Keynesian Theory of Employment (With Diagram)

As per Keynes theory of employment, effective demand signifies the money spent on the consumption of goods and services and on investment.

The total expenditure is equal to the national income, which is equivalent to the national output.

Therefore, effective demand is equal to total expenditure as well as national income and national output.

The theory of Keynes was against the belief of classical economists that the market forces in capitalist economy adjust themselves to attain equilibrium. He has criticized classical theory of employment in his book. Vie General Theory of Employment, Interest and Money. Keynes not only criticized classical economists, but also advocated his own theory of employment.

His theory was followed by several modern economists. Keynes book was published post-Great Depression period. The Great Depression had proved that market forces cannot attain equilibrium themselves; they need an external support for achieving it. This became a major reason for accepting the Keynes view of employment.

The Keynes theory of employment was based on the view of the short run. In the short run, he assumed that the factors of production, such as capital goods, supply of labor, technology, and efficiency of labor, remain unchanged while determining the level of employment. Therefore, according to Keynes, level of employment is dependent on national income and output.

In addition, Keynes advocated that if there is an increase in national income, there would be an increase in level of employment and vice versa. Therefore, Keynes theory of employment is also known as theory of employment determination and theory of income determination.

Principle of Effective Demand:

The main point related to starting point of Keynes theory of employment is the principle of effective demand. Keynes propounded that the level of employment in the short run is dependent on the aggregate effective demand of products and services.

According to him, an increase in the aggregate effective demand would increase the level of employment and vice-versa. Total employment of a country can be determined with the help of total demand of the country. A decline in total effective demand would lead to unemployment.

As per Keynes theory of employment, effective demand signifies the money spent on the consumption of goods and services and on investment. The total expenditure is equal to the national income, which is equivalent to the national output. Therefore, effective demand is equal to total expenditure as well as national income and national output.

The effective demand can be expressed as follows:

Effective demand = National Income = National Output

Therefore effective demand affects employment level of a country, national income, and national output. It declines due to the mismatch of income and consumption and this decline lead to unemployment.

With the increase in the national income the consumption rate also increases, but the increase in consumption rate is relatively low as compared to the increase in national income. Low consumption rate leads to a decline in effective demand.

Therefore, the gap between the income and consumption rate should be reduced by increasing the number of investment opportunities. Consequently, effective demand also increases, which further helps in reducing unemployment and bringing full employment condition.

Moreover, effective demand refers to the total expenditure of an economy at a particular employment level. The total equal to the total supply price of economy (cost of production of products and services) at a certain level of employment. Therefore, effective demand refers to the demand of consumption and investment of an economy.

Determination of Effective Demand:

Keynes has used two key terms, namely, aggregate demand price and aggregate supply price, for determining effective demand. Aggregate demand price and aggregate supply price together contribute to determine effective demand, which further helps in estimating the level of employment of an economy at a particular period of time.

In an economy, the employment level depends on the number of workers that are employed, so that maximum profit can be drawn. Therefore, the employment level of an economy is dependent on the decisions of organizations related to hiring of employee and placing them.

The level of employment can be determined with the help of aggregate supply price and aggregate demand price. Let us study these two concepts in detail.

Aggregate Supply Price:

Aggregate supply price refers to the total amount of money that all organizations in an economy should receive from the sale of output produced by employing a specific number of workers. In simpler words, aggregate supply price is the cost of production of products and services at a particular level of employment.

It is the total amount of money paid by organizations to the different factors of production involved in the production of output. Therefore, organizations would not employ the factors of production until they can recover the cost of production incurred for employing them.

A certain minimum amount of price is required for inducing employers to offer a specific amount of employment. According to Dillard, “This minimum price or proceeds, which will just induce employment on a given scale, is called the aggregate supply price of that amount of employment.”

If an organization does not get an adequate price so that cost of production is covered, then it employs less number of workers. Therefore the aggregate supply price varies according to different number of workers employed. So, aggregate supply price schedule Id Tut can be prepared as per the total number of workers employed.

