Keynesian Theory of Employment
It is also referred to as the effective demand theory of employment. Keynes developed this first systematic theory of employment. The Keynesian theory of employment states that the cause of unemployment is the deficiency of effective demand, and unemployment can be removed by raising effective demand. With the increase in effective demand, the production in the economy goes up. The increased production generates more jobs thus increasing the employment and giving a boost to the nation’s economy. With the increase in effective demand, there is also an increase in inflation which is good for the economy if controlled within a limit. Therefore, Keynesian theory of employment has a very positive looking approach for the economy of a nation. It helps in dealing with the situations of economic crisis like the Great Depression and the recession.
Keynes Effect
The principle of effective demand is the foundation of Keynes' General Theory of Employment. Employment is dependent upon effective demand and is directly proportional to Effective Demand. As Effective Demand increases, employment and output and real income increase.
Introduction to Keynesian Theory of Employment
This theory deals with all levels of employment that is full employment, widespread unemployment or intermediate level. Keynesian theory is a short-run theory. Keynes strongly believed in government intervention. He did not support the policy of Laissez Faire. In his theory of employment, money is important in determining employment.
Keynesian Economics: Demand Side Driven Theory
British Economist John Maynard Keynes, during the 1930s, developed Keynesian Economics to understand the Great Depression. This Economics is a demand-side driven theory and is based on the belief that with the help of government intervention, a nation's economy can be stabilised. The main focus of this economics is centred around government intervention to manage aggregate demand to prevent situations like recession and depression. This theory believes that when aggregate demand is increased through government policy intervention, the performance of any economy can be optimised. Keynesian economics is based on the belief that aggregate demand and aggregate supply are governed by effective demand. Employment and income depend on effective demand.
Some of the features of Keynesian Economics are:
Aggregate demand and aggregate supply governs the effective demand.
The aggregate supply does not change in the short run so Keynes focussed on the aggregate demand.
Keynesian economists believe that employment and income are dependent on effective demand.
The supply of money and the demand for money determines the rate of interest in an economy.
Keynesian Economics
Keynesian Economics
Keynes developed this theory to deal with the situation of the Great Depression. Keynesian Economists recommend fiscal and monetary policy as the primary tools to manage the economy and fight the menace of unemployment. Keynes's fiscal stimulus theory states that when the government spends money, it leads to an increase in business activity which generates more income and thus increases the GDP. The growth in GDP can be greater than the stimulus amount spent by the government initially. Keynesian Economists believe in saving less and spending more principle so that full employment and economic growth goes on.
Summary
Keynesian Economics is also sometimes known as Depression Economics. Keynesian Economics recommends a demand-side solution to deal with recessions. The intervention of the government forms an important part of Keynesian Theory. Keynes developed the Keynesian Theory of Employment in his book “The General Theory of Employment, Interest, Money” (1936). Monetarism is a branch of Keynesian Economics, and it advocates the use of Monetary Policy over Fiscal policy to deal with various economical problems. Keynesian theory of employment has the following policy implications:
Reform of Capitalism
Government Intervention
Monetary Policy Non – Reliability
Public Works Programme
Full Employment
FAQs on Effective Demand Theory of Employment
1. What is the principle of effective demand in Keynesian economics?
The principle of effective demand, central to Keynesian economics, states that the level of employment in an economy is determined by the point where the aggregate demand (AD) equals the aggregate supply (AS). This is the point where entrepreneurs' expectations of revenue are met by the actual expenditure in the economy. Unlike classical theory, it suggests that this equilibrium can occur at a level below full employment, leading to involuntary unemployment.
2. What are the main components of Aggregate Demand (AD) and Aggregate Supply (AS) in Keynesian theory?
In the Keynesian framework, the main components are:
- Aggregate Demand (AD): This is the total planned expenditure in an economy. It is composed of Consumption (C), Investment (I), Government Spending (G), and Net Exports (X-M). The formula is AD = C + I + G + (X-M).
- Aggregate Supply (AS): This is the total value of goods and services that firms are willing and able to supply at a given price level. Keynes assumed that in the short run, the price level is fixed, and the AS curve is perfectly elastic until the full employment level is reached.
3. How is the equilibrium level of income and employment determined by effective demand?
The equilibrium level of income and employment is determined at the point where planned aggregate demand equals aggregate supply (AD = AS). At this point, the economy is in a state of rest because producers have no incentive to change the level of output or employment. If AD is greater than AS, firms will increase production and hire more workers to meet the excess demand. Conversely, if AD is less than AS, firms will cut production and employment due to unsold stock.
4. What is the primary difference between the Classical and Keynesian theories of employment?
The primary difference lies in their core assumptions about the economy:
- Equilibrium: Classical theory assumes the economy always operates at full employment. Keynesian theory argues that equilibrium can exist at underemployment levels.
- Basis of Theory: Classical theory is based on Say's Law (supply creates its own demand), while Keynesian theory is based on the Principle of Effective Demand.
- Government Role: Classical economists advocate for a laissez-faire (no intervention) policy, whereas Keynesians strongly support active government intervention through fiscal and monetary policies to manage demand.
5. What is the role of government intervention according to the Keynesian theory of employment?
According to Keynes, government intervention is crucial for stabilising the economy. During a recession caused by deficient demand, the government should increase its spending (e.g., on public works) or reduce taxes to boost aggregate demand. This fiscal stimulus helps increase production, create jobs, and pull the economy out of the slump. The government acts as a balancing force when private consumption and investment are insufficient.
6. Why does Keynes' theory state that an economy can be in equilibrium even with involuntary unemployment?
Keynes argued that an economy can settle into an 'underemployment equilibrium' because of insufficient aggregate demand. Even if people are willing to work (involuntary unemployment), firms will not hire them if there isn't enough demand for the goods and services they would produce. Unlike classical economists who believed wage cuts would solve unemployment, Keynes noted that wages are 'sticky' downwards and that falling wages could further reduce aggregate demand, worsening the problem. Therefore, the equilibrium is determined by demand, not by the availability of labour.
7. How does the theory of effective demand explain real-world situations like the Great Depression?
The theory of effective demand provides a direct explanation for the Great Depression. The economic collapse was not due to a lack of productive capacity (supply) but a severe lack of aggregate demand. People lost jobs, which reduced their income and consumption. Businesses, seeing falling demand, cut back on investment. This created a vicious cycle of deficient demand, leading to mass unemployment and falling output. Keynes's theory explained that only massive government spending could break this cycle by injecting new demand into the economy.
8. What happens if aggregate demand is not equal to aggregate supply at the full employment level?
This situation leads to two distinct problems:
- Deficient Demand (Deflationary Gap): If aggregate demand is less than the aggregate supply at the full employment level, it creates a deflationary gap. This means total spending is insufficient to purchase all the goods that could be produced. This leads to unsold stock, falling prices, reduced production, and rising involuntary unemployment.
- Excess Demand (Inflationary Gap): If aggregate demand exceeds the aggregate supply at the full employment level, it creates an inflationary gap. Since the economy is already at its maximum production capacity, the excess demand cannot be met by increasing output. This leads to a rise in the general price level, or inflation.
