Keynesian Theory of Output and Employment Determination

Keynesian Theory of Output and Employment
Determination
Introduction: A British economist John Maynard Keynes who is also known as ‘the
father of modern economics’ wrote a book titled ‘The General Theory of
Employment, Interest and Money’ in 1936. This is one of the most celebrated
books in economics. In this book Keynes proposed a new theory of employment. To
understand this theory, we must know the background that is under what
circumstances this theory was formulated.
Background: Classical economists (Keynes called all the economists before him as
‘classical economists’) were of the view that there is always tendency towards full
employment in the economy and if there is an unemployment in the economy certain
economic forces automatically operate in such a way as to bring the economy
towards full employment level. But this theory was challenged during the Great
Depression which occurred in the major capitalist countries during 1929 to 1933.
This great depression caused a huge unemployment of labour and other resources
as a result of which the level of national income fell down. Many factories were
closed and those which were working were not being used to their full capacity. Due
to this decrease in production and huge unemployment created by this depression
people had to undergo a great deal of sufferings. This situation did not seem to
disappear automatically so that people’s belief in the classical theory was broken &
this theory was largely criticized and discarded. In this background Keynes wrote his
book in which he not only criticized the classical theory but also put forth his theory
of employment.
Assumptions of the Keynesian theory:
1) There is a closed capitalist economy.

2) This theory is applicable in the short run.
3) There is perfect competition in the product and labour market.
4) The amount of labour, capital, technology is given and constant.
5) Wages and Prices are rigid or sticky down.
Implications or Propositions of the theory:
1) Underemployment is a normal situation: Keynes criticized the fundamental

assumption of the classical theory that there is always full employment in the
economy. He considered it as unrealistic. He regarded full employment as a
special and accidental situation. According to him, the general situation in the
economy is of underemployment. (Less than full employment). This is
because the economy does not function according to the Say’s law of market.
Supply exceeds demand i.e. each product that comes to the market is not
sold. Due to which we saw many workers who are willing to work at current
wage rate or even below it but they do not find job.
2) Saving and Investment are distinct functions: All the incomes earned by
factor owners would not be spent on buying products but a part of it is saved.
According to classical economists that saved part of income is automatically
invested i.e. saving is equal to investment. But Keynes is of the view that
saving and investment are not equal and the equality between them is not
maintained by the rate of interest because saving and investment are distinct
functions. Saving depends upon the level of income and not on the rate of
interest. On the other hand, investment depends not only upon the rate of
interest but also on the expected rate of return on the investment. For
example, a low rate of interest cannot increase investment, if business
expectations are low.
3) State intervention is necessary: Classical economists were the advocates

of laissez faire policy. According to classicists, if the capitalist economies are
left on their own, they can automatically utilize the fullest capacity of the
economies or bring the economies at the full employment level. But according
to Keynes, capitalist economies are incapable of using the fullest productive
power. There is no any example of an economy that has achieved full
employment level when left on its own. So that state intervention is necessary.
Keynes advocated the positive role of the state in the economy.
4) Wage-Price Rigidity: One of the assumptions of the classical theory was that
wages and prices are flexible. In the situation of depression, wages and prices
will automatically adjust to restore full employment equilibrium but Keynes
criticized this. According to Keynes wages do not fall very fast. Wages are
sticky down. Workers don’t want wage cut. They will definitely resist it. They
will organise through trade unions & go on strike. So wages do not fall quickly,
efficiently and in the overnight. Prices also don’t fall immediately. Producers
do not drop the prices of their product suddenly and start price war. It will take
a great deal of time for prices to fall.
5) Short run Analysis: Classical theory was based on the long run analysis.
According to this theory full employment level of output will be achieved in the
long run through self-adjustment process. Whereas, Keynesian economics is
based on the short run analysis. Keynes had no patience to wait for long run.
According to him, “In the long run, we are all dead”. So it is better to look for
short run solution to deal with the problem of unemployment.
6) Diagrammatic representation of underemployment equilibrium: The
Keynesian model of employment can be represented with the help of following
diagram;
In the above diagram, AS is the aggregate supply

curve, AD1 and AD2 are aggregate demand curves. Level of output and employment
are measured on the horizontal axis and the price level is measured on the vertical
axis. The horizontal portion of aggregate supply curve is because of the wage price
rigidity and the vertical portion is because Keynes believed that there is a certain
level of output beyond which the production cannot be increased that is the full
employment level of output, represented by YF. Suppose that economy is in the
depression. This situation is represented at point E and the level output Y D (D for
depression). If we apply the logic of classical economists, the economy will
automatically come to the full employment level i.e. Y F through wage-price
adjustment. But according to Keynes, due to the wage price rigidity, the economy will
stuck down at point E and it will take a great deal to time to come at Y F. Whether it
will take 5 years or 10 years or 20 years was not told by the classical economists. So
what should be done to move the economy towards full employment level? What is
the short run solution for that? Keynes suggested that in this case, the state should
intervene in the economy. Keynes is expecting active demand side management i.e.
policies that will increase the aggregate demand by the government. It requires
increase in government spending and reduction in taxes i.e. government should run
budget deficit (spend more than its revenue by taking public borrowings). If
government decreases tax rate, it will result in increased spending which will boost
the aggregate demand. Government should invest in the economy through
commercial undertakings, welfare schemes, employment schemes etc. which will
increase the aggregate demand in the economy. This is indicated by the shift in the
aggregate demand curve to AD2 and increased employment and output from YD to Y1
in the above diagram.
Conclusion: In this way the Keynesian theory of employment and output can be
explained. Keynesian theory is nothing but the departure from the classical non-
interventionist approach to the positive role of the state in the economy.

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Keynesian Theory of Output and Employment

Assumptions of the Keynesian theory:

1) There is a closed capitalist economy.

Implications or Propositions of the theory:

1) Underemployment is a normal situation: Keynes criticized the fundamental

3) State intervention is necessary: Classical economists were the advocates

In the above diagram, AS is the aggregate supply

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