Aggregate supply price schedule is a schedule of minimum price required to induce the different quantities of employment. Thus, higher the price required to induce the different quantities of employment, greater the level of employment would be. Therefore, the slope of the aggregate supply curve is upward to the right.

Aggregate Demand Price:

Aggregate demand price is different from demand for products of individual organizations and industries. The demand for individual organizations or industries refers to a schedule of quantity purchased at different levels of price of a single product.

On the hand, aggregate demand price is the total amount of money that an organization expects to receive from the sale of output produced by a specific number of workers. In other words, the aggregate demand price signifies the expected sale receipts received by the organization by employing a specific number of workers.

Aggregate demand price schedule refers to the schedule of expected earnings by selling the product at different level of employment Mo higher the level of employment, greater the level of output would be.

Consequently, the increase in the employment level would increase the aggregate demand price. Thus, the slope of aggregate demand curve would be upward to the right. However, the individual demand curve slopes downward.

The basic difference between the aggregate supply price and aggregate demand price should be analyzed carefully as both of them seem to be same. In aggregate supply price, organizations should receive money from the sale of output produced by employing a specific number of workers.

However, in aggregate demand price, organizations expect to receive from the sale of output produced by a specific number of workers. Therefore, in aggregate supply price, the amount of money is the necessary amount that should be received by the organization, while in aggregate demand price the amount of money may or may not be received.

Determination of Equilibrium Level of Employment:

The aggregate demand price and aggregate supply price help in determining the equilibrium level of employment.

The aggregate demand (AD) and aggregate supply (AS) curve are used for determining the equilibrium level of employment, as shown in Figure-3:

In Figure-3, AD represents the aggregate demand curve, while AS represents the aggregate supply curve. It can be interpreted from Figure-3 that although the aggregate demand and aggregate supply curve are moving in the same direction, but they are not alike. There are different aggregate demand price and aggregate supply price for different levels of employment.

For example, in Figure-3, at AS curve, the organization would employ ON₁ number of workers, when they receive OC amount of sales receipts. Similarly, in case of AD curve, the organization would employ ON₁ number of workers with the expectation that they would produce OH amount of sales receipt for them.

The aggregate demand price exceeds the aggregate supply price or vice versa at some levels of employment. For example, at ON₁ employment level, the aggregate demand price (OH) is greater than the aggregate supply price (OC). However, at certain level of employment, the aggregate demand price and aggregate supply price become equal.

At this point, aggregate demand and aggregate supply curve intersect each other. This point of intersection is termed as the equilibrium level of employment. In Figure-3, point E represents the equilibrium level of employment because at this point, the aggregate demand curve and aggregate supply curve intersect each other.

In Figure-3, initially, there is a slow movement in the AS curve, but after a certain point of time it shows a sharp rise. This implies that when a number of workers increases initially, the cost incurred for production also increases but at a slow rate. However, when the amount of sales receipt increases, the organization starts employing more and more workers. In Figure-3, the ON₁ numbers of workers are employed, when OT amount of sales receipts are received by the organization.

On the other hand, the AD curve shows a rapid increase initially, but after some time it gets flattened. This means that the expected sales receipts increase with an increase in the number of workers. As a result, the expectations of the organization to earn more profit increases. As a result, the organization start employing more workers. However, after a certain level, the increase in employment level would not show an increase in the amount of sales receipts.

In Figure-3, before reaching the employment level of ON₂, the employment level keeps on increasing as the organizations want to higher more and more workers to get the maximum profit. However, when the employment level crosses the ON₂₁ level, the AD curve is below the AS curve, which shows that the aggregate supply price exceeds the aggregate demand price. As a result, the organization would start incurring losses; therefore would reduce the employment rate.

Thus, the economy would be in equilibrium when the aggregate supply price and aggregate demand price become equal. In other words, equilibrium can be achieved when the amount of sales receipt necessary and the amount of sales receipt expected to be received by the organization at a specified level of employment are equal.