, in the long-run there is no problem; in the long-run, we are all dead.
  • Keynes criticized the classical assumption of self-regulating economy and advocated that government intervention was necessary to tackle the problem of the economy.
  • In Keynesian theory, the amount of employment depends upon the level of national income and production as the amount of capital, the size of population and labor force, technology, efficiency of laborers, etc., do not change in short run.
  • Keynes thought that prices and wages do not adjust quickly to balance demand and supply. Therefore, he assumes that prices and money wages remain constant.
  • According to him, the level of employment depends upon the level of aggregate effective demand, the greater the level of effective demand, the greater the amount of employment in the economy.

In Keynes’s words, “The value of D (Aggregate Demand) at the point of Aggregate Demand function, where it is intersected by the Aggregate Supply function, will be called the effective demand.”

According to Keynes, the total demand for goods and services in an economy at various levels of employment is called effective demand. Total demand for goods and services by the people is the sum of consumption expenditures and investment expenditures in a two-sector economy.

people are employed to produce all kinds of goods, both consumption goods and investment goods. However, we need another component of effective demand—the component of government expenditure.

Thus, effective demand may be defined as the total of all expenditures, i.e., C + I + G

Where, C, I and G stand for consumption expenditures, investment expenditures, and government expenditures.

Here, for simplicity, we ignore government expenditure as a component of effective demand.

According to Keynes, the level of employment is determined by effective demand which, in turn, is determined by aggregate demand price and aggregate supply price.

Aggregate Demand Price:

It is aggregate demand function which plays a more important role in the determination of employment. “The aggregate demand price for the output of any given amount of employment is the total sum of money or proceeds, which is expected from the sale of the output produced when that amount of labor is employed.” It refers to the expected revenue from the sale of output produced at a particular level of employment. Thus, the aggregate demand price is the amount of money which the entrepreneurs expect to get by selling the output produced by the number of men employed.  Different aggregate demand prices relate to different levels of employment in the economy.

A statement showing the various aggregate demand prices at different levels of employment is called the aggregate demand price schedule or aggregate demand function. The aggregate demand function is an increasing function of the level of employment and is expressed as D = F (N), where D is the proceeds which entrepreneurs expect from the employment of N men. The aggregate demand curve slopes upward from left to right because as the level of employment increases aggregate demand price also rises.

Aggregate demand schedule

Level of Employment(N)

(In Lakhs)

Aggregate Demand Price(D)

(Rs Crores)

10 130
15 140
20 150
25 160
30 170
35 180
40 190

The table shows that with the increase in the level of employment proceeds expected rise and at lower levels of employment decline. When 10 lakh people are provided employment the aggregate demand price is Rs 130 crores and when 15 lakh people are provided jobs, it is Rs 140 crores. Aggregate demand price is increasing with the increase in the level of employment. According to Keynes, the aggregate demand function is an increasing function of the level of employment D = F (N), where D is the proceeds which entrepreneurs expect from the employment of N men.

Aggregate Supply Price:

for production, an entrepreneur requires certain quantities of cooperant factors like land, capital, raw materials, etc. along with certain amount of labor which will be paid remuneration. Thus, each level of employment involves certain money costs of production including normal profits which the entrepreneur must cover.  Aggregate supply price is the total cost of production incurred by employing a certain given number of laborers. Aggregate supply price will rise as more labor is employed to produce goods and services. Keynes’s aggregate supply function (curve) shows the relationship between the number of workers employed and the aggregate supply price. The aggregate supply function is a schedule of the minimum amounts of proceeds required to induce varying quantities of employment.

It slopes upward from left to right because as the necessary expected proceeds increase, the level of employment also rises. But when the economy reaches the level of full employment, the aggregate supply curve becomes vertical. Even with the increase in the aggregate supply price, it is not possible to provide more employment as the economy has attained the level of full employment.

Aggregate supply schedule

Level of Employment(N)

(In Lakhs)

Aggregate Supply Price(S)

(Rs Crores)

10 115
15 130
20 145
25 160
30 175
30 190
30 205

The above table shows that the aggregate supply price rises with the increase in the level of employment. If entrepreneurs are to provide employment to 10 lakh workers, they must receive Rs 115 crores from the sale of the output produced by them. It is only when they expect to receive the minimum amounts of proceeds (Rs 130 crores, Rs 145 crores and Rs 160 crores) that they will provide employment to more workers (15 lakhs, 20 lakhs and 25 lakhs respectively). But when the economy reaches the level of full employment (at 30 lakh workers) the aggregate supply price (Rs 175,190 and 205 crores) continues to increase but there is no further increase in employment. According to Keynes, the aggregate supply function is an increasing function of the level of employment Z = f[N], where Z is aggregate supply price of the output from employing N men.

Keynes assumed AS curve to be constant and paid greater attention on increasing aggregate demand to achieve the equilibrium at full-employment level. At the level of twenty-five lakhs employment, aggregate demand price is equal to aggregate supply price at Rs 160 crores and it is called effective demand.

Determination of Effective Demand:

The level of employment is determined at the point where the aggregate demand price equals the aggregate supply price. This point is called the effective demand and here entrepreneurs earn normal profits. So long as the aggregate demand price is higher than the aggregate supply price, the prospects of getting additional profits are greater when more workers are provided employment. The proceeds expected(revenue) rise more than the proceeds necessary(costs). This process will continue till the aggregate demand price equals the aggregate supply price and the point of effective demand is reached. This point determines the level of employment and output in the economy. The point of effective demand is, however, not necessarily one of full employment but of underemployment equilibrium.

