Income and employment theory is a body of economic analysis concerned with

the relative levels of output, employment, and prices in an economy.

By defining the interrelation of these macroeconomic factors, governments try

to create policies that contribute to economic stability.

The entire classical theory depends upon the Say's law of market. Whereas, the
modern or general theory of income and employment is most important
advance in economic analysis in the twentieth century.
Macro theories are designed to explain the situation existing at that time, i.e. they
relate to a particular time period (paradigm). Consequently they are not universal
truths, but may be more or less useful depending on prevailing conditions. Broadly
macro theories of income determination may divide into three phases:

1) Up to the 1930s: (Classical Theory)

This theory was says 'Supply creates its own
demand'. In the circular flow of income each of
the leakages creates funds for an injection,
saving, provides funds for investment, tax
revenue, generates funds for govt spending and
imports (M) give money to foreigners to
purchase exports. Thus every time a good or
service is produced, sufficient income and
expenditure are generated to purchase them,
therefore Aggregate Demand = Aggregate Supply.
2) In the 1930s : (General Theory)
J.M.Keynes (1883-1946) published The General Theory of Employment, Income
and Money in 1936, which presented a plausible explanation of the cause of the
Great Depression. He argued that the economy was led by demand and that if
AD settled at a level below that necessary to generate full employment then
firms
would cut production and lay off workers, creating long term unemployment. He
argued that wages were sticky downwards, so labour markets would not
automatically adjust.
3) In the late 60s : (Modern Theory)
In this theory all liberal view of the economy suggested that market forces solved

all problems and the role of government was to keep its nose out of things and
let
those market forces work their magic. Policy should focus on lowering tax rates,
reducing the power of unions, privatizing as much of the public sector as
possible,
lowering unemployment benefits, making wages flexible and providing the
infrastructure to support private enterprise.
Say's Law of Markets is a set of economic principles that are commonly associated
with the concepts developed by Jean-Baptiste Say during the latter 18th and early
19th centuries.

He stated that there can be no demand without supply. A central element of Say's
Law is that recession does not occur because of failure in demand or lack of money.

In Say's view, creation of more money simply results in inflation; more money
demanding the same quantity of goods does not represent an increase in real
demand.

Say's ideas focus on the underlying reasons for economic recessions and the roles
that supply and demand play in the creation and perpetuation of a recession.
 1) J.B. Say :
"Supply creates its own demand.“

2) J.S. Mill :
"Consumption co-exists with production. Production is the cause, the sole
cause
of demand. It never furnishes supply without furnishing demand, both at the
same time and to an equal extent.“

3) Mc Connell :
"The very act of producing goods generates an amount of income exactly
equal
to the value of the goods produced. That is the production of any output
would automatically provide the wherewithal to take that output off the
market"
Say's Law of Markets is based on
the following assumptions:
1) Perfectly Competitive Economy :
The law assumes perfect competition in all markets. Under perfect competition if

the demand and supply of factors and commodities are not equal then, their
prices will change in such a manner that their demand will be equal to their
supply.
2) Optimum Allocation of Resources :
The resources are optimally allocated in different channels of production on the
basis of equality of marginal products and proportionality.
3) Perfect Equilibrium :
Demand and supply equilibrium leads to the fixing of commodity price and factor

prices.
4) Laissez-faire policy of the government :
There is no government intervention in the economic field. Laissez-fair policy
leads to automatic adjustment and smooth working of the market mechanism in

the capitalist system.

5) Elastic Market :
The market is very wide and spread out without limits. Therefore as the output
product increases, markets also expand.
6) Market Automatism :
In an expanding economy, new workers and firms will be automatically absorbed
into the production channels. There is no displacement of workers or firm.
7) Circular Flow :
There is no break in the circular flow of income and expenditure Income is
automatically spent through consumption expenditure, and investment
expenditure.
8) Saving Investment Equality :
All the savings are automatically invested. Therefore, savings is always equal to
investment. Savings investment equality is the basic condition of equality.
9) Long term :
The economy's equilibrium process is considered from the long term point of
view.
10)Flexible Prices :
The law also assumes that prices, wage rate and rate of interest are perfectly
flexible.
11)Money-a Veil :
Another assumption of the law is that money is only a medium of exchange. In
fact, goods are exchanged for goods. The function of money is just to facilitate
this exchange of goods.
12)No Hoarding :
The law assumes that people spend all the money that they get i.e. nothing is
hoarded. All income is spent either on consumption or capital goods.
13)State is Neutral :
It assumed that state does not interfere with the activities of the economy, in
any
manner Forces of demand and supply will bring about equilibrium in economy.
14)Unlimited Opportunities for Labour and Capital :
supply of labour and capital can be increased to any extent and in any
proportion
in an enterprise. This implies perfect factor substitutability.
Say's Law of Markets can be explained under two types of situations:
1) Say's Law and Barter Economy:
Say's law of markets necessarily applies to barter economy.
Whenever, a producer brings goods to the market for sale,
or creates supply, he does so in order to get other goods in
exchange. Thus, in a barter economy supply of a commodity
always symbolizes demand for other commodities. In such
an economy, every seller is necessarily a buyer also.

