UNIT- 02

Classical
Economics

Outline of This Unit

1. J. B. Say's Law of Market Output and Employment
2. Criticisms of Say's Law of 5. Keynes Theory of Income
Market Determination
3. Wage Cut and Wage Flexibility 6. Keynes Theory of Employment
Principle of Prof. Pigou Objective Study - M.C.Q.
4. Classical Theory of Income Self Study

1. J. B. Say's Law of Market

I. Introduction : Accordingto classicaleconomists full employment is a
permanentphenomena and employment or excess production is a short term or
temporaryphenomena. Classical economists believe in the free market economy with
full flexibilityin the internal structure. The entire production is on the basis of the
demand of the economy. Thus there is no over or under production. J. B. Say took the
help of classical model to explain the concept of full employment. He narrated the
abovestated facts in his book. "Treatise on political Economy". Here he emphasis that
"Supplycreates its own demand."
2. Assumptions of the Theory :
(l) Full Employment : There is full employment in the economy and all the
factors of production are fully employed.
(2) Medium of Exchange : Money acts only as a medium of exchange and
measurementof value.
(3) Interest rate influcnccs the capital market : Interest rate is a flexible
variablein the capital market, which influences the demand and supply factor.
53
54 Kumar • Macro Economics
the
(4) The production is influencedby market demand : It is argued that
market demand influences the aggregateproduction in the economy
productivity: The wages are determined
(5) Wages will equate to the marginal
of the factors of production. The marginal
on the basis of marginalproductivity of product.
value
productivity multiplied by price gives us the marginal
: The J. B. Say's law of market was initially
3. Explanation of J.B. Say's Law
stated that the above law is still valid
developedfor the barter economy. Howeverit is
at the macro level.
in the money economy with the saving
Thus the argument is presented for both the structures.
Barter Economy: In the barter economy goods and services are inter
in
exchanged.The producer do not produce everything but what he produces gives
exchangeto the other party on the basis of his demand. Farmer gets shoes from the
cobbler in exchange of wheat he produces. He follows two techniques :
(l) Certain portion of the output is kept for self consumption.
(2) Residual is sold/exchanged. As a farmer he produces only grains and satisfy
all his requirements through exchange. The global specialization is maintained in this
regard.Farmer produces food grains, cobbler produces shoes and weaver produces
cloth etc. The production increase till the full employment is not achieved.
Disequilibrium: The production in the economy is limited to the specific
market and that is why the over production or under production is not possible.If
production of food grain is more than cloth then the food grain will remain unsold,
which reduces the exchange rate of it. This will motivate the producer to reduce the
productionin the subsequent year. The exchange rate will once again reach to the
parity level. In the similar manner if production of cloth is low then the exchange rate
willrise in favour of clothes. This will motivate the producers to produce more cloth.
This will again reduce the exchange rate. Thus the production of each commodity wül
be a parity with their demand. The disequilibrium be only for the short period. In
the long run the production supply and demand be in parity.
Monetary Economy : In the economy with the existence of money as a
mediumof exchangethe transactionsare done in a similar manner. The self-
consumptionis kept in the similar manner but the exchange is done through money
rather than baiter system. The producer produces the surplus commodities and this is
exchangedin the market for money. The necessary requirement is satisfied through
money.Thus the equilibrium between demand and supply is automatically
maintained
Saving economy : In any economy, the income is not always equal to the
expenditure.mien the demand is not shown in the market it leads to generate surplus
productionin the economy.Classicalargues that there will not be any surplus
 Economics
Classical
2•
55
auction or unemployment in the
pisautomaticallyinvested and economy due to the fact
thus there is no that what ever is saved
production. It is stated that investment problem of unemployment or excess
is also one type of
usedfor consumption expenditure or for investment. expenditure and thus it is
Expenditure : Thus Say's law
of market is valid in
economyand also in the saving economy. the barter economy, money
The economy do not faces any problems
excessproduction or unemployment. like
The excess production or unemployment
arisein the short time period but it is do
automatically adjusted through changes in the
interestrates. The savings and investment
interestrates. In this way the equality imbalances are equated by changes in the
between saving and investment is automatically
maintained.
3. conclusions : Implications : The
above discussions reveal following
conclusions.
(1) No excess production : As
supply creates its own demand there is no case
forexcessproduction or under production. The
imbalances are automatically adjusted
throughchanges in prices. The interference of the
government is not required.
(2) Full employment is a permanent
phenomenon : It is argued here that
unemployment is short-term phenomena but full employment is a long-term
phenomenon.
(3) Money as a medium of exchange : In the Says law
of market money plays
onlyprimaryfunction as a medium of exchange and measurement of
value.
(4) Unemployment is not possible : Unemploymentis a special case, which
occursdue to the over production in the economy.Such situation is not seen in
the
economy;the full employment is automatically maintained.
(5) Economic stability: The supply creates its own demand and that is why the
productionin the economy is directly associated with the demand of the economy.
(6) Flexibility in the markets : It is estimated that wages, prices and interest
ratesare flexible.This leads to equilibrium in the labour, goods and capital market.
Herethe role of government is very less.

