- By Sidra Munir
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Keynes in 1936 wrote his esteemed book named “General Theory”, in which he not only criticized the classists, but also presented his own theory of income and employment. The silent features of his theory are as follow.
1. Salient Features
- According to Keynes, equilibrium level of NI takes place where aggregate dd (aggregate expenditure) is equal to aggregate supply ( Aggregate output).
- The equilibrium level may be at above the full employment and may be at below the full employment level.Full employment represents maximum level of output which could be obtained by utilizing all the natural and human resources of the economy. Thus at the level of full employment AD = AS and the equilibrium level of NI will be maintained at full employment level.
If at the level of full employment AD > AS, NI will take place above the full employment increased in AD means more demand for goods + services. So profit of the producer will increase, so investment (i) also increases, so NI increases.The increases in NI will be only in monetary units. If at the level of full employment AD < AS, NI will take place below the full employment level.Decreased AD means less dd for goods + service. So producers profit and ii will decrease. Hence NI will also decrease and in this situation unemployment occurs.
- Keynes introduced the idea of “effective demand” effective dd represents AS, AD and the level of NI.According to Keynes higher level of effective demand, higher will be the level of output and employment.He says effective dd deficiency is responsible for unemployment.
- In response to classical utopianism of “Laissez-faire” Keynes is in favor of government intervention in inflation and deflation also.He is advocating deficit budget and deficit financing which increases employment and output and also effective dd.
2. Determination of Equilibrium level of income and employment:
2.1. Assumptions of the Model
- It is two-sec-economy where there is no government and foreign trade, i-e y = C+1 where G +T = 0.
- The consumption expenditures ( c ) has the following equation:
C = C0 + Cy ( C0 = Autonomous Consumptions, Cy=Induced consumptions).
- The investment expenditure I= Io ( Autonomous II).
- The SS equation is S= -S0 + Sy (-S0 is autonomous dis-saving and Sy is induced saving).
The output side of NI is y= C+S
Equilibrium/Basic Thesis of the Model
According to Keynes; the equilibrium level of NI and employment is determined where AD (aggregate expenditure) = AS (aggregate output) it is as: y= C+1=C+s
S = I
Thus we see that there are two approaches to present equilibrium level of NI;
- AD = AS method
- S = I (Leakage and injection Approach)
3. 1:Equilibrium level of NI- AD = AS approach
In 2 sec economy equilibrium level of NI takes place, where AD = AS, where AD=y = C + 1 (aggregate DD y = C + 1).
AD = in 2-sec services or AD is the national income received by the four factors of production against their services, such income will be spent by them on consumption goods and an investment(ii) goods. So on one hand AD represents the total income earned is NI while on the other hand AD is total expenditure (On consumer as well as on producer goods) of the economy.
Along with increase in NI, AD = C + 1 go on to increase as shown in diagram:
In diagram when NI increases, AD = C + 1 also increases. We also know that at zero level of NI, there are some fizzed consumption as well as autonomous II, i-e c0+L0 AS: y=C+s
AS= In 2sec economy AS: y = C + S consists of total output produced in the economy or AS is that NI which has been produced by the factors of production produce the goods + services, they get payments against their services.
A part of such economy will be spent by them or consumption goods and a part will be saved. Thus AS represents total goods + services produced. On the other hand AS also represents total factor’s payments along with increase in output of the economy, the factor’s payment (AS) also increases as shown in diagram.
In diagram as the level of NI (produced goods + services) increases, the level of factor’s carrying also increase which will be split in to consumption and saving.
3.1. Determination of Equilibrium level NI
According to Keynes equilibrium level of NI in 2 sec economy will be determined at the level where AD= AS.Such point is known as Keynesian cross I point. This cross I point is also known as effective demand.According to Keynes; higher the effective dd, higher will be the level of NI and employment.This concept can be explained with the help of diagram.
In the figure equilibrium level of NI takes place at E, where AD = AS.So the determined NI = 0y2.The equilibrium will not take place at 0y1 because here AD > AS.It would have the effect of increasing income of the country.At 0y3 equilibrium level of NI will not take place because AS>AS.This would have the effect of decreasing the income of the country.
So we find that NI will be determined at that point where AD=AS, so E is the equilibrium point where AD = AS and NI is determined at 0y2.