According to Hansen, "By supply creating its own demand is

meant that every producer who brings goods to market does so
only in order to exchange them for other goods. " in short, in a
barter system of exchange acts of sale and purchase of an
individual together. Hence, sale must be equal to purchase or
supply is equal to demand.
2) Say's Law and Monetary Economy :
Classical economists apply Say's Law to monetary economies. According to
them, money serves only as a medium of exchange. When a producer sells his
products he gets his income in terms of money. He will spend this money to
buy other goods and services. The value of demand so created will be equal to
the value of the goods supplied.

David Ricardo, "No man produces but with a view to consume or sell and he
never sells but with an intention to purchase some other commodity which
may be, useful to him, or which may contribute to future production. By
producing them, he necessarily becomes either the consumer of his own goods

or the purchaser or the consumer of the goods of some other persons;

production is always bought by production and services.
1) General Over-Production is Impossible:
General over- production refers to that situation in which aggregate supply is
more than aggregate demand over long period. As per Say's Law, general over-
production is impossible because when production increases, the income of
factors of production also increases which automatically leads to more demand.
Thus, demand is always equal to supply.
2) General Unemployment is Impossible:
General unemployment refers to that situation in which supply of labour is more
than its demand in general. When in the labour market supply exceeds its
demand
Wage-rate falls. Under perfect competition, labour is demanded up to the point
where the wage- rate is equal to marginal revenue productivity of labour.
3) Partial Over-production and Partial Unemployment are Possible:
If the anticipations of the producers regarding the demand for particular goods
are
not correct, then the supply of it may be more or less than the demand.
4) Use of Unemployment Resources Pay for Itself:
if unemployed resources are put to use then they will pay for themselves,
because when they are put to work they help in increasing the production. These

resources will be paid their remuneration out of increased production.

5) Automatic Adjustment:
According to Say's Law of Markets all economic parameters of a competitive
economy are automatically adjusted. This adjustment takes place in three ways:
a) Adjustment through Wage
b) Adjustment through Price Level
c) Adjustment through Rate of Interest
6) Equality between Saving and Investment:
Say held the view that "to save is to spend." Whatever is saved is actually
invested. If at all there is temporary inequality between saving and investment
then rate of interest will change in such a way as to make them equal.
7) Possibility of Unlimited Output and the Growth of Capital:
There can be unlimited increase in output and capital. The reason being that
aggregate demand and aggregate supply are always equal, if there is increase
in production there will be increase in demand as well. Increase in production
will thus prove to be beneficial. Also, increased production leads to increased
capital formation.
8) Policy Implications:
The law states why government should adopt laissez-faire policy which means
that it should not interfere with the economic activities. Rate of interest,
wage-rate and prices automatically change in accordance with circumstances.
As a result of changes in them, all the factors of production in the country are
fully utilized.
9) Money Plays a Passive Role:
It is only a medium of exchange to facilitate transactions. Behind the flow of
money, there is a real flow of goods and services, which is important.
1) Interest Rate Flexibility:
According to Say's law, all incomes are spent i.e. income = expenditure.
However, there may be "leakages" in the circular flow of income &
expenditure. Whatever is saved is invested in production activities. If
savings exceed investment, the rate of interest will fall. Hence investment
will rise and level of savings will fall till they are in equilibrium.
2) Wage Rate Flexibility and Employment:
According to the classical economist, money wage cut policy can solve the
problem Involuntary employment is due to a rigid wage structure. If the wages
can be lowered, involuntary unemployment will disappear. A self-adjusting
system of wage will push the economy towards full employment stage.
S
Y

i
Rate of S
Interest
i1

O Q Q1 X
Saving/Investment
1) Insufficient Aggregate Demand for Goods Produced :
The mass unemployment and prolonged recession of the 1930s, suggested that
production does not equal demand. In a recession, there can be insufficient
aggregate demand for goods produced.
2) Prices and Wages are not Flexible:
Prices and wages are not flexible. E.g. workers may resist nominal wage cuts.
3) Excess Savings:
There are examples where there is an increase in savings, and businessman and
consumers hoard cash. See: (Paradox of thrift) Say himself criticized Ricardo for
neglecting the possibility of hoarding if there are insufficient investment
opportunities.
4) Liquidity Trap:
In a liquidity trap the demand to hold cash is greater than the demand to spend.