2. Criticisms of Say's Law of Market

Keynes criticised Say's law and proved that it was quite invalid.
(l) Deficiency of demand : According to Prof. Keynes, it is not possible that all
thetimethe economy gets full demand. It is likelythat proper demand is not generated
andwhichleads to unemployment. This may be due to the inactive savings in the
economythat the demand is not materialised.
(2) Money as a store of value : Classicalwriters have considered that money
playsa role only as a medium of exchange and not as a store of value or standard for
 56
Kumar • Macro
deterred payment. The amount of cash balance reduces the effective demand in
economy.
(3) Investment Influenced by other factors : There are many factors.
influence investment decision. Interest rate is one of the variable. Investment is
influenced by profit. Such factors are ignored in the present theory.
(4) Role of Government : The Government can play a vital role in the econorm
When the economy faces unemployment or depression the interference of the
government becomes necessary.
(5) Saving : Investment influenced by income, saving and investment do
influenced only by the rate of interest but it is also influenced by the changes in
level of income when becomes high. saving is high even when the interest rate is
(6) Full employment - unrealistic : The assumption of full employment is fairly
unrealistic in nature. If there is unemployment in the economy, the Say's law of market
becomes unimportant.
(7) Very long-term : Says law of market explains the market situations
a very long run in terms of over production or under production. It also explains
the problem is solved. The important part is the short run problems and their solutioro
which is not discussed in the Says'slaw of market.
(8) Equality of saving an investment : The equality of saving and investment
achieved only at the full employment level is a wrong notion. Equality is also achieved
at the unemploymentlevel.
(9) Trade cycles : The discussions of the trade cycles are not explained by tir
Says law.They believe that such cycles do not arise. The change in the economi
activities is not explained with this theory.
(10) Unrealistic in the barter system : In the barter system where the theory
should be more realistic there also it is found to be unreal. The unsold production rnay
lead to unemployment and other problems.
(JI) Unemployment: It is also argued that the full employmentis not
permanent event. In most of the time the economy faces unemployment which is not
considered here.
Harison says that it fails to explain the depression or peak situation of
economy. Keynesconcept of inflationary and deflationary gap is also not fully valid
3. Wage Cut and Wage Flexibility Principle of Pod. Pigou
i. Introdudion : Accordingto classical writers the equilibrium is possible J
the fun employment level. J/ there is unemployment in the economy. then factors
production wdj accept the wage cut policy and the labour will be cheaper in
long-run the equilibrium be possible at Jowwage rate. In the reverse case the w.
rate will go up. According to classical
writers full employment is a permanent
phenomenon and unetnploytncnt is a temporary
to classical
writers in full employnu•nt situation voluntaryphenomena. According
or fluctuating unemployment is
possible.Classicalwriter emphasis on the
increase in the employmentopportunity.
Thisis possible by increase in the production
technique,increase in the opportunity
of labourer,etc. are the long-run factors to influence the employment opportunity. In
the short run the only alternative is to increase
employment by the wage cut policy. Jf
full flexibilityof the factors of production is accepted then, the employment is
automatic.The equilibrium is also established at the full employment level.
2. Meaning of Unemployment : Accordingto classicalwriters voluntary or
compulsoryunemployment don't last for the long period. The unemployment is a
short- term factor and that is why not much to be worried about it. If the
unemploymentis due to the technologicalfactors then it will be automatically
rernoved.
Prof. Pigou is of the opinion that in the developed countries unemployment is
possibledue to development of trade union and minimum wage act policies. If the
wagesof the workers are more then their marginalvalue productivityis (MPPLx P).
In short he is of the opinion that unemploymentis due to high and constant
(rigid)wage rates. According to Pigou, in depression, when prices of the commodities
falls,rent of land and interest of capital remains unchanged. If interest and rent are
reduced then the owner of that factor may prefer to withdraw that factor of production
fromthe production process then the labourer willnot be in a position to produce and
that way he has to face unemployment. In the depression also it is not possible to
reduce the profit margin because if profit is reduced then the producer is not prepared
to continue the production process. The labourer willremain unemployed in this case.
It is thus advisable to accept wage cut policy.If the workers do not accept the wage cut
policythe unernployment arises. In short, in depression,when marginal productivity
of the workers is low, if workers ask for the wage rise in an artificial way then the
demandfor labour falls to the supply of labour and it leads to unemployment. If wage
cut policyis accepted then it is possible to absorb additional employment.
3. Pigou's strategy to solve Unemployment : Pigou emphasis that in the
depressionthe workers must be prepared to accept low wages.The labour union
activitiesand minimum wage act policy should be controlled. If the workers are
