(When national income moves up or down we speak of a state of disequilibrium). Decisions to save and invest are constantly being made by different groups of people at different times and for different reasons. Thus, APC should exceed MPC. Since the effect of any change is magnified, it is possible to achieve large results from relatively small beginnings. Investment expenditure is of much impor­tance to a modern economy. Keynes argued that monetary policy was neither the best way to stabilize the economy nor help the unemployed. We have also noted that when planned expen­diture is equal to total output, national income is in equilibrium. Of this output, Rs. This means that there will be an increase in the employment of resources, which will, in turn, enlarge incomes. Keynes’ theory of employment is a demand-deficient theory. In a market economy, buyers, through their spending decisions, choose goods and services that are produced by sellers. Keynes "The General Theory of employment, Interest and Money" published in 1936. When we adopt the income-expenditure approa­ch we determine the equilibrium level of national in­come by the intersection of the 45° line and the ag­gregate expenditure line. It is quite obvious that if (3) holds, (6) must also be true. However, in the simple. The money which entrepreneurs receive is paid in the form of rent, wages, interest and profit. 76, respectively. Yet we stated earlier that as income increases, MPC tends to fall. Thus, at any level of income, planned investment is the expenditure line and the consumption line. In … As savings are not passed on through the purchase of goods and services they act as leakages from the circular flow. sets or simple pocket calculators due to the emer­gence of more useful calculating devices such as mini-computers). Two Theories of Employment The General Theory is not primarily a theory of the determination of the level and distribution of income, and it is certainly not a theory of growth through the accumulation of wealth or the advance of technology. In the case of investment goods we see that business firms are both buyers and sellers. It should be required reading for anyone seriously interested in our present economic situation. Keynesian economics developed during and after the Great Depression from the ideas presented by Keynes in his 1936 book, The General Theory of Employment, Interest and Money. A fall in the rate of interest to r1, (say, 15%), increases the amount of profit investment to OI1. THE GENERAL THEORY 2. 800 crore and save Rs. Thus, the slope of the consumption schedule gives us the MPC. This point may be illustrated in the following manner. If their view of future prospects is pessimistic they will be less willing to spend more on investment. Alternatively, we can say (following Keynes) that the equilibrium level of income is reached when planned saving is equal to planned investment. This indicates that planned investment exceeds planned saving. Thus the entire income received by the household sector leaks out of the cir­cular flow; none of it is passed on to firms through spending on consumption goods. With a twelve­month multiplier of 2, this change would bring a Rs. Graphically this is shown by the intersection between the aggregate ex­penditure line and the 45° line. There are merely two sectors that is, consumers ( C ) and firms ( I ). If they reduce the volume of production, stocks will gradually get exhausted. We may now consider the second approach, viz., the leakages-injections approach. Investment expenditure is the second com­ponent of aggregate effective demand. This is known as saving-investment equilibrium,see Table 34.3 below. 64 and Rs. If, for instance, people suddenly start saving more, their spending on consumption goods would fall. Equilibrium income is Rs. In each of these examples actual saving has been equal to actual investment. Let us assume that business firms are producing an output of Rs. It is also possible for firms to plan to reduce their investment expenditure at the same time that households plan to increase their saving. MEC is the yield expected from a new unit of capital. The Keynesian Theory Keynes's theory of the determination of equilibrium real GDP, employment, and prices focuses on the relationship between aggregate income and expenditure. Government persuade on the economy is nil. In other words, if the income-expenditure equilibrium condition is fulfill­ed, the leakages-injections condition will be automat­ically fulfilled. Alternatively, Keynes said that, as income rises, the MPS falls. Hence saving is called a leakage from the circular flow of income. In fact, the level of employment in a country largely depends on the volume of investment. Business investment refers to expenditure on capital goods such as plant, equipment and machinery (fixed capital) as also stocks (working capital), i.e., physical or real investment. So national output or national in­come will be held constant at this level. His pioneering work "The General Theory of Employment, Interest and Money" published in 1936, provided a completely new approach to the modern study of macroeconomics.It served as a guide for both macroeconomic theory and macroeconomic policy making during the Great Depression and the period … Since the saving line in Fig. 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). It is not too much to expect that every-thing will continue in future as at present. 460. 52, Rs. The additional output will then permit business firms to sell more without a further reduction of stocks. We know that, out of total income, a part is consumed and another part is saved, i.e., Y = C + S. Thus, if we know APC or MPC, then we can determine APS and MPS in the following way: Thus, APC and APS are complementary concepts. Therefore, according to Keynes, level of employment is dependent on national income and output. Hence, investment provides additional income into the flow and this causes the flow to get larger. 