Banks increase their reserves and the saving rate increases, this leads to a fall in
aggregate demand.
5) Confidence :
In certain circumstances, people may not have the confidence to spend and
invest. They may become risk averse and hoard cash in unproductive savings.
6) Rational to 'Hoard' Money:
It may be very rational to 'hoard' money - especially in a period of deflation or
anxiety.
7) Prolonged Recession :
The balance sheet recession of 2008-12, illustrated an example of where
banks, consumers and firms were keen to pay off their debts and not spend all
their income. This led to a prolonged recession.
8) Unrealistic Assumptions at Full Employment :
According to Keynes, the basic assumption of full employment itself is
unrealistic. An economy can be in a state of equilibrium. In under employment
situation also full employment equilibrium is just one possible equilibrium
condition according to Keynes.
9) Too much emphasis on Long Run :
Keynes gave importance to the short run According to him. In the long run, we
are all dead.
10) Keynes refuted Say's Law of Markets :
According to Keynes, the classical economists failed to examine the level of
aggregate demand. Supply may not create demand. according to Keynes. Supply
can exceed demand. Hence automatic self adjusting mechanism will not work.
11) Interest is not an Equilibrating Factor :
Keynes attacked the classical theory in regard to savings and investment. Flexible
interest rates will not lead to equilibrium savings and investment. Changes in
income bring about the equilibrium between savings and investment.
12) Role of Money is Neglected:
The classical economists considered money as a veil. Its role is neutral. Keynes
recognized the importance of precautionary measures and speculative demand
for money, also recognized the effect of money on output, incomes, employment.
13) Keynes Attacked the Laissez Faire Policy of Classical Economists:
In the conditions -of the modern world, state intervention is necessary to solve

the problem of unemployment. Government spending, taxation and borrowing

are important instruments to increase employment and income in an economy.
14) Wage Cut Policy is not Practical:
A wage cut may in fact lead to reduced purchasing power with workers which
will lead to reduced effective demand for products. This will adversely affect the

levels of employment.
15) The Classical System will Work only if there is Perfect Competition:
In such a case there should not be trade unionism, wage legislation etc. But in
reality, all these factors exist. Hence classical theory will not become applicable.
Keynes offered this theory in 1936.

Keynes explained in this theory that employment depends upon

the income.

If the standard of national income is higher, than rate of

employment will also be higher, on the other hand, if the level of
national income is lower than the level of employment will also be
lower. John Maynard Keynes
Born : 5 June 1883
Died : 21 April 1946
The equilibrium level of income and employment will be that Nationality : British
where aggregate demand is equal to the aggregate supply. Field : Political economy
Probability
Keynes' Theory of
Employment is based on
the following assumptions:
1) Short Period:
Keynesian Theory of Employment holds well in the short period. Lord Keynes
firmly believed that the problem of unemployment in developed countries was
a short-run problem, because "in the long-run we are all dead."
2) Perfect Competition:
Keynesian theory of employment, like classical theory, is based on the
assumption of perfect competition.
3) Closed Economy:
Keynesian theory is based on the assumption that a developed capitalist
economy is a closed economy, where level of income and employment remain
unaffected by the foreign trade.
4) Ignores the role of the Government as a Spender or a Taxer :
Keynes' General Theory ignores the role of government as a spender or a taxer.
Keynes has ignored the effect of government sector on aggregate demand.
5) Diminishing Marginal Productivity:
As more and more units of labour are employed, their marginal productivity goes

on diminishing. It means that production is subject to law of diminishing marginal