preparedto accept low wages then it will lead to followingadvantages to them :
(I) Labour will be more cheaper to capital and other factors.
(2) If workers accepts the wage cut policy then, production cost diminishes
and employment increases.
 (3) Reduction in wages reduces the prices and this will reduce the demand
cash in hand, less funds will be required and this increases the demand.
(4) The workers, standard of living will not go
down because the wages cut
be accompanied by the price cut and this increases the standard of li
of the workers. ving
(5) When the profit margin is maintained by the workers the producer don't
wish to cut of their production plans. The employment will remain as it
(6) The reduction in wages reduces the prices and this in turn increasethe
purchasing power of people. This increases the effective demand of the small savers.
This motivates the investors to go for additional investment, which will in turn
increases the employment. This is defined as Pigou effect. The wage reduction and a
price reduction leads to increase in cash balances and this increases the purchasing
power and the demand for the product in the economy.Increase in employment
opportunity gives additional benefits here.
If wage cut policy is flexible then unemployment is removed automatically.But
if the workers refuses to accept the wage cut policy and accepts the policy
recommendations of trade unions then in that case if the government also supply the
workers and refuses the wage cut. Policy, then entrepreneur's profit reduces and they
prefer to leave the workers to maintain the level of profit.
This concluded that "The trade union is responsiblefor the unemployment
during the depression years and not the entrepreneurs."
4. Criticism by Keynes :
(l) Reduction in effective demand : According to Keynes the wage cut policy
is successful only in a single industry but in case of all industries the wagecut policy
reduces income of workers. This reduces the effective demand and the employment at
the aggregate level.
(2) Involuntary unemployment is possible : According to classical economists
involuntary unemployment and equilibrium is not possible but according to Keynesit
is possible.
(3) Unrealistic : According to Keynes in the modern time period in the welfare
state it is necessary to pay minimum wages to the workers through minimum wage cut
policy but it nill be opposed by the workers.This may be good economicsbut bad
politics.
(4) Supply of labour demands on money wages not real wages : When Keynes
argues for the employment he states that the labour supply depends on money wages
which faces the problem of money illusion. They are prepared to accept low real wages
but not low money wages. If price increases and money wages remains constant the
real wages reduces. The workers are prepared to accept low wages in this way.Here
even when real wages reduces, labour supply don't fall.
 Classical e
2- 59
(5) Investment will not rise
: According to Prof. Pigou, the
wage cut policies to
increase more workers must accept
employment. But Keynes argues against this. He
meansthat when money wages reduces
prices falls and investmentand employment
reduces.
(6) Money wages don't tuluce
real wages : According to Pigou real wages must
IVduced,but Keynes argues, don't lead to fall in
real wages. When wages falls prices
alsofallsand thus the real Wagesremains unchanged
and thus it carit affect the
employment.
(7) Income distribution ineffective
: Accordingto Keynes the wage cut policy
leadsto redistribution income against the workers.This will reduce the effective
demandof the working class people.
(8) Unjustifiable : The price cut policy is not
justifiable to raise the
employment.In certain sectors the price falls at the early stage while in the other, it is
late.If only workers in the initial sectors accepts the wage cut policy it is not proper
e.g..If price reduces in the agricultural sector and remains steady in industry then the
agriculturalworkers purchase less from the market and thus the inequities increases.
(9) Productivity reduces : Accordingto Keynes,the wage cut may lead to
reductionin the productivity of the workers. In this case the profitability reduces and
the entire plan fails.
(10)Against the democratic principle : The democratic country can't accept the
principleof wage cut policy. No government would accept this as policy measures, is
not supported by the historical facts.
(l l) Not supported by historical facts : The technique of wage cut policy is not
supported by the historical facts.
(12)Pigou effect neutral ; The Price increasesthe real wages, which in turn
increasethe employment opportunities. Accordingto Prof. Patinkin the fall in price
reducesthe market value of an asset and in order to compensate the above loss, people
mayreduce the consumption and there by the fall in consumption reduces the
employmentopportunity.
(13)Criticism : Accordingto J. B. Say, the economy is always at the fall
employment level. This assumption was not true in 1929depression. People have given
up their faith in the Say's law of the market. At this time the Pigou's theory of wage cut
policywas advocated. They believed that in the depression, the wage cut policy could
leadthe economy at the full employment level. The workers are responsible for
unemployment because they accepts wage cut policy In the free economy where the
interferenceof state is minimum. The unemployment in the short time period in the
shortrun may be removed by the wage cut policy.
(Note: Following points are connected with the new syllabus of this unit, so it is
explained here]
 60

