MODULE II

THEORY OF INCOME AND EMPLOYMENT

Full employment
Absence of involuntary unemployment (willing to
work at prevailing wage rate but fail to find work)
Compatible with frictional & voluntary
unemployment

CLASSICAL THEORY OF
INCOME & EMPLOYMENT

BASIC TENET
Flexibility of
wages & prices- built in
arrangement in economy that makes it function
at full employment level
Lapse from full emp will not last long

ASSUMPTIONS
Says law of markets: supply creates its own
demand (by the virtue of factor price payments,
production & supply create equivalent demandnever overproduction or underproduction)
PTC = 1
Laissez faire
Closed economy
Wages are not sticky

SAYS LAW OF MARKETS: WORKING

PRODUCTION
OF GOODS
WORTH Rs 5 crore

SUPPLY OF GOODS
WORTH
Rs 5 crore

CREATION OF INCOME
BY WAY OF WAGES, RENT,
INTEREST TO THE TUNE
OF Rs 5 crore

INCOME OF Rs 5 CRORE
BECOMES THE SOURCE
OF DEMAND FOR GOODS
WORTH Rs 5 crore

UNREALISTIC ASSUMPTIONS OF SAYS

LAW
SO

INTRODUCTION OF SAVINGS & CLASSICAL

ADJUSTMENT MECHANISM
S=YC
Y = Rs 100 crore
Spending: 90% of Y
Saving = 10 crore. LEADS TO over production,
decline in profits, production, employment &
income level
SOLUTION
Savings = investment (assumption of classical
economists)

INTRODUCTION OF SAVINGS & CLASSICAL

ADJUSTMENT MECHANISM
Flexibility in
interest rate is the
mechanism which
maintains equality
b/w S & I

RATE
OF
INTEREST

SAVING & INVT

FAILURE OF CLASSICAL THEORY

Great depression OF 1930s

At least 15 million unemployed workers in U.S.
Similar position in European countries
They all clamoured for jobs & were willing to accept
any wage rate
Failure of Classical theory
WAGES WERE NOT FLEXIBLE (ROLE OF TRADE
UNIONS & GOVT INTERVENTION)

SHORTCOMINGS

Ruled out possibility of involuntary unemp

Flexibility of wages & prices
S=I
PTC = 1

KEYNESIAN THEORY OF INCOME &

EMPLOYMENT

BASIC TENET
Total emp depends on total demand
Unemp results from deficiency of demand
As employment increase, income increase

EMPLOYMENT
EFFECTIVE DEMAND

ARREGATE
DEMAND
(AD)

AGGREGATE
SUPPLY (AS)

INVESTMENT (I)

CONSUMPTION (C)

PROPENSITY
TO CONSUME

SIZE OF
INCOME

RATE
OF INTEREST

MEC

AGGREGATE DEMAND (AD)

Y

Total demand for all

goods & services in
an economy

AD
AGGREGATE
DEMAND
PROCEEDS

X
O

LEVEL OF EMPLOYMENT

The slope of AD curve diminishes because people tend to

spend a smaller Proportion of their income as their income
rises in response to Output & employment. So AD rises at
a diminishing rate

AGGREGATE SUPPLY (AS)

AS
AGGREGATE
SUPPLY
PRICE

Total volume
of all goods &
services
produced in
an economy

Nf
LEVEL OF EMPLOYMENT

AS curve is upwards sloping an increase in employment level

results in more O/P, so firms expect higher proceeds.

EQUILIBRIUM EMPLOYMENT
Y

AS

Point of effective
demand
AD
&
AS

N Nf
EMPLOYMENT

AD

Right of ON: AD < AS

producers will not be wiling to employ workers more than ON
& the level of employment will show a tendency to fall

Left of ON: AD > AS

expansion of employment
CONCLUSION:

Keynes asserted that there is no reason to believe that

equilibrium will be characterised by full employment.
There can very well be under employment at the point
of equilibrium

CONSUMPTION FUNCTION

Consumption expenditure
depend upon:
their disposable Y
their past savings
rate of interest

of

individuals

CONSUMPTION FUNCTION
C = f (Y)
Where C: Consumption spending
Y: income
C = a + bY
Where C : consumption
a : autonomous consumption
b : MPC
Y : income

Graphical representation
Plot the graph for C = 200 + 0.75Y

PHYCHOLOGICAL LAW OF CONSUMPTION

Men are disposed, as a rule and on an average, to increase
their consumption as their Y increases, but not as much as
the increase in their Y
The increment in Income is divided between consumption (C)
& savings (S)

FEW CONCEPTS.
APC = C / Y

MPC = C / Y
APS = S / Y
MPS = S / Y

APC + APS = 1
MPC + MPS = 1

CONSUMPTION FUNCTION SCHEDULE

INCOME

CONS SAVING APC

30

-30

100

105

-5

200

180

20

.9

300

255

45

.85

400

330

70

APS MPC MPS

.75

.25

.01

.75

.25

.15

.75

.25

.825 .175

.75

.25

1.05 - .05

DETERMINANTS OF PTC

Income
Consumer credit
Availability of goods
Future reserve against unforeseen contingencies
Price
Wealth

SAVING FUNCTION
S =f (Y)
S=YC
= Y (a + bY)
= -a + (1 b) Y
Here

1 b : MPS
-a : dissavings (equal to consumption)

SAVING FUNCTION

Y
CONSUMPTION

INCOME

O
S

SAVING

INCOME

NATIONAL INCOME DETERMINATION

& MULTIPLIER

RELEVANCE FOR BUSINESS MANAGER

To understand business environment, it is imp to
find out what determines NY & economic growth
Enables manager to understand behavior & impact
of macro economic variables on business
environment & to make a forecast

EQUILIBRIUM LEVEL OF INCOME- TWO

SECTOR MODEL
AD- AS Approach
S- I Approach