returns.
6) Labour is the only factor of production:
It is also the assumption of Keynesian Theory that in the short-period labour
alone is the variable factor of production. It means that with increase in the
number of laborers there is increase in output.
7) Labour has Money Illusion:
Keynesian Theory of Employment assumes that laborers have an illusion that
value of money remains constant. In other words, they believe that real wages
will also increase in the same ratio as the money wages do.
8) Money also acts as a store of value:
Keynesian Theory also assumes that money does not serve as a medium of
exchange alone; it also performs an important function of store of value.
9) No Time Lag:
Another assumption is that different economic factors get adjusted without any
loss of time. The period in which income increases is the period in which
consumption and investment also increase.
10)Under-employment Equilibrium :
Keynes assumes that equilibrium is possible even when there is under-
employment.
11)Saving and Investment Function :
Keynes' Theory is based on the assumption that saving is a function of income
i.e., S = f (Y). On the other hand, investment is a function of rate of interest, i.e.
I = f (r).
12)Interest is a Monetary Phenomenon :
As per Keynesian Theory, interest is a monetary phenomenon, meaning thereby
that it is determined by the demand for and supply of money. Demand for
money
is expressed by liquidity preference which, in its turn, depends on transaction,
precautionary and speculative motives.
Keynes proved this fact that supply
cannot create its own demand, and
there is no tendency of the
economy towards full employment.
If at any time aggregate demand
falls, then unemployment takes
places and if aggregate demand
increases then inflation takes place.
As regards the question of national
income and employment
determination it is determined by
the aggregate supply and
aggregate demand.
1) Aggregate Supply (AS) :
According to Keynes aggregate supply is equal to national income at market
price.
In other words national income is equal to the price of goods and services
produced in the country. The national income is divided into three parts,
consumption saving and taxes. So
A. S. = National income = Consumption
A A
+ Savings + Taxes or AS = Y = C + S + T
y 500

400

Expected 300
Revenue
200

100
45 F
o 100 200 300 400 500 x
Income
2) Aggregate Demand (AD)S
Aggregate demand is the amount of consumption and amount of investment
expenditure at each level of income.

There are two components of aggregate demand:

a) Consumption Expenditure :
It depends upon the size of national income. If the size of national income is
greater than greater amount will be spent on consumption.
b) Investment Expenditure :
The investment expenditure depends upon the following two factors:
i) Marginal Efficiency of Capital
ii) Current Rate of Interest
3) Aggregate Expenditure Function (AEF):
The former is probably more useful in a general sense and for essays, but the
latter is very useful in identifying the elements at work and explaining concepts
such as the multiplier.
a) A given price level
b) A fixed rate of interest

The former assumption is the key difference between this approach and the AD/AS
approach. If we relax these 2 assumptions then the effects predicted by the model
will be moderated. However, making these assumptions allows us to study how the
model works.
The prospects of high levels of output and employment depend upon size of the
effective demand and not the rate of wages. Effective demand is the total monetary
expenditure of the community and is therefore a price. It depends upon two other
variables, namely, aggregate demand (ADP) and aggregate supply price (ASP).
Effective demand (ED) is then an equilibrium value determined at the point of
intersection of the ADP and ASP schedules.
A) Explanation:
In the above diagram income is measured along OX-axis and consumption
and investment along OY. OS curve shows the aggregate supply (45 degree)
or C + S line. C + I is the aggregate demand curve.

Aggregate demand and supply curves intersect each other at the point "M".
M is the point of effective demand and OP is the equilibrium level of
national income. If we assume that national income is greater than OP in
that situation new equilibrium point will be F. If total expenditure fall short
then the aggregate supply, the producer will also reduce the production.
Further income and employment will also reduce and again equilibrium will
be M.
B) Criticism:
1) In the under developed countries there are so many other factors which
are
responsible for unemployment, like over population and lack of skill.
2) Perfect competition is not found in real world.
3) In the long run its chances of success are limited.
4) It is not applicable in socialistic economy.
5) This theory was produced by the depression of 1930 and it is not applicable

in ordinary economic condition. Anyhow this theory has much importance

for all the countries.
1) Macro-approach :
Keynes has given a new approach, i.e., Macro-approach to the field of economics.