4. Classical Theory of Income Output and Employment

i. introduction : AH0"Iing to the classical economics. labour market.
matket and tnoney nun ket am intportant. Vollowingconditions are considered •
(1) According to classical writers. wage rate is flexible and labour supply
demand changes arx•determined by the wage rate changes. The
employment is automatically achieved
(2) 'Thecapital market equilibrium is established when saving and
are equal.
(3) goods market equilibrium is established by changes in the supply
demand for goods.
goods and labour market are defined as real markets and capital market
thc finanual market. Money is neuttal and that is why the real markets such as labot.
and goods are impoHant. lhus wal are vital factors in the economy.
2. Classical theory of employment output and income : The clan'•a
economists believe that in the short period the supply and demand for
determines the wages and level of employment. Ole full employment is attained.
3. Assumptions : No change is observed in following variables
(l) Technology (2) Capital Stock (3) Population (4) Taste preferences (5)
(6) Full emplovment (7) Prefect competition in labour market.
4. Demand for labour : The demand for labour depends on two factors
(1) Production function (2) Marginal physical productivity of labour.
(a) Production Function : If the amount of capital is constant and if units
labour increases the output increases at diminishing rate. The marginal productivity
dinunashes.
(b) Marginal physical productivity of labour : The marginal physical
productivity of the labour is calculated on the basis of addition to the output produce
of keeping the other factors of production as given. If the productivity declines
marpnal productivity curve shows concave to origin.
The demand for the factors of production depends on two factors.
(l) Marginal revenue from the product.
(2) Marginal cost Ior the additional unit of labour.
The marginal revenue depends upon the marginal productivity and price of tir
coaunodity. The cost of labour depends on the monetary wages.The marginal revemr
should be equal to the marginal cost for the equilibrium in the market.
When the marginal productivity is a declining factor it is necessary to irrreue
the employment by reduction the wage rates. In other cases the product has to face
josses. Tlus policy is possible by keeping prices constant and reducing the mot*'
wages of the workers. This will reduce the real wages of the workers. The real wages
employ•mem are inversely related.
5. of labour : supply of labour and real rates are
related. The worker is innuenced by the fatigue, dissatBfEtion ottwr
Withthe work. This øves hun pain. The workers. choee the woru
 Economics
2 Classical 61
depends on the wage rate. If more
leisure real wages are paid to the worker then they
arepreparedto work more. The worker compares the dissatisfaction with the high real
wagesbeen available to him. Thus real wage rate and supply of labour are positively
dated. If real wage rate increases, supply of labour increases and if real wage rate
reducessupply of labour reduces.
The above stated relationship can
be observed in the graph given below :
The graph represents the labour market
Uncmloyment situation. The wage rate is presented on OYaxis
s and demand/supply of labour on OXaxis. The
supply of labour is positively related to wage rate
c
and demand for labour is negatively related.
b If the supply of labour exceeds the demand
for labour as stated in the graph the wage rate
will fall. The demand is C and supply is B so ON
s D < OS.Thus B is the current wage rate which will
fall to OAand demand and supply of labour will
be equated. The wage rate will fall from 0B to OA
x and the demand and supply will be equated at
Demand/supply of labour 0M. In the long run due to the wage flexibility
the demand for labour equates with the supply
oflabour.The classical economists are of the view that it is not necessary to interfere
in the market structure. The equilibrium will be established in an automatic way.
6. Equilibrium of output/employment : How the employmentand
equilibriumis attained can be explained by the followinggraph.