300 crores on investment goods but they also have an unplanned (undesired) exhaustion of stocks. Thus, it is useful to study both. So there is no necessary reason why house­holds should decide to save exactly the same amount as firms decide to invest. This, in its turn, would raise the volume of sav­ing. 1. 5,000 per month. 50, if lent in the market. Most of the modern economists agree with the concept of Keynes. In this case C0 = R/e, so that, if the machine costs Rs. Keynes Theory of Income and Employment Essay The term ‘classical economists’ was firstly used by Karl Marx to describe economic thought of Ricardo and his predecessors including Adam Smith. Thus, actual (ex-post) sav­ings are equal to actual (ex-post) investment. The owners and suppliers of the fac­tors are largely the households. Assuming that planned investment is autonomous and that all household plans are realised, an equilibrium level of income can be calculated. In economics, saving is treated as residue. The General Theory of Employment, Interest, and Money. It is the philosophy of Keynes which ought to catch the attention of political theory. This will cause national income to fall because withdrawals ex­ceed injections. In economics, the term investment relates specifically to physical investment. In Keynes’ theory, the multiplier (m) investment is the number by which the change in interest has to be multiplied to find out the resulting change in national income (GNP). Question 27. Thus, saving causes the flow of income to become smaller. THE PROPENSITY TO CONSUME 119 3.1 Average and Marginal 120 3.2 Consumption and Employment 124 3.3 Income, Effective Demand and the Multiplier 125 There is excess demand of the amount LM. The same condition will be obtained if we use the second approach, viz., the saving-investment ap­proach. Income provides employment. The equilibrium level of income is given by the point of intersection of the saving and investment schedules. So it logically follows that national income reaches its equi­librium level where the saving and investment lines intersect each other. So the investment demand function can be written as: On the basis of the two factors affecting investment (i.e., MEC and the rate of interest) we can draw the MEC schedules in Fig. An alternative to the Keynesian income-expenditure theory is the saving investment approach to income theory. Planned and Actual Expenditure: It was Keynes who first discovered the relation between planned and actual figures. His theory of employment is widely accepted by modern economists. The multiplier ignores all external economic transactions that could be significant for a country with foreign sector. Keynesian economics is a theory of total spending in the economy (called aggregate demand) and its effects on output and inflation. Investment expenditure is normally defined as consisting only of private sector investment spending. Therefore effective demand equals national income. 1. In other words, the reciprocal of MPS gives us the numerical value of the multiplier. As business firms reduce the volume of production, national income will fall. However, this is not a general result in the sense that it does not always hold. #YOUCANLEARNECONOMICS It is clear that investment will be profitable up to the point where MEC is equal to the rate of interest (which measures the cost of capital). Firstly there is the possibility that households and business firms will not be able to spend Rs. The ‘multiplier effect’ denotes the phenomenon whereby a small change (increase or decrease) in autonomous spending (such as investment) brings about a more than proportionate change in national income (output). Investment expenditure is a component of aggregate demand and an addition to the circular flow of income. They are just two alterna­tive ways of stating the same (or equilibrium) level of national income implied by the Keynesian model. vi The Economics of Keynes: A New Guide to The General Theory 3. Incomes are generated by production and the economic system is said to be in equilibrium when all the incomes earned are returned to the income flow through spending. Saving is that part of income which is not consumed and, therefore, not passed on in the income flow. Income provides employment. Let us now determine MPS from MPC. Thus, investment increases the flow of income and is therefore rightly called an injection. The economy is said to in equilibrium. Planned investment figures for 8%, 6% and 4% rates of interest are Rs. In Fig. We may now consider each of these extreme possibilities in greater detail. Assumptions of keynes: Keynes made the assumption to describe income determination in a simple manner a follows: 1. 800, i.e., Rs. Therefore, the level of income will not reach OX. The classical economists took full employment for granted, believed in the automatic adjustment of the economy, and, therefore, felt no need to present a proper theory of employment. (d) ASF is given in the Short period, and ADF is the significant factor on Keynes's theory. Thus, it is a short-run theory and provide solution to short-run employment problem. 34.1 the aggre­gate expenditure function is E. It is the sum-total of C and I. 9,000 crore is spent on consumer goods and services, MPC = 9/10 or 0.9. The income-expenditure approach may now be illustrated diagrammatically. The Basic Concept of Leakages and Injections: It is to be noted, at the outset, that there are both injections into and leakages from the circular flow of income. 18.3, we have drawn a linear saving function whose equation is: In this equation -a indicates negative saving and (1 – b) indicates MPS. If households’ plan to spend Rs. On the other hand, optimism among entrepre­neurs can make them more ready to undertake new investment projects. 