Just as the behaviour of prices and quantities in individual markets can be explained by the interaction of demand and supplies, the behaviour of a country’s total output (or its national income) depends on the economy’s total demand and total supply. This website includes study notes, research papers, essays, articles and other allied information submitted by visitors like YOU. In the General theory of employment, interest, and money, Keynes disagreed with the Classical notion that: a market economy is self-regulating and always automatically moves to macroeconomic equilibrium at the full employment level of real GDP Features of The Keynesian Theory Some of the basic features of Keynes theory of income and employment are as follows: 1. Thus an act of investment leads to an increase in income of firms that produce capital goods such as plant, equipment and machinery. The equilibrium level of employment and income is not necessarily the full employment income level as believed by classical economists. Apparently the above analysis is true at all points of time. In this way there is a much larger increase in income than the original increase in investment. Oppositely, if saving exceeds investment, when income is income will fall for obvious reasons. Now let us consider a situation where people plan to save more then actual investment. 1,000 is invested in the new machine, the annual return is Rs. 52, Rs. Thus, if total spending were to decrease, output would decrease; if total spending were to increase, output would increase; and if total spending remained unchanged, output would not change. 200 crores worth of goods will remain unsold. We see that the equilibrium level of income is OYe. Saving is income that is not spent on consumption. So they reduce production. 40 when the rate of interest is 10%. Likewise, aggregate planned expenditure is the sum total of planned consumption and planned investment expenditure. An injection or an addition refers to payments received by firms or households that are not derived from the spending of the other group. Thus, in both the case (i.e., case of unfulfilled expenditure plan and unplanned changes in stocks) the effect of an excess of planned expenditure over actual output is a rise in GNP or in national income. Substituting (8) and (7) into (9) we get: Equation (10) states that the equilibrium level of national income is found out by dividing autonomous expenditure by the MPS. It follows from the national income accounting system. So they cannot avoid saving a portion of their income. In other words, if the income-expenditure equilibrium condition is fulfilled, the leakages-injections condition will be automatically fulfilled. It also follows from the Keynesian model that national income equilibrium occurs where planned saving equals planned investment. The circular flow is in complete if there is no mention of saving. It was Keynes who first noted that what people plan to do and what they succeed in doing may be two different things. Since there is neither excess demand nor excess supply there is no upward or downward pressure on national income either. What is the logic of this equilibrium? Keynesian Theory of Income and Employment! Thus, APC should exceed MPC. If saving and investment are equal, the flow will remain unchanged because the amount withdrawn from it is equal to the amount of injected into it. In other words, if business firms try to eliminate the unplanned increase in stocks, output reduction is inevitable. So it is necessary to refer to the relation between output and planned expenditure on one hand and actual expenditure on the other hand. 34.1 and Fig. So an increase in the rate of interest makes new investment less attractive than before. 1,000 crore for a particular period. Keynes’ “propensity to consume” (or MPC) plays an important role in his theory. As a result national income falls. Let us go back to Table 34.1 for the sake of illustration. Keynes's theory of the determination of equilibrium income and employment focuses on the relationship between aggregate demand (AD) and aggregate supply (AS). According to the leakages-injections approach, the equilibrium condition: Intended saving equals intended investment. Therefore, a more realistic consumption function would be of the type shown in Fig. Suppose, now national income is Rs. It is revolutionary theory and marks a sharp departure from classical thinking. We may well start with the income-expenditure approach. In the General theory of employment, interest, and money, Keynes disagreed with the Classical notion that: a market economy is self-regulating and always automatically moves to macroeconomic equilibrium at the full employment level of real GDP KEYNESIAN MODEL VIII. It could be that the full employment level is higher than the equilibrium level or it could be that it is below the equilibrium level. If the expected return on investment remains constant at, say, 10%, and the rate of interest increases from 5% to 7%, the net return on investment goes down from 5% to 2%. Output expansion will continue until full employment is reached. The Keynesian concept of multiplier is based on the following assumptions: The Keynesian multiplier comes into operation for any autonomous (income-independent) change in spending. The income obtained from the production of the national output is distributed to the various factors of production employed in the production process and, so, national income and national output are always and necessarily equal. But, in economics, the term investment is used in a different way. 10,000 crore and out of this Rs. have ever since widened the scope of macroeconomic analysis. 100. significance and criticism of keynesian theory of income and employment ... posted by shashi aggarwal at This time no goods are added to stocks and none are taken from stocks. Thus investment decisions are governed by whether the expected rate of return on the machine is greater than the cost of borrowing the necessary funds, or, if the funds are already available, the cost of the earnings lost by purchasing the machine rather than by lending out of funds. Its prescriptions have wider application to solve practical economic problems. Clearly then, if MEC remains constant, the number of new machines that will be bought in any period depends on the market rate of interest. Keynes’ theory of employment is a demand-deficient theory. 