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Keynesian Theory Of Income, Output And Employment

 Keynesian Theory of Income, Output and Employment

    In the Keynesian thesis, employment is based on effective demand. Effective demand results in productivity or output. Productivity generates earnings or income. Earnings offer employment. Since Keynes believes all these four volumes namely, Effective demand (ED), Productivity or Output (Q), Earnings (Y) and Employment (N) parities each other, he considers employment as a function of earnings.

    Effective demand is ascertained by two aspects, the aggregate supply function and the aggregate demand function. The aggregate supply function is based on physical or technical situations of manufacturing which does not vary in the short term. Since Keynes believes the aggregate supply function to be stable, he contemplates his entire concentration upon the aggregate demand function to fight gloominess and redundancy. Thus employment is based on aggregate demand which in turn is ascertained by consumption demand and investment demand.

    According to Keynes, employment can be hiked by enhancing consumption and or investment. Consumption is based on income C(Y) and when income hikes, consumption also hikes but not as much as earnings. In other words, as income enhances savings augments. Consumption can be enhanced by hiking the inclination to consume in order to enhance earnings and employment. But the inclination to consume is based on the attitude of the people, their choices, behaviour, requirements and the social structure which decide the distribution of earnings.

    All these elements remain constant during the short run. Hence, the propensity to consume is stable. Employment thus depends on investment and it varies in the same direction as the volume of investment. Investment in turn, depends on the rate of interest and the marginal efficiency of capital MEC. Investment can be augmented by a drop in the rate of interest and or a rise in the MEC. The MEC is based on the supply price of capital assets and their prospective yield.

    It can be augmented when the supply price of capital assets is stable in the short run; it is difficult to lower it. The next determinant of MEC is the potential yield of capital assets which is based on the prospect of yields on the part of businessmen. It is again a psychological aspect which cannot be depended upon to enhance the MEC to hike investment. Therefore, there is little scope for augmenting investment by raising the MEC.

    The other determinant of investment is the cost of interest. Investment and employment can be augmented by reducing the cost of rate. The rate of interest is determined by the demand for money and supply of money. On the demand side is the liquidity preference (LP) agenda. The greater the liquidity preference the greater is the rate of interest that will have to be paid to cash holders to persuade then to part with their liquid assets and alternatively.

    Public hold money (M) in cash for three motives: transactions, precautionary and speculative. The transactions and precautionary motives (M) are income elastic. Thus the amount held under these two motives (M1) is a function (L1) of the level of earnings (Y), i.e. M1 = L1 (Y). But the money held for speculative motive (M2) is a function of the cost of interest (r), i.e. M2 = L2 (r). The higher the rate of interest, the lower the demand for money and alternatively. Public hold money (M) in cash for three motives: transactions, precautionary and speculative. The transactions and precautionary motives (M) are income elastic. Therefore the interest held under these two motives (M1) is a function (L1) of the level of income (Y), i.e. M1 = L1 (Y). But the money held for speculative motive M2 is a function of the rate of interest (r), i.e. M2 = L2 (r).

    The greater the rate of interest the lower the demand for money and alternatively. Since LP is based on the attitude to liquidity on the part of speculators with regard to future interest rate of interest. The other determinant of interest rate is the supply of money which is believed to be fixed by the monetary authority during the short term.

    The association between interest rate, MEC and investment is represented in the diagram below, where in Panels (1) and (2) the total demand for money is evaluated along the horizontal axis from M onward. The transactions and defensive demand is presented by the L1 curve at OY1 income level, the transactions demand is presented by OM1 and at OY2 level of earnings it is OM2. In panel (2) the L2 curve depicts the speculative demand for money as a function of the rate of interest.

    When the drop in the rate of interest to R1, the speculative demand for money hikes to MM1. Panel (3) depicts investment as a function of the rate of interest and the MEC. Given the MEC when the rate of interest is R2, the level of investment is OI1. But when the rate of interest drops to R1, investment hikes to OI2.

    In Keynesian study the symmetry level of employment and earnings is ascertained at the point of equality between saving and investment. Saving is a function of earnings, i.e. S = f (Y). It is defined as the excess of earnings over consumption, S = Y – C and the earnings is equal to consumption plus investment.

Therefore,

                                    Y         =          C + I

Or,      

    Y – C  =          I

    Hence,

    Y – C  =          S

    Therefore,

    I           =          S

    So the equilibrium level of earnings is established where saving parities investment. This is shown in Panel (4), where the horizontal axis from O toward the right depicts investment and saving and OY axis depicts earnings. S is the saving incline. The line I1E1 is the investment curve which touches the S curve at E1. Therefore, OY1 is the symmetry beyond E as in an S and I representation. This is the level of under employment symmetry, as per Keynes.

    If OY2 is presumed to be the full employment level of earnings then the equality between saving and investment will take place at E2 where I2 E2 investment equals Y2 E2 saving aggregate supply (C + S) and aggregate demand (C + I). Since redundancy results from the insufficiency of aggregate demand, employment and earnings can be augmented by enhancing aggregate demand.

    Presuming the tendency to consume to be constant during the short term aggregate demand can be augmented by enhancing investment. Once investment augments employment and earnings enhances. Enhanced earnings tend to a hike in the demand for consumption goods which tends to hike in a cumulative manner through the multiplier process till they reach the symmetry level.

    According to Keynes the symmetry level of employment will be one of under employment symmetry for the reason that when earnings enhances consumption also enhances but by less than the augment in earnings. This mannerism of the consumption function widens the gap amidst income and consumption which ordinarily cannot fill up due to the lack of required investment. The full employment earnings level can only be established if the volume of investment is enhanced to fill the earnings – consumption gap corresponding to full employment.

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