The OX axis represents employment and OYaxis wage rate OYaxis wage
representsthe output. The labour market equilibrium at P is achieved and on that basis
theproduction relationship is decided. OAis the wage rate and 01 is the output.
Y Production function
Production function
D
s

s
1 D
s IP
I

x x
Demand/supply of Labour Employment
 5. Keynes Theory of Income Determination
J. Introduction (u;rding to Keynes enjpjoyment and income
are cjonejy Production and ctnpJoyment determination
on If demand increat„esit will increue
output Mid and ejnjijoyjnent, On the other hand if aggregate demand redurgs
it affect%the enjployjnent, and output in t}je revert,edirection, According
Keynes, ongutiij)tion depend", up on type of psychological factors, 'Ibe consumption
at the "lower rate than ingojnc, in other word%it at rate, The
conqurjiJ)tion reanc "jong with the rise in "Jbc awrev,ate demand
for can be explained by 47)
ion and inve%tJjjejjtexpenditure, "JTji%
2. Assumption of the Model : [Jollowing
are the the Keynes
incorne deterrjiinatiotijji0dcj
j',cononjy i",at full crjjployrncnt level.
(2) "Ihe tijnc period of the analysis is %hortterm,
(3) No change in the quality of the lactor%of production.
(4) (110%cd economy or ab%cjjceof foreign trade,
in Free market %tructurcin the capitalistic economy.
(6) Economy at under cjnploymcnt jcvcj,
(7) Production technique, taste, preference and population are constant.
Inflation i', only after fuJjemployment is reached,
3. Keynes theory of Income Determination :
(A) Aggregate demand : According to Keynes aggregate demand consists of two
factors. (J) Consurnption expenditure and (2) invettrnent expenditure. The total is
defined as total expenditure,L C + J.
The income line has a positive %lopc,'Jlje expenditure line also shows the
positive slope but it shows high expenditures in the beginning but at the later phase
the additionalexpenditurerises at the Slowerrate to rise in income.
The slow rate of consumption expenditure is due to two reasons (J) The rise in
income reduces the additional consumption due to diminishing propensity to
consume. (2) It al%0depends on level of income and expenditure.The demand for
investment also reduces with the fall in the marginal efficiencyof capital.
(B) Aggregate supply aggregate supply represents the factors or resource
in the economy.The awregate demand represents the expenditures this represents the
income. Jn the Short period, the supply remains stable because factors affecting the
productivityor production are likelyto remain constant.
Keynesconsiders income in two formats (i) How much of income is consumed ?
Jlow much is saved ? If we put this in the equation format we get Y C + S or income
•cconsumption savings.
 Classical Economics 63
2-
Totalsupply price or aggregateincome is presented by OR line this is also
knownas C + I line. It starts from the origin and goes in the upward direction. Supply
priceand aggregate income or output are positively related. In the total expenditure,
rent,wages,interest and profit are related. The expendituresby the entrepreneur
becomesincome of other sections of the society. Income and expenditures are two
sidesof the same coin and that is why it is known as Y E or identity of income and
expenditures.The factors of produqtion are unemployed. Factors, its quality and
productiontechnique etc. are assumed to be constant. The constant cost rule •uso
prevailsin the production structure.
Accordingto Keynes income determination depends on short term total
expendituresof the economy. In the short term, the supply remains constant and that
is whyit plays a vital role in determiningaggregatedemand of the economy. If
aggregatedemand increases, it increases the national income and reduces if demand
decreases.Thus aggregate level of income is determined at the place where aggregate
supplyequates with the aggregate demand. This determines the level of income. The
determinationis possible at unemployment level and also at the full employment level.
Accordingto Keynes,
Aggregate Demand Aggregate Supply
AggregateDemand
Consumption + Investment + expenditure