40 4- 0.20F. 700. the equilibrium level of income. At this level of income autonomous planned investment is 50, thereby bringing total expenditure (con­sumption + investment) equal to the level of output (or income). With planned saving and investment being equal, the economy is in a state of equilibrium—there are no forces at work changing the level of output or income. The concept of consumption function plays an important role in Keynes’ theory of income and employment. These two functions are known as the building blocks of the theory of income determina­tion (as presented by Keynes). In the Keynesian theory, employment depends upon effective demand. Additional spending will have to be generated by government directly or by stimulating consumer spending or business investment. Planned sav­ing is the difference between income and planned con­sumption. Since households wish to buy less than this, firms will be forced to hold stocks. If, for example, investment increases by Rs. It is that part of society’s current income which is not spent on consumption goods. So they will increase their production to maintain their level of stocks. Being unable to sell anything they will gradually reduce their out­put of consumption goods to zero. STEP 2: Reading The Keynes Theory Of Income And Employment Harvard Case Study: To have a complete understanding of the case, one should focus on case reading. 200 crore is only half that amount when the twelve-month multiplier is 2. This cutback in turn leads to a decrease in resource owners’ incomes. An increase in investment will create income for those who produce the capital goods. Since the S line intersects the I line at this point, national income Ye is in­deed the equilibrium level of income. But to be able to sell more, they must produce more. In Keynes’ terminology, the value of the marginal propensity to consume (MPC) is less than one. The mechanism is in the change in national income that occurs when desired saving is not equal to desired investment. This website includes study notes, research papers, essays, articles and other allied information submitted by visitors like YOU. Keynes has strongly criticised the classical theory in his book. 100 crore worth of unsold goods will be added to stocks. Keynesian economics is called the Keynesian revolution. Keynes in his eminent work “General Theory of Employment, Interest and Money” not only criticised the classical Say’s law but also propounded a new theory of income and employment. We see that the equilibrium level of income is OYe. To construct Keynesian macroeconomic models, it is necessary to have a clear under­standing of the consumption function. The consequent pressure of excess demand will cause prices to rise, production to expand, and the demand for factors of production to increase. Thus it is quite obvious that national income is in equilibrium when planned saving equals planned investment. C0 = R1/(1 + e) + R2/(1 + e)2 + … + Rn/(1 + e)n + K/(1 + e)n. Therefore, if Q, K and R’s are known, e can be calculated. The equilibrium level of employment and income is not necessarily the full employment income level as believed by classical economists. According to Keynes, the productive capacity of the economy sometimes behaves erratically, affecting production, employment, and inflation. Keynes Theory of Income and Employment; The theory has reference in the short run since the stock of capital, technique of production efficiency of labor, size of population etc are assumed to remain constant in the short run. 4 crore + 0.7 (Y); and for any given value of Y, we can calculate the value of C. In Fig. In a different language, an injection is an income receipt that did not arise from household spending while a leakage is that portion of an income receipt which does not lead to further spending (or responding). Keynes pointed out that equilibrium national in­come is not necessarily the full employment level of in­come. The relationship between an autonomous change in expenditure (in this case, invest­ment) and the resulting change in income is known as the ‘investment multiplier’ (or simply multiplier). Let ΔY denote the change (Δ) in the flow of income (Y), I stand for the initial increase in injections and b for the proportion of extra income spent on consumption (the marginal propensity to consume). In a closed economy (i.e., one having no trading relation with the rest of the world) with no government sector. Moreover, since MPC + MPS = 1, the multiplier can be found by using following formula: where s is the MPS. Anything that leads to a fall in national income through the multiplier is to be consi­dered as a leakage. If demand is so strong as to absorb the full employment GNP of the economy, the economy’s actual output will be equal to its potential, i.e., maximum capacity output. But, as income increases, saving increases, so saving curve must be a rising one. The modern theory of income determination was presented in 1936 by J. M. Keynes, the great English economist. But this is not desirable for obvi­ous reasons. 100 crore, thereby bringing investment down to Rs. The ideas presented at that time are applicable to the present income disparity seen today. Thus, in this example, the multiplier (∆Y/∆I) is 5. If firms continue to produce a total output of Rs. 100 crore worth of goods from their stocks. But when the two are not equal, certain forces in the economy will be at work that cause national income to change in the desired direction. CRITICISM OF KEYNESIAN THEORY 3. A few numerical examples will help to show why saving and investment must be equal. Nevertheless he repudiated the doctrine of laissez-faire. Basically, expansions and contractions in economic activity, or changes in real output, are caused by changes in total, or aggregate, spending. Here s is the MPS. Output creates income. KEYNESIAN THEORY OF EMPLOYMENT J.M. The result is that the Rs. It is an injection into the circular flow of national income. Keynes ignores long-run problem: Keynes assumes that ASF is given. It is worked out by dividing total consumption expenditure (C) by total income (Y) – APC = C/Y. However, from the output side, income received by people is divided be­tween consumption and saving. Since employment depends on production and production responds to spending, the level of em­ployment in a market economy depends on the level of planned spending in the economy. 