Keynesian Theory of Income and Employment

Keynesian Theory of Income and Employment

Among many economists that introduced important theories, John Maynard Keynes proposed many theories that contradicted previously accepted economic concepts. One of his theories that allowed different economies to understand unemployment better was the theory of income and employment.

What is the Keynesian Theory of Income and Employment?

This theory, also known as the Effective Demand Theory of Employment, was developed by John Maynard Keynes, an English economist, in 1936. He introduced this concept in one of his books, ‘The General Theory of Employment, Interest, and Money’. This theory states that when the rate of aggregate demand is reduced, it results in unemployment and plummeting income, and vice versa. Interestingly, John Maynard Keynes deduced this idea by analyzing different countries and why they could not reduce the rate of unemployment over the years, despite applying all the suggestions given by different economists. Moreover, Keynes was among the few economists that challenged the traditional theory of employment.

Keynes’ Criticism of the Classical Theory

Keynes' Criticism of the Classical Theory

1. Money Illusion

The traditional theory states that perfect competition is possible within the market, and the workforce changes according to the supply, creating more jobs; however, Keynes objected that with an increase in money wage, the supply is also increased, resulting in a drop in real wages.

2. Wage Rigidity

Keynes also criticized wage rigidity or sticky prices. This model states that prices and wages are flexible and change according to demand and supply. Keynes believed this not to be the case, as there are various factors, such as labor unions, that hinder the change in wages, especially with wage cuts. By doing so, resources are not used to their full potential, causing a fluctuation in GDP.

3. Full-employment Equilibrium

According to the classic theory, full-employment equilibrium can be achieved in the long run, but the exact period is not predictable. Keynes argued that solving the problem of unemployment should be a short-term process because he said, “in the long run, we are all dead”.

4. Self-Regulation Economy

Another criticism from Keynes of the classic theory was the idea of full-employment equilibrium within a self-regulating economy. Although this idea was accepted widely, the great depression of the 1930s made Keynes realize that full employment equilibrium is not something that can happen on its own. He argued that state intervention is essential to resolve unemployment problems.

Assumptions of Keynesian Theory of Income and Employment

Assumption of Keynesian Theory of Employment

1. Short Period

As mentioned previously, Keynes was a firm believer in resolving economic problems in a short period. Thus, this theory assumes that a limited period is given to solve the issues of low wages and unemployment, in this case.

2. Perfect Competition

Although Keynes argues that perfect competition cannot exist within a self-regulating economy, perfect competition is assumed to apply this theory.

3. Closed Economy

This means that to apply this theory, it is assumed that a particular economy does not participate in international trade.

4. Ignoring the Government as Spender and Taxer

Some roles of the government are recognized in this theory; however, it is assumed that the government does not spend or levy taxes.

5. Diminishing Marginal Productivity

This assumption is taken into consideration when using the Keynesian Theory of Income and Employment, which states that as the input is increased or the production is increased, productivity will begin to show a diminishing trend.

6. Only Variable Factor is Labor

To raise the production, it is assumed that all factors are constant except labor.

7. Money Illusion

Despite him criticizing the money illusion, his theory also assumes money illusion.

8. Money as a Store of Value

Whereas the classical theory only saw money as a tool for transactions, Keynes stated that it can be assumed as a store of value, which means that money can retain its purchasing power in the future.

9. Zero Time Lag

It is also assumed that for an income to transition into consumption or become an investment, there is no time lag.

Propositions of Keynesian Theory of Income and Employment

Propositions of Keynesian Theory of Income and Employment

1. Interrelations 

Keynes proposed that total employment is equal to total output, which is equal to total income. Therefore, as employment increases, so do output and income.

2. Demand and Employment

As mentioned briefly in the introduction, the rate of employment is affected by the demand. With an increase in demand, the rate of employment increases and vice versa.

3. Effective Demand

At the point at which the aggregate demand and the aggregate supply become equal, the effective demand is determined.

4. Aggregate Demand 

Keynes proposed that both the consumption expenditure and investment expenditure are the governing factors of the aggregate demand function.

5. Trend of Consumption Expenditure

The amount of money spent on the final product is known as consumption expenditure, and it depends on the amount of income and the inclination towards consumption. Additionally, consumption expenditure remains stable in the short run as the rate of consumption does not change rapidly despite an increase in income.

6. Trend of Investment Expenditure

The expected rate of profitability on investment is referred to as the marginal efficiency of capital, and the investment expenditure is governed by it. Investment expenditure is unstable in both the short and long runs.

7. Marginal Efficiency Investment

Similar to investment expenditure, the marginal efficiency of investment is greatly unstable. Also, it depends on two aspects; the supply price of capital assets and the prospective yield.

8. Rate of Interest

Keynes proposed that the rate of interest depends on the demand and amount of money. Also, it is a monetary phenomenon.

Implications of Keynesian Theory of Income and Employment

Implications of Keynesian Theory of Income and Employment

1. Enhancing Capitalism 

As the majority of the countries opt for capitalism, these experience unemployment to varying degrees. Keynes stated that unemployment is a natural phenomenon in a capitalistic economy; however, he did not propose transitioning to socialism. He suggested that enhancing the capitalistic economy is the most effective way to reduce unemployment.

2. Government Intervention

As mentioned previously, Keynes strongly believed in state intervention to raise demand to increase employment rates.

3. Taxation

Although Keynes did not suggest imposing tax directly, he suggested progressive taxation must be implemented to distribute the propensity to consume from the rich to the poor.

4. Monetary Policies are Unreliable

Governments usually lower the rate of interest to increase investments during a recession; however, Keynes stated that it is an unreliable approach, as, despite the drop in interest rates, people might still not invest.

5. Public Works Programs

While Keynes placed great importance on investment, he preferred public investment over private investment because of the unstable nature of the latter. Therefore, to boost investment in the public sector, he suggested introducing public works programs specifically for the unemployed. As the economy develops because of these programs, public investment will increase as well.

6. Aim of Full Employment

The idea to achieve full employment only came into existence after the introduction of this theory.

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