consumption + saving
1 s
Investment = savings.
4. Explanation with the graph : The graph presented here shows aggregate
demand, income or employment on OXaxis and
consumption, investment and government
expenditureon OYaxis. The slope of the line
Q represents the marginal propensity to consume.
The line represents the consumption
expenditure. C + I shows consumption and
c investment expenditures. The consumption
1
expenditure is increasing function of income. OX
C,
axispresentsincome.This indicates that rise in
450 income increases the consumption but at
x diminishingrate. The initial points are on
O OY
Aggregate income axis, which represents even at zero level of
demand / employment income, the consumption is positive. At point B
64 Kumar • Macro Economics
indicates that
income is equal to the consumption and after the C < Y.This
than
consumption is less than income. After point B, the consumption will be less
income.
The gap between 450line and C line represents the saving.
C + I + G line : The C + I line presents the consumption plus investment
expenditure.The difference between C and C + I line shows investment expenditure.
point P represents the equilibrium point and at that point, the level of income and
employmentis 0M. If 0M is not the full employment income then is necessaryto
increase the government expenditures to get full employment. The government must
interfere in the market and by direct or indirect expenditure, which increases the
aggregatedemand, income and employment.
It is not possibleto increase the consumption expenditure or investment
expenditure in he short time period. Thus the factors affecting the C + I remains
constant in the short period.
The investment depends on two factors (1)marginal efficiency of capital (2)rate
of interest. Marginal efficiency of capital depends on trade cycles like peak and
depression.In the depression,output do not increaseand as a result depressionis
observed.
To come out from this, the best way is to increase the government expenditure.
The increase in government expenditure increases the aggregate demand, income and
employment at the macro economic level.
5. Evaluation : The economies of Keynes is rejected on the following
grounds.
(l) Depression economics : It is argued the economics of Keynes is basically a
depression economics. It is not applicable in todays inflationary economics. Prof.
Harison says that it fails to explain the depression or peak situation of the economy.
Keynesconcept of inflationaryand deflationarygap is also not fullyvalid.
(2) Long-run factors are ignored : The theory fails to explain the long run
factors. It explains only the short-term factors in determining the aggregate macro
economic structure.
(3) Micro economic analysis is ignored : The macro structure fails to interpret
the microeconomic analysis of an economic behaviour. In fact both micro and macro
analysis are required in an economic analysis.
(4) Criticismsof Keynes : The concept of consumption is based on the
absolute levels of income. But Duesenberry has established concept that the
propensity to consume is also influenced by the demonstration effect. Friedman has
given the concept of permanent real income.
 cløssic.aieconomics
65
(6) A'j(jllary effect : prijnary investment influence
effect,
Oitjltij)licc the ultimate income
ancillary effect is not taken
care of iri the present theory.
inducedeffect can't be ignored.
(0) Useful for developed economies
; 'I he theory is useful only' for the
dOelopedeconojjiicn where the unernpJoyynent is only
due to deficiency of demand.
Indevelopingeconojnics it i",01%0due to structural factors
such and scarcity of factors of
In all the
production, theory is not applicable,
6. Keynes Theory of Employment
1. Effective demand The effective
demand curve is determined on the
basisof demand function and supply price. Accordingto Keynes, income and
expendituje arc the two sides of the coin and expenditureof the society can be
by the effective dcjnand.
identified
2. The effective demand consists of following components :
(J) Consumption expenditure, (2) Jnve%tmentexpenditure.
Thesetwo cornponents can be sub divided into followingsub-groups.
Effective emand