In the above diagram, AD is the aggregate demand function and AS the aggregate supply function.  The level of employment in the economy is on OX axis and the proceeds expected(revenue) and the proceeds necessary (costs) on OY axis. Both curves AD and AS intersect each other at point E. This is effective demand where ON workers are employed. At this point, the entrepreneurs’ expectations of profits are maximized. At any point other than this, the entrepreneurs will either incur losses or earn subnormal profits. At ON1 level of employment, the proceeds expected(revenue) are more than the proceeds necessary (costs), i.e., DN1 > SN1. This indicates that it is profitable for the entrepreneurs to provide increasing employment to workers till ON level is reached where the proceeds expected and necessary equal at point E though it is underemployment equilibrium. It would not be, however, profitable for the entrepreneurs to increase employment beyond this to NF level S1NF >D1NF and they incur losses.

So, the entrepreneurs will not employ workers beyond the point of effective demand till the aggregate demand price rises to meet the aggregate supply price at the new equilibrium point which may be one of full employment.

Keynes regards the aggregate supply function to be given because it depends on the technical conditions of production, the availability of raw materials, machines etc. which do not change in the short run. It is, therefore, the aggregate demand function which plays an important role in determining the level of employment in the economy. According to Keynes, the aggregate demand function depends on the consumption function and investment function.

The level of employment can be raised by increasing either consumption expenditure or investment expenditure, or both. Thus, it is the aggregate demand function which is the “effective” element in the principle of effective demand.

This can be explained in the below diagram, where E is the point of

effective demand which determines ON level of employment. To achieve ONF level of full employment for the economy, it requires the raising of the point of effective demand. This is possible by raising the aggregate demand curve to AD1 where it intersects aggregate supply curve AS at E1. This is the new point of effective demand which provides an optimum level of employment ONF to the economy. If the aggregate demand function is raised beyond this point, the economy will experience inflation because all the existing resources are fully employed and their supply cannot be increased during the short run, as it is apparent from the vertical portion of the AS curve.

KEY POINT OF KEYNES’S THEORY OF EMPLOYMENT

1. Effective demand determines the level of employment in the economy. When effective demand increases, employment also increases, and a decline in effective demand decreases the level of employment. Thus, unemployment is caused by a deficiency of effective demand.

2. Level of output or income of a country depends on the level of employment as effective demand represents the total expenditure on the total output produced at an equilibrium level of employment. It indicates the value of total output which equals national income. National income equals national expenditure. Effective Demand =Value of National Output=Volume of Employment=National Income=National Expenditure=Expenditure on consumption goods+Expenditure on investment goods.

3. Aggregate supply of an economy depends on physical and technical conditions of production that is the quality of labor, stock of capital and raw materials available in the economy and the state of technology. Since these factors do not change much in the short run, aggregate supply curve remains constant in the short run.

4. In the Keynesian analysis of effective demand, consumption and investment expenditures relate to the private sector because Keynes considers government expenditure as autonomous. But the post-Keynesian economists include government expenditure as a component of effective demand. Thus, Effective Demand (D) = Private consumption expenditure (C) + Private investment (I)+Government expenditure (G) on both.

5. Unemployment can be removed by an increase in consumption expenditure and investment expenditure. Since the propensity to consume is stable during the short run, it is not possible to raise the consumption expenditure. Therefore, the level of effective demand and hence of employment can be raised by an increase in investment.

6. Investment demand depends on the rate of interest and marginal efficiency of capital. According to Keynes, rate of interest is determined by supply of money and the state of liquidity preference. Marginal efficiency of capital depends on the expected future yields or profit expectations of entrepreneurs on the one hand and replacement cost of capital on the other. Changes in marginal efficiency of capital cause a great deal of fluctuations in investment by entrepreneurs. Investment demand is thus highly volatile and causes recession or depression when it falls, and boom and prosperity when it increases significantly. In case the private expenditures are insufficient in bringing about the required level of employment, the same can be achieved by government expenditure.

7. The principle of effective demand repudiates Say’s law of markets that supply creates its own demand. According to Keynes, supply fails to create its own demand because the whole of the earned income is not spent on the consumption goods and services. Besides it, saving and investment decisions are made by different people. As a result, the existence of full employment is not possible. Instead, it is the effective demand which creates supply.

8. He was not in the favor of the Pigou’s wage cut theory. A money wage-cut will reduce the expenditure on goods and services leading to a fall in effective demand and hence in the level of employment. Keynes emphasized on the stickiness or rigidity of money wage that implies that money wage rate will not quickly change. According to him, there is a money illusion on the part of the workers. By money illusion it is meant that workers fail to realize that value of money, that is, its purchasing power in terms of commodities, changes when prices rise. They regard money such as a rupee or a dollar as something which has a stable value or purchasing power. Therefore, while they would strongly oppose and resist any cut in money wages, they would not resist much if their real wages are reduced through rise in prices of commodities with money wages remaining constant.

Thus, we can summarize the various determinants of employment, income and output ofKeynes’s Theory in a tabular form.

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