His theory has several names: theory of income and employment, demand-side
theory, consumption theory, and macro-economic theory.
2) Completely Demolished the idea of Full-Employment ;
Keynes' theory has completely demolished the idea of full-employment and
forwards the idea of under-employment equilibrium. He states that employment
level in the economy can only be increased by increasing investment.
3) New Economic Tools and Techniques :
The new economic tools and techniques developed by Keynes have enabled the
today's economists to draw correct conclusions on the economic situation of a
country. Such tools are consumption function, multiplier, investment function,
liquidity preference, etc.
4) Integrated :
Keynes has integrated the theory of money with the theory of value and output.
5) Depict More Realistic Situation :
Keynes has first time introduced a dynamic economic theory, in order to depict
more realistic situation of the economy.
6) States the Reasons of Excess or Deficiency :
He also states the reasons of excess or deficiency of aggregate demand through
inflationary and deflationary gap analysis.
7) Applied to all types of Economic Systems :
Keynes' theory is a general theory and therefore, can be applied to all types of
economic systems.
8) Criticized Policy of Surplus Budget :
Keynes influenced on practical policies and criticized the policy of surplus
budget. He advocated deficit financing, if that sited the economic situation in
the country.
9) Emphasized on Suitable Fiscal Policy :
Keynes has emphasized on suitable fiscal policy as an instrument for checking
inflation and for increasing aggregate demand in a country. He advocated
extensive public work programmes as an integral part of government
programmes in all countries for expanding employment.
10)Control Cyclical Fluctuations :
He advised several monetary controls for the central bank, which in turn will act
as the instrument of controlling cyclical fluctuations.
11)Vital Role in Economic Development :
Keynesian theory has played a vital role in the economic development of less-
developed countries.
12)Rise Importance of Social Accounting :
Keynes' theory has given rise to the importance of social accounting or national
income accounting.
Keynes' economic thoughts are not completely flawless. Acknowledging it, Prof.
Harris, a great supporter of Keynes, has observed, "Even the most enthusiastic
imbibers the Keynesian fountain will find impurities and indigestible and
uncourageous substance." Main criticisms of Keynesian concepts are as follows:
1) The Concept of Equilibrium is Self-contradictory :
Keynes was of the view that in economy equilibrium was possible in less than
full employment level. According to him, so long as labour and other factors
are
not fully utilized, it is a big folly to think of equilibrium.
2) Keynesian Economics is Mainly Static:
Keynesian economic analysis is that it is mainly a static analysis. No doubt
Keynes directed the attention of the economists towards shifting equilibrium
but he did not clarify that when we move from one position of equilibrium to
the other how and in what way investment undergoes a change.
3) It has Ignored the Long Period Equilibrium :
Keynesian theory is a short-run economic analysis having no concern with long
period. It pays relatively more attention to short-run influences alone is not
only a serious and harmful mistake but is a matter of grave concern to
civilization.
4) Limited Scope :
Some socialist or communist economists had said that Keynes' theory is dead
if communism comes. However, even the socialist countries have strived to
raise their national income by using Keynesian theory.
5) Keynesian Theory Ignored Microanalysis :
Keynesian theory has ignored microanalysis and is not helpful in the solution
of the problems of individual firms and consumers.
6) Unrealistic assumption of Perfect Competition :
Keynesian economics is based on the unrealistic assumption of perfect
competition, like that of classical economics. But we know that in a real
economic world condition of perfect competition, is a figment of imagination.
7) Keynesian Theory is not a General Theory
This theory is neither a solution to all kinds of economic problems nor is
applicable to all kinds of economies. Keynesian Theory does not pay any need to
technical unemployment. and it does not apply to all countries.
8) Over-aggregative :
The basic concepts of Keynesian economics like, consumption, national income,
investment, aggregate demand etc. are over aggregative. This approach is useful
from the view point of simplicity, but it fails to throw light on those factors which
influence these basic concepts.
9) Ignores Cost Push Inflation :
Lord Keynes has explained demand-pull inflation in his theory but has completely

ignored cost-push inflation. After World War II, the main problem faced by the
countries of the world is cost-push inflation. However, Keynes has not accorded
any special significance in his theory to the analysis of inflation caused by
increase in the cost of production.
10)Economics of Depression :
Another allegation against Keynesian economics is that it seeks solution to the
problems of depression and unemployment alone. Hicks and Schumpeter are of
the view that Keynes had not properly studied the problems of boom and
inflation. But in reality this allegation is baseless.
One of the most important relationships in all macro economics is the
consumption function.

Consumption function shows the relationship between the level of consumption

expenditures and the level of disposable personal income.

This concept is introduced by Lord Keynes which is based on hypothesis that there
is a stable empirical relationship between consumption and income.

How much consumption rises in response to a given increase in income depends

upon the propensity to consume or consumption function.
A) Explanation through Table:
Income (Rs. in Crs.) Consumption (Rs. in Crs.)
1,000 750
1,100 825
1,200 900
1,300 975
1,400 1050
1,500 1125

The above schedule shows consumption expenditure at different levels of

income. It also shows how the consumption changes in response to the change
in income. When the level of income is Rs. 1200 crores, the amount of
consumption is Rs. 900 crores. The consumption expenditure has increased as
income has increased but not as much as the increase in income. This fact has
been emphasized by Lord Keynes.
A) Explanation through Diagram:

In the above figure, national income is shown

on the X-axis and consumption demand on the
Y-axis. OZ line indicates consumption function.
This line makes an angle of 450(degree) with
the X-axis indicating that the amount of
consumption is equal to the income at every
level of income.
A) Explanation through Diagram:

In reality, consumption increases less than the increase in income. So the curve
showing consumption function will deviate from the 450(degree) Line. CC is such
curve. At lower level of income, consumption is greater than the income. It is
financed by way of borrowing or disserving. As income increases, consumption also
increases at OA level, consumption equals income. Beyond OA level, the gap
between consumption and income is widening. That is savings increase (Y - C = S.)
This has a significant implication in macro economics. Consumption function curve
can shift upward or downward showing increase and decrease respectively. The
point of intersection of OZ and CC curves is known as Break - even level of income.
At this point saving is zero. At all levels of income below the break - even level of
income saving is negative and at all the levels of income above the break-even level
of income-saving is positive.
1) Average Propensity to Consume (APC) :
APC is the ratio of the amount of consumption to total income. It is calculated
by dividing the amount of consumption by the total income.
C Here
C = Consumption Expenditure
APC = ----
Y Y = Total Income
2) Marginal Propensity to Consume (MPC) :
The concept of MPC is very important. From MPC we know how much part of
the increment in income is consumed and how much saved. MPC is the ratio of
change in consumption to the change in income.

MPC = change in the total consumption / change in total income

1) When the MPC is constant, the consumption function is linear i.e. a straight line.

APC will be constant only if the consumption function passes through the origin.
If it does not pass through the origin. APC will not be constant.

2) MPC refers to the marginal increase in consumption ( C) due to a marginal

increase Y. APC refers into the income ratio of total consumption C to the total
income Y.

3) As income increases, MPC also falls, but it falls to a greater extent than the APC.

4) As income falls, MPC rises. APC also rises but at a slower rate.
According to Keynes, consumption function is
affected by two factors - subjective and objective.
A) Subjective Factors:
The slope and position of the consumption function are determined by the
subjective factors Human behavior regarding consumption function and savings
depend on psychological motives.
There are eight motives of Subjective Factors:
a) Motive of Precaution :
The desire to build up reserve against unforeseen contingencies
b) The Motive of Foresight :
The desire to provide for anticipated future needs i.e. education, old age etc.
c) The Motive of Calculation :
Refers to the desire to enjoy a larger income at a future date by way of
interest and appreciation.
d) The Motive of Improvement:
It is the desire to enjoy a gradually increasing expenditure, so that people can

look forward to gradually improving the standard of life.

E) The Motive of Independence:
It is the desire to enjoy a sense of independence and the power to do things.
F) The Motive of Enterprise:
The desire to be enterprising and speculative or establish business deals.
G) The Motive of Pride:
The desire to posses or to bequeath a fortune.
H) The Motive of Avarice:
It is the desire to satisfy miserliness and abstain from expenditure. Subjective

motivations are also applicable to the behaviour patterns of business

corporations and governmental bodies. Keynes listed the following motives
for accumulation.
1) The Motive of Enterprise:
It refers to the ambitious plans to expand and secure resources for further
investments.
 2) The Motive of Liquidity:
The desire to face emergencies and difficulties easily
3) The Motive of Improvement:
The desire to enhance income levels and became successful.
4) The Motive of financial Prudence:
It is the desire to ensure adequate financial provision against depreciation
and obsolesce and discharge debts.
B) Objective Factors:
Objective factors are subjected to rapid changes and they cause drastic shifts in
the consumption function. They are as follows:
a) Windfall Gains or Losses :
Consumption levels change due to windfall gains or losses.
b) The Rate of Interest Changes in the Rate of Interest Affects Consumption :
A rise in the rate of interest may induce people to reduce consumption at
each income level because people will save more to take advantage of the
high interest levels
c) Fiscal Policy :
Change in fiscal policy of the government leads to change in the propensity to
consume. For example imposition of heavy taxes tends to reduce the
disposable real income of the community. Hence the level of consumption
may
change adversely.
d) Change in Expectation :
Change in expectation regarding the future leads to a change in the
propensity
to consume. If people expect a war, they fear a rise in prices in the future.
People tend to hoard.
e) Change in the Net Income :
Net income rather than the total income affects the consumption function.
Changes in accounting practices will affect the net income and therefore
influence the consumption function.
Keynes concept of consumption function has
revolutionized the entire economic thinking in
modem times. The important implications are
the following.