Consumption Investment
expenditure expenditure

Income Marginal Marginal Rate of

propensity efficiency interest
to consume of capital

Supply Expected Money Demand

price of income supply for
capital flows money.

(I) Consumption expenditure : The consumption expenditure depends on two

factors.(l) level of income and marginal propensity to consume. Keynesassumes that
thefactorsaffecting the marginal propensity to consume remains constant in the short

(2) Investment expenditure : The investment expenditure is the main factor

determiningthe aggregate demand at macro economic level.The investment depends
Ontwofactors. (I) Marginal efficiency of capital and (2) Rate of interest.
66 Kumar • Macro Econorniq
In the short period, the rate of interest is the main factor that determines the
investment expenditure along with expected income flows. As the interest rate i,
constant, the expected profit margin determines the investment expenditure.
The marginal efficiency of capital depends on two factors (1) Supply price
capital or cost of capital equipment (2) expected rate of profit from the capita
equipment. Accordingto Keynes, the expected rate of profit diminishes in the
capitalistic society. This reduces the profitabilityof investment.The governmem
should take necessary steps to have the capital productivity. Keynes also advocates for
government interferences in the market structure.
(3) Public expenditure, government expenditure : Keynesianeconomists have
given more weightage to government to enhance economic welfare. It is necessaryfor
the government to come forward through public expenditure programmes. It is stated
that the government should provide income through any means by providing them
jobs. This would generate public income. (However Keyneshas not included the public
expenditure as major determinants of effective demand that the capitalistic structure
runs mostly by the private sector.) Thus public sector is relatively less important factor
and that is why it was excluded. In the modern time period the importance of it has
gone up and that is why it is an important factor in the determinationof effective
demand.
(4) Foreign trade : Most of the countries are engaged with the foreign trade
with different countries. These factors also determine the effective demand and
employment. If export value exceeds import value, then the demand for the home
countries increases. This reduces the effective demand and employment. In the reverse
case when imports exceeds exports, the demand for the foreign products increase. This
reduces the effective demand.
In short effective demand = Consumption Investment government
expenditure + expenditure + expenditure
+ exports — imports.
3. Keynes theory of employment : Accordingto Keynes,employment
depends on national income. National income and employment are closely related
According to him, production and employment depends on effective demand. If the
effective demand increases, the output, employment and income also increases. In the
reverse case it will decrease employment, income and output. Consumption increases
at diminishing rate, thus the gap between income and expenditure increases.
rate increases.)The savingmust be investedto give push up to the economy.Thb
saving must be properly used to maintain the level of employment in the economy.The
effective demand depends on C+I.Accordingto Keynes,aggregate demand function
and aggregatesupply function mines the employment.
 ClassicalEconomics
67
4. Assumption of the
model : (Asper
point 5 of the income determination
fljodcl)
5. Employment theory of
Keynes : According to Keynes, total demand
curve(CAI)along with the total supply
curve (C+ICurve 450line.) determines the
effectivedemand. If the equilibrium is
attained
According to Keynes, C can't be increased below the level then it must be uplifted.
because income and expenditure level
remainsconstant. Thus I must be increased.
I investment expenditure depends on rate
ofinterestand marginal efficiency of
capital. The rate of interest is fixed in the short
periodso the rise in investment depends on marginal
marginalefficiency depends on expected profit
efficiency of capital. The
rates. The expected profit depends on
theanticipation of the business activity, if the
anticipation are dull then the investment
isnot motivated. The new businessman prefer
not to start, expand the business
here the interference of the government is
activity,
urgently required, to increase the
effectivedemand. Keynes advocates that people should
be provided jobs on any public
projects.
Explanation : Equilibrium : The equilibrium
is possible at below or above the
full employment level. ADC and ASC are the
demand curves and supply curves. In the short
C+I+G run when there is unemployment in the
economy, the short run supply curve will remain
constant. The demand curve or ADC or C+I line
should be shifted on the upward direction. It is
not possible to shift it on the upward direction
then, government expenditure should be
450
increased to reach the economy at the full
X employment level.
o The graph presented here shows income
Income/ Employment
and employmenton OXaxis.
Whena producer provides to the factors of production he gets income through selling
ofgoodsin the market produced by the labourers. He considers these facts also that
howmuch income he will get from the additional labourer. This is defined as demand
function.
I. Lakh labourer = 2 Cr of income
2. Lakh labourer = 3.5 Cr of income
3. Lakh labourer = 4.5 Cr of income.
The demand function represents consumption and investment expenditure of
theeconomy.According to Keynes theory income is always equal to expenditure. Thus
68 Kumar • Macro Economjq