3,000 crore, APS = 3/10 or 0.3. When firms undertake investment, capital goods are being produced. 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. Keynes’ theory of employment is called the effective demand theory of employment. If we let ‘m’ stand for the multiplier we can write. 34.2—also give the same result. If the market rate of interest is 5%, the Rs. Suppose planned saving is S = – Rs. Keynes used his income‐expenditure model to argue that the economy's equilibrium level of output or real GDP may not corresPond to the natural level of real GDP. 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. At the zero level of income, APC is infinite. The distance EY represents output because E lies on the 45° line. 300 crores minus the reduction in stocks. 2,400 crores in Table 34.1. This is the maximum output the economy is capable of producing by utilizing all its existing resources of land, labour power, capital and organi­zation. The amount spent on consumer goods must equal the sale of consumer goods. 18.1 and 18.4. 18.3. They regarded unemployment as a temporary phenomenon and assumed that there is always a tendency towards full employment. This shows that planned expenditure is less than income. Likewise, aggregate planned expenditure is the sum total of planned consumption and planned investment expenditure. In Keynes’ model we have the following three equations: Here b is the MPC and investment is autonomous. Keynes' approach was a stark contrast to the aggregate supply -focused classical economics that preceded his … If we look at different income groups, we observe that as income rises, the average propensity to consume (APC) falls, or, what comes to the same thing, the average propensity to save (APS) rises. 50 + 0.80Yd and intended investment is Rs. National income reaches equilibrium when S = 1. Likewise since investment is an injection it is marked with a plus sign. 80; and Yd = Y since there is no government sector, (a) Derive an equation for the saving function, (b) Calculate equilibrium value of income by equating desired saving and desired in­vestment. 1800 crores, one of the following two things must happen: either (1) production plans will be fulfilled and expenditure plans unfulfilled or (2) expenditure plans will be fulfilled and production plans will be unfulfilled. So it is necessary to refer to the relation between output and planned expenditure on one hand and actual expenditure on the other hand. But each has different insights. Since consumption and saving are the two sides of the same coin, the determinants of consumption are also the determinants of saving. 800 crore worth of goods. 1. Assumptions of keynes: Keynes made the assumption to describe income determination in a simple manner a follows: 1. We know that s = 1 — b (what is saved out of every rupee of income is the portion of income that is not spent on consumption). Employment depends on aggregate demand. 4 crore and the MPC is 0.7, then the consumption function will be: C = Rs. Following Keynes we use the 45°-line as a guideline. The firms’ plans are the same as they were in Example 1. So two points are to be noted in this context: (1) Equilibrium in­come may lie below the potential income and. Thus, for example, the distance OYe represents is equal to EYe. The income-expenditure approach is illustrated in Table 34.1. As the rate of interest falls from 10% to 8%, the volume of investment rises from Rs. (b) Substituting, we have Y = (Rs. Why do changes in spending cause the level of economic activity to change? Effective demand results in output. In the second case, the stocks of finished goods accumulated in the past will get exhausted. sets due to the added attraction of colour T.V. However, in this example, households intend to spend Rs. Keynesian Theory of Income Determination . 18.2, the marginal propensity to con­sume is constant. When income is 500 the consumption spending is 450 and saving is 50. Beyond this point, saving becomes positive and rises as income rises. However, stocks will get exhausted sooner or later. To the extent households save they reduce their expenditure on consumption goods. Moreover, the growth and prosperity of a nation largely depends on the rate of investment (or capital formation). In all non-socialist countries the major portion of saving originates from the household sector. This amplified effect of investment on income is called the ‘multiplier’ doctrine. The average propensity to consume (APC): It is the proportion of income which is spent on consumption. 1,000 crore because total output is, by definition, equal to total income. It can be below or above the level of full employment. All other terms have their usual meaning and significance. We now explain the reason(s). It is also assumed that the economy is closed. Privacy Policy3. Thus, if the full employment level of income is above equilibrium level, the result is un­employment, while, if the full employment level is below the equilibrium level, the result is inflation. 40 to Rs. We assume that firms plan an output of Rs. Behaviour of national income is the only way to stabilize and boost employment and is. With more goods and that all saving is 50 starts somewhere from the household sector spend their money on of. Capital goods are being produced ; and since expec­tations are largely carried by. Based on the other hand ( in reality, however, for example, investment the. S Law of Markets act of investment lies in the change in invest­ment leads a. ) Table 34.1 money ' ( 1936 ) won him everlasting fame in economics, the of! The contrary, if saving and investment goods is likely to shift frequently and. 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