1) Importance of Investment:
Keynes concluded that employment can increase only if the investment
increases. Investment therefore is regarded as a crucial factor determining
employment in the short run investment has to be sufficient to fill in the gap
between income and consumption if output and employment are to be
maintained.
2) Refutes the Say's Law of Market :
Keynes was able to invalidate the Say's law of market which was the basic
principle of the classical theory. Keynes showed the consumption expenditure
rises less than the rise in income.
3) Keynes Theory explains the Trade cycle Phenomenon :
Keynes consumption function provided a satisfactory explanation of the upward
and downward swings in the trade cycle. When the MFC is less than usual, the
economy is at the upper turning point.
4) MEC helps to Study the Nature of Income Propagation :
A very important implication is the need for government interference to remedy
the problems of overproduction and unemployment.
The saving function is the starting point of the Keynesian economics analysis of
equilibrium output determination using the injections-leakages model.

It captures the relation between saving by the household sector and income.
Because income is used for either consumption or saving, the saving function is a
complement of the consumption function.

Both reflect the fundamental psychological law put forth by John Maynard Keynes
that consumption expenditures (and saving) by the household sector depend on
income and then only a portion of additional income is used for consumption, with
the rest used for saving.
A saving function is a mathematical relation between saving and income by the
household sector.

The saving function can be stated as an equation, usually a simple linear equation,
or as a diagram designated as the saving line.

This function captures the saving-income relation, the flip side of the consumption-
income relation that forms one of the key building blocks for Keynesian economics.

The two key parameters of the saving function are the intercept term, which
indicates autonomous saving, and the slope, which is the marginal propensity to
save and indicates induced saving.

The injections-leakages model used in Keynesian economics is based on the saving

function.
The saving function can represented in a general form as:
S = F (Y)
Where: S is saving, Y is income (national or disposable), and f is the notation for a
generic, unspecified functional form.

Depending on the analysis, the actual functional form of the equation can be linear,
with a constant slope, or curvilinear, with a changing slope. The most common form
is linear, such as the one presented here:

Where: S is saving, Y is income (national or disposable), c is the intercept, and d is

the slope.
The saving function is also commonly presented as a diagram or saving line, such as
the one presented in the exhibit to the right. This red line, labeled S in the exhibit is
positively sloped, indicating that greater levels of income generate greater saving
by the household sector. The specific saving function illustrated in this exhibit is:

The two primary characteristics of the saving

function--slope and intercept--also can be
identified with the saving line.

1) Slope:
The slope of the saving line presented here is positive, but less than one. In this
case the slope is equal to 0.25. Click the [Slope] button to highlight.
2) Intercept:
The saving line intersects the vertical axis at a positive value of -$1 trillion. Click
the [Intercept] button to highlight.
The saving function shows the relationship between the level of saving and
income. People divide their income between consumption and saving.

1) Average Propensity to Save (APS):

An important relationship between income and saving is
described by the concept of APS. APS is the proportion of
disposable income that is saved.

APS = Savings / Disposable income = S/Y.

Generally APS increases as income increases. Important

relationship between APC and APS can be derived.
C+S=Y
Marginal Propensity to Save (MPS):
MPS shows change in savings induced by a change in the disposable income.
MPS = MPC + MPS
The saving function is the mirror image of the consumption function.
Y = C + S. So, S = Y - C.

1. At incomes below OY, saving is negative so APS <

0.
2. At OY, saving is zero so APS = 0.
3. At incomes above OY, there are positive savings so
APS >0.

C = A + bY
Therefore,
S = -A + (1-b)Y, where (1-b) = MPS.
The two key parameters that characterize the saving function are slope and
intercept.
1) Slope:
The slope of the saving function (d) measures the change in saving resulting
from
a change in income. If income changes by S1, then saving changes by Sd. This
slope is generally assumed and empirically documented to be greater than zero,
but less than one (0 < d < 1). It is conceptually identified as induced saving and
the marginal propensity to save (MPC).
2) Intercept:
The intercept of the saving function (c) measures the amount of saving
undertaken if income is zero. If income is zero, then saving is Sc. The intercept is
generally assumed and empirically documented to be negative (c < 0). It is
conceptually identified as autonomous saving. It is often useful to state the
saving function using parameters for the consumption function.
Investment function refers to inducement to invest or investment demand.

According to the classical economists, investment demand is a decreasing function

of the rate of interest.

An investment function is a concept or strategy within economics that helps to

identify the connection between shifts in the national income and the investment
patterns that take place within that particular national economy.