the C+l increases at slow rate because expenditure increases at the slower rate.
marginal efficiency also decreases and that is way the investment demand increase at
slower rate. Thus total demand curve shows downward slope.
Average supply price : (450line) The average supply price shows production side
of the producer. It represents the cost factor.This includes, rent wages, profit and
interest. Total supply cutwe represents the costs at different levels of employment. It is
necessary that the cost should be minimum and sales income should be maximum.
When employment increases, cost after the factors of production increases. This
increases supply cost. According to Keynes,in the short run the factors of production
are unemployed and at the stage law of fixed cost prevails so that the additional factors
of production are available at the same price, Thus the supply price and employment
due to these reasons the ASPhas 450 slope or positive straight line the real income do
not go up after reaching at full employment level. Only monetary expenditure
increases, and that is why it becomes parallel to OYaxis.
In the above stated figure, 0M represents equilibrium at underemployed
because the demand curve ADP and ASP (450line) touches at point P.At this level the
income equate expenditure. But at this stage the economy has not reached at the
full
employment level. In order to have full employment it is necessary to reach at ON level
of income.
If the economy is static, then it is necessary to generate additional
employment
opportunities through effective demand. It is not possible to increase
the consumption
expenditure because the propensity to consume do not
change in the short run. The
investment expenditure can be.raised through government
expenditure. It is necessary
to increase the marginal efficiency of capital in an
indirect way.When the consumption
and investment moves on the upward direction with the help of
expenditure is the equilibrium. government
The demand curve can be shifted on the upward
employment is achieved, it is not possible to direction but when the full
raise total output. ASCwill be parallel
OYaxis and rise in expenditure leads to to
inflation.
Multiple Choice Questions
 Self Study
l. Explainthe J. B. Say's law of market.
2. "Supplycreates its own demand" —Explainits assumptions and implications.
3. Explainthe Pigou's wage cut theory.
4. "Wageflexibility leads to full employment". Explainthe Keynes's argument against
Pigou.
5. Discuss the Keynesian theory of employment.
6. Explainthe Keynes' theory of income determination through 450 line and
C+ 1 line.