18.1, one can establish the relationship between APC and MPC. If not augmented by wisely chosen fiscal policies, the economy, he believed, could linger for months, years, or even decades below its full-employment … Firstly there is the possibility that households and business firms will not be able to spend Rs. A fall in the rate of interest to r1, (say, 15%), increases the amount of profit investment to OI1. The implication is simple if there was equilibrium there would be full employment, too. A more pessimistic outlook would cause the MEC curve to shift to the left, e.g., to MEC2 indicating that less investment will be undertaken at any given rate of interest. Suppose C = Rs. 40 4- 0.20F. 76, respectively. Classical Theory of Income and Employment, 2. In each of the two cases described above the following conclusion will hold at any level of national income or national output at which total planned (desired) expenditure exceeds total output, national income will have to rise—sooner or later. In economics, the term investment relates specifically to physical investment. Keynesian Theory of Income and Employment (a) Criticism against Classical Theory Keynes criticised the Classical theory stating that the assumptions on which the theory is based are wrong and impractical. The total expenditure is equal to the national income , which is equivalent to the national output . b. decrease in nominal income, but no change in real output . This point may be illustrated in the following manner. Keynes’ multiplier is known as the investment multiplier, because investment is the key variable in his theory. When Keynes stated that saving was always equal to investment he was referring to actual or realised saving and actual or realised investment. Content Guidelines 2. National income reaches equilibrium at point A where desired expenditure is equal to national income (output). This brings us on to the consumption function, which lies at the heart of the Keynesian analysis. A change in investment leads to a change in national income through the multiplier process. Alternatively, we can say (following Keynes) that the equilibrium level of income is reached when planned saving is equal to planned investment. The process will continue until and unless the inventories are totally exhausted. In fact, income change continues until the two become equal. 1,000 per month and the marginal propensity to consume (MPC) is 4/5 (i.e., a constant ratio was the proportion of the increase in income spent on consumption) total incomes will raised by Rs. These will come up again and again in our discussion of macroeconomics. 50 4- 0.20Y. Thus, for example, the distance OYe represents is equal to EYe. The table gives a consumption function, from which saving plans can be obtained. sets or simple pocket calculators due to the emergence of more useful calculating devices such as mini-computers). The marginal propensity to consume (MPC): It is the proportion of an addition to income that is spent on consumption. The potential output of an economy is nothing other than its full employment output (national income). Thus when the expenditure line cuts the 45° line, planned expenditure not only equals income but planned saving equals planned investment, too (since the saving line cuts the investment line). Given the specified spending plans, find out the equilibrium value of national income. In our example this would be 1/(1 – 4/5) = 5. Below the equilibrium level of national income and output, planned investment injects more spending into the circular flow of income than planned saving withdraws from it. 10 crore rise in the value of output in the coming year. If we make these two assumptions we observe that the economy’s GNP or national income depends on aggregate demand (i.e., consumption demand and investment demand). There is a second way in which the Keynesian multiplier is important. There is a deficiency of demand of the amount AB. This indicates that planned saving exceeds planned investment. All other terms have their usual meaning and significance. But the distance EYe also represents aggregate demand because E lies on the C + I schedule. This is what would happen if there were no government activity. 18.6. Thus, a reduction in spending leads to a recession, or contraction in economic activity, because of its dampening effect on output, employment, and income. 1600 crores by exactly Rs. Therefore, the multiplier only tells us the position which will be reached by an economy after a lapse of time if the rate of injection remains constant. 76. This is indeed the equilibrium level of income. Keynesian Theory of Income and Employment: Definition and Explanation: John Maynard Keynes was the main critic of the classical macro economics. He used the term effective demand to denote the total demand for goods and services at various levels of employment. If current consumption is high, investment will be high too, in as much as entrepreneurs will be optimistic. From the Fig. Income of the household sector is also Rs. In other words, the reciprocal of MPS gives us the numerical value of the multiplier. Keynesian Theory of Income and Employment! 34.1 is the same as the level of income, Ye where the saving line intersects the investment line in Fig. Investment requires that an amount of current consumption is sacrificed (i.e., a portion of income is saved) so as to release the resources to finance it. The amount spent on consumer goods must equal the sale of consumer goods. In Fig. Therefore, the slope is given by which is indeed the marginal propensity to consume (MPC). The firms producing and selling such goods get extra revenue. At this stage realised investment — made up of planned and unplanned investment—will still be equal to realised saving, but the discrepancy between the intentions of savers and investors will result in the level of income falling back until it reaches the equilibrium level of 500. 4 crore and the MPC is 0.7, then the consumption function will be: C = Rs. J. M. Keynesian theory is a general theory. Keynes's theory of the determination of equilibrium income and employment focuses on the relationship between aggregate demand (AD) and aggregate supply (AS). Consequently, it pays to invest in the machine rather than in the bond. Building new factories, adding new machinery and equipment, and investing in new products and processes (methods of production) enables industry to supply a large volume of more sophisticated products and services to the consumers at large. It has a wider application on all such situations of unemployment, partial employment and near full employment. Planned investment figures for 8%, 6% and 4% rates of interest are Rs. In Keynes’ model the equilibrium level of national income is the level at which aggregate demand is equal to output (aggregate supply). As a result, employment and income will also rise. However, the increase in consumption is less than the increase in income — because part of the increase in income is likely to the saved. 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