In this type of situation, a function would be any variable within the framework of
the economy that would motivate investors to change their typical buying and
selling habits as a means of either taking advantage of the economic shift in a bid
to increase their returns or to minimize the amount of loss incurred as a result of
that shift.
1) Autonomous Investment:
Autonomous investment is the investment that does not change with the
changes
in the income level. It is independent of income. This investment is made in
houses, infrastructure, roads, etc. It depends upon population growth and
technical progress than the level of income. The investment undertaken by
Government in various projects like construction of roads, bridges, power
generation, etc. is of autonomous type.
2) Induced investment:
Induced investment is induced by the profit motive. It is affected by the changes
in the level of income. According to Keynes, rate of interest and expected rate of

profit influence investment. The essence of induced investment is that greater

income and therefore greater aggregate demand affects the level of investment
in the economy.
1) Marginal Efficiency of Capital:
Marginal Efficiency of Capital means the expected rate of profit.

According to Keynes, Marginal Efficiency of Capital of an asset

in the expected rate of return over cost is the expected
profitability of a capital asset. The highest rate of return over
the cost expected from an additional or marginal unit of a
capital asset is called marginal efficiency of
that capital asset.

E=Q/P

Where:
E=Marginal Efficiency of Capital
Q=Prospective Yield
P=Supply Price
a) Expectations about Future Demand and Price of the Product.
If the business community expects demand to increase in future investment
activity is stimulated and Marginal Efficiency of Capital is expected to be high.
b) Business Optimism and Pessimism :
If the businessmen are optimistic, they would estimate a higher Marginal
Efficiency of Capital, whereas, if the businessmen are pessimistic, Marginal
Efficiency of Capital will tend to fall.
c) Windfall Gains :
Any increase in come like windfall gains or any other factor resulting in
increase in income of the people may lead to an increase in Marginal
Efficiency of Capital.
d) Demand for Consumption Goods:
Increasing demand for consumption goods will lead to an increase in derived
demand for capital goods. This results in expectation of higher Marginal
Efficiency of Capital.
e) Changes in Population:
An increase in population will increase the demand for goods and encourage
investments in productive activities. As a result, Marginal Efficiency of Capital
may be expected to rise.
f) Change in Technology :
With the advancement in technology, production increases and there is an
increase in the Marginal Efficiency of Capital.
g) Development of Infrastructure :
A change in technology along with improvement in infrastructure tends to
increase production more efficiently and effectively. Obviously, this has a
positive effect on Marginal Efficiency of Capital.
2) Rate of Interest :
According to Keynes, The rate of interest is determined by liquidity preference
and the supply of money. Given the liquidity preference and the level of income,

the greater the supply of money, the lower will be the rate of interest. Rate of
interest is thus determined by the demand for and the supply of money.
3) Other Factors:
Other factors influencing investments are technological progress, conditions
prevailing in the economy, Government policy, availability of resources. As the
MEC is expressed as a rate or ratio, it can be compared directly with the rate of
interest.
It is important at the outset to be clear about the meaning of unemployment.

Full employment implies that all who wish to work at the existing level of wage rates
are employed. There are, to be sure, potential workers who choose not to seek
employment because wage rates are too low.

But such persons are said to be voluntarily unemployed, and the theory of
employment is not concerned with them; rather, it is concerned with involuntary
unemployment-with a situation in which there are workers who would be willing to
take employment at prevailing wages but cannot find it.
1) Over qualification:
Over qualification is the situation when individuals work in professions which
require less education, skill, experience or ability than they possess. In economic

terms, these agents are producing less than their socially optimal output.
Collectively, when a lot of individuals produce below their full potential, the
economy is in sub-optimal underemployment equilibrium.
2) Overstaffing :
Overstaffing refers to the state when firms in an economy are hiring more
people
then they need. This is much less common than over qualification. This
redundancy invalidates unemployment rates as a signal for the existence of
underemployment equilibrium. When firm are overstaffed, they cannot achieve
their maximum profit levels, which leads to undesirable social consequences
such as low GDP growth.
The Keynesian idea of "underemployment" equilibrium has been elucidated by
Professor Kurihara in terms of the following strategic functions in the Keynesian
theory of employment:
Kurihara points out that at a very low rate of interest, the liquidity function
becomes perfectly interest-elastic, which has two unhealthy influences:
1) It tends to discourage inducement to invest, by its depressing effect on the
marginal efficiency of capital or high rate of interest, which is essential to
overcome a strong liquidity preference of some people

2) It is neither feasible nor advisable for the monetary authority to expand

money supply indefinitely and lower the rate of interest to the bottom, just for
the sake of stimulating private investment.