Running head: PHILOSOPHICAL IDEAS BEHIND KEYNES’ THEORY OF INCOME AND

EMPLOYMENT 1

PHILOSOPHICAL IDEAS BEHIND KEYNES’ THEORY OF INCOME AND EMPLOYMENT

PRIYANSHI AGRAWAL

1933360

1ECOH A

CHRIST (DEEMED TO BE UNIVERSITY)

PHILOSOPHICAL IDEAS BEHIND KEYNES’ THEORY OF INCOME AND EMPLOYMENT
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PHILOSOPHICAL IDEAS BEHIND KEYNES THEORY OF INCOME AND EMPLOYMENT

John Maynard Keynes was born in an academic family. He always excelled in his subjects

especially mathematics. His best-known work ‘The general theory of employment, interest and

money’ published in 1936 became a standard in economic thoughts for future. In 1944, he guided

the British authority to the Bretton Woods Conference at United States of America. He gave a

new thought on income and employment theory at the time of Great Depression in his book, The

General Theory of Employment, Interest and Money.

In this theory Keynesians have emphasized the link between income, employment and

output. Generally, the transactions are two-sided—in this, one person’s income is another

person’s expenditure which can be expressed in terms of the equation—Y=O=E where Y is

national income, O is national output and E is national expenditure. A consumer has two options

—either to save or to spend in consumption so, income (Y)=consumption(C) + savings(S).

Similarly, for estimation of national output, produced goods are either sold in the market for

consumption or invested by the firms in stock. Thus, equation becomes O=C+I. So, from the

previous two equations we conclude that C+S=C+I or S=I. From the equation, inference is that

saving and investment are equal but ex-post investment and ex-post savings are never equal.

Therefore, Keynesians say that economic uncertainty arises from this difference between savings

and investment. For an instance, if present savings rise above its previous level due to high prices

then there will be reduction in preset demand for a commodity to demand more in future at a

lower price. If by chance the investment increases by same amount of savings in the economy

i.e., productive resources continue to operate at capacity; then there will be no net change in the

economy and the economy will be at equilibrium. On the other hand, if there is no subsequent

rise in investment, then demand for one of the factors of the production that is, demand of labor
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will fall (keeping fixed the wage rate) leading to voluntary unemployment and thus it may lead to

reduction in their present income. The reduction in income reduces market demand for a

commodity and also savings. So, at this point if producers do not increase their investment plans,

equilibrium will be established at lower level of income. So, in reality investments are uncertain

not savings. So, we conclude that a fall in investment and a rise in savings badly affects economy

while rise in investment or decrease in saving will stabilize the economy. This instance depicts

how changes in savings will affect changes in national income but it does not show the extent of

those changes. So, to determine this change Keynes designed consumption function. The motive

behind this theory was to reveal that under certain circumstances, economy could be stuck in

disequilibrium with productive resources in surplus i.e., unemployment, but income and output

unable to rise sufficiently to reach equilibrium level (Practice, n.d.). In his essay on Economic

Research and the Keynesian Thinking of our times, Keynes said about underemployment

equilibrium that a free enterprise economy, unless stimulated by government policies may sink

into a condition of permanent mass unemployment.

Determination of income and employment level---

According to Keynes theory of income and

employment- “in the short period, level of national income and level of employment is

determined by aggregate demand and aggregate supply in the country. Equilibrium of national

income occurs where aggregate demand is equal to aggregate supply. But this equilibrium level

of income necessarily does not indicate the full employment level” (Keynes,1930).
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In the above diagram,

income is measured along X-axis and desired consumption and investment are shown on the y-

axis. C+I curve represents the aggregate demand and 45-degree line represents the aggregate

supply. The intersection of these two curves determines the equilibrium level of national income.

The equilibrium level is at E1 corresponding to the desired aggregate demand curve (C+I) with

the supply curve. Accordingly, equilibrium level of income is Y1 because at this level of income

desired aggregate demand equals aggregate supply. At this level of income desired aggregate

spending is equal to the national output. Purchaser can fulfill their spending plans and the firms

are able to sell whatever they desire to produce. There is no incentive for the firms to change

their output. Therefore, output and income are at equilibrium. Keynes had made many

assumptions before proposing his theory of income and employment. Following are his

assumptions-- 1)RIGID PRICE-

Keynes assumed price to be constant in his theory. He also gave reasons for price to be constant.

Firstly, producers generally have long-term, multi-year agreements with suppliers of different

raw materials and different resources so these contracts prevent the fluctuation of prices.

Secondly wages are the means of livelihood for labors so they oppose to lower their wages.

Therefore, workers are ready to get temporarily unemployed instead of getting lower wages.

2)EFFECTIVE
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DEMAND- The point at which aggregate demand is equal to the aggregate supply is called

effective demand point. People demand goods only at their disposable income. Disposable

income means the income available to the consumer only after paying several taxes. This

assumption primarily states that change in specifically disposable income leads to change in

consumption pattern which in turn leads to change in demand for goods by the consumer. When

economic growth is increasing then there is increase in per capita income so consumption

expenditure also increases. On the other hand, if economic growth is decreasing, then there is

reduction in per capita income and hence consumption expenditure falls.

3)THE SHORT PERIOD-Keynes said that short period is the time in which induction of new

investment do not change the technique, the organization and the assets. According to this

assumption, method of production and the fixed capital amount remain unchanged.

4)PERFECT COMPETITION- Keynes assumed that there is high degree of perfect competition

in the market in which firms can sell more of goods only by lowering its price. He chose perfect

competition because in this market form, price is decided by the market forces and in his theory

also price is determined at that level where aggregate demand is equal to the aggregate supply.

5)OPERATING IN DIMNISHING RETURN STAGE-In this stage, total product goes on

increasing but at a decreasing rate. So, Keynes assumed this stage because a rational producer

does production of goods in this stage as there is increase in total production without any fall in

marginal production.

6)CLOSED ECONOMY-In order to simplify his theory, he did not want any foreign interference

in the form of exports, imports, and foreign investments in a national economy. Therefore, he

considered an economy to be a closed economy (Practice, n.d.).

Now there is Keynes theory of involuntary unemployment that states that wage
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fixability is the main cause of involuntary unemployment. It means that a free enterprise working

in a capitalist form of economy fails to achieve full employment level because of wage rigidity.

The other reason for involuntary unemployment is liquidity trap i.e., a situation where interest

rate on investment is low but savings rates are high. In this situation, consumers withdraw from

investing in any bonds or shares of a company and keep most part of their fund as savings.

CRITICISM OF KEYNES THEORY-

Keynesian theory failed to explain the problems caused by stagnation and inflation. Economic

experience of 1970s show that there is a chance of existence of inflation if there is

unemployment. This is called as stagflation. Also, the together occurrence of inflation and

unemployment in an economy becomes one of drawback of the Keynesian theory.

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References

Keynes , J.M. (1930). The general theory of employment, interest and money.

Practice, (n.d.). In the Editors of Encyclopedia Britannica. Retrieved

from https://www.britannica.com/science/income-and-employment-theory

Practice, (n.d.).Deepali Pal. Retrieved from www.economicdiscussion.net/keynesian-

economics/keynesian-theory-of-income-and-employment-2/20753