Sebi Grade A 2020: Economics: Determination of Output & Employment

SEBI Grade A 2020: ECONOMICS: DETERMINATION OF OUTPUT & EMPLOYMENT
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Classical Theory of Output & Employment ......................................................................... 3

Assumptions of Classical Theory of Output & Employment: ............................................... 3
Determination of Output & Employment as per the Classical Theory ...................................... 3
Keynes’ Theory of Output & Employment .......................................................................... 4
Effective Demand ....................................................................................................... 4
Investment ............................................................................................................... 4
Keynesian Theory of Employment and Income in terms of the Equality of Aggregate Supply
and Aggregate Demand............................................................................................... 6
Keynesian Model of Under-Employment Equilibrium ............................................................ 6

Classical Theory of Output & Employment
As per the Classical economists, full employment was a normal situation in an economy. According
to Pigou, the tendency of the economic system is to automatically provide full employment
in the labor market when the demand and supply of labor are equal. As per the classical
theory, unemployment results from the rigidity in the wage structure and interference in the
working of the free-market system in the form of trade union legislation, minimum wage legislation
etc. In other words, those who are not prepared to work at the existing wage rate are not
unemployed because they are voluntarily unemployed. So full employment is a situation
where there is no possibility of involuntary unemployment.
Assumptions of Classical Theory of Output & Employment:

● Full employment exists without inflation.
● There is a laissez-faire capitalist economy without government interference.
● It is a closed economy (without any foreign trade).
● There is perfect competition in labor and product markets.
● Labor is homogeneous.
● The total output of the economy is divided between consumption and investment expenditures.
● The quantity of money is given, and money is the only medium of exchange.
● Wages and prices are perfectly flexible.
● There is perfect information on the part of all market participants.
● Money wages and real wages are directly related and proportional.
● Savings are automatically invested and equality between the two is brought about by the rate
of interest.
● Capital stock and technical knowledge are given.
● The law of diminishing returns operates in production.
● It assumes a long run.
Determination of Output & Employment as per the Classical

Theory
The production function and the demand & supply for labour determines the output and
employment as per the classical theory. A precise relation exists between total output and the size
of employment, i.e., the number of workers. This is shown in the form of the following production
function:
Q = f(K, T, N)
where Total output => Q
Capital stock => K
Technical knowledge => T
Number of workers => N
So, total output (Q) is a function (f) of capital stock (K),

technical knowledge (T), and the number of workers
(N).
K & T are given, so the production function becomes Q
= f(N). So the output is an increasing function of the
number of workers but after a point, when more workers
are added, diminishing marginal returns to labour start.
This is shown in the below figure where the curve Q = f
(N) is the production function and the total output OQ1
corresponds to the full employment level NF.
But when some more workers NFN2 are employed beyond the full employment level of output OQ1
the increase in output Q1Q2 is less than the increase in employment N1N2.

Keynes’ Theory of Output & Employment

Keynes criticized the classical theory and put forward his own theory where employment
depends upon effective demand. Effective demand results in output. Output creates
income. Income provides employment. Keynes assumed all the above 4 quantities equal to
each other and therefore he regarded employment as a function of income.
Effective Demand
Effective demand is determined by two factors: the aggregate supply function and the aggregate
demand function. The aggregate supply function depends on physical or technical conditions of
production which do not change in the short-run. Keynes also assumed the aggregate supply
function to be stable and therefore he concentrated on the aggregate demand function.
As per Keynes, employment can be increased by increasing consumption and/or investment. As

income increases, consumption also increases but not as much as income. In other words, as
income rises, saving rises. Coming to consumption, it can be increased by raising the propensity
to consume in order to increase income and employment. But the propensity to consume depends
upon various factors like the psychology of the people, their tastes, habits, wants and the social
structure which determines the distribution of income.
All these elements remain constant during the short-run. Therefore, the propensity to consume is
stable. Employment thus depends on investment and it varies in the same direction as the
volume of investment.
Investment
Investment, in turn, depends on the rate of interest and the marginal efficiency of capital (MEC)
(the net rate of return that is expected from the purchase of additional capital). Investment can
be increased by a fall in the rate of interest and/or a rise in the MEC. The MEC depends on the
supply price of capital assets and their prospective yield. MEC can be raised when the supply price
of capital assets falls or their prospective yield increases. Since the supply price of capital assets
is stable in the short- run, it is difficult to lower it. The second determinant of MEC is the
prospective yield of capital assets which depends on the expectations of yields on the part of
businessmen. It is again a psychological factor which cannot be depended upon to increase the
MEC to raise investment. Thus there is little scope for increasing investment by raising the
MEC.
The other determinant of investment is the rate of interest. Investment and employment can
be increased by lowering the rate of interest. The rate of interest is determined by the
demand for money and the supply of money. On the demand side is the liquidity preference
(LP) schedule. Now, the higher the liquidity preference, the higher is the rate of interest that will
have to be paid to cash holders to induce them to part with their liquid assets, and vice versa.
People hold money 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 income (Y), i.e. M=L (Y). But the money

held for speculative motive (M2) is a function of the rate of interest (r), i.e. M=L2 (r). The higher
the rate of interest, the lower the demand for money, and vice versa.
Since LP depends on the psychological attitude to liquidity on the part of speculators with regard
to future interest rates, it is not possible to lower the liquidity preference in order to bring
down the rate of interest. The other determinant of interest rate is the supply of money
which is assumed to be fixed by the monetary authority during the short-run.
The relationship between interest rate, MEC and investment is shown in the below figure, where
in Panels (A) and (B) the total demand for money is measured along the horizontal axis from M
onward. The transactions (and precautionary) demand is given by the L1 curve at OY1 and OY2
levels of income in Panel (A) of the figure.
Thus at OY1 income level, the transactions demand is given by OM1 and at OY2 level of income it
is OM2. In Panel (B), the L2 curve represents the speculative demand for money as a function of
the rate of interest.
When the rate of interest is R2, the speculative demand for money is MM2. With the fall in the rate
of interest to R1, the speculative demand for money increases to MM1. Panel (C) shows investment
as a function of the rate of interest and the MEC. Given the MEC, when the rate of interest is R 2,
the level of investment is OI1. But when the rate of interest falls to R1, investment increases to
OI2.
So, in the Keynesian analysis, the equilibrium level of employment and income is
determined at the point of equality between saving and investment. Saving is a function
of income, i.e. S = f (Y) and it is defined as the excess of income over consumption, S=Y-C and
income is equal to consumption plus investment.

Thus Y = C + I
or Y - C = I
or Y - C = S
or I = S
So the equilibrium level of income is established where saving equals investment. This is shown
in Panel (D) of the above figure where the horizontal axis from O toward the right represents
investment and saving, and OY axis represents income. S is the saving curve. The line I1E1 is the
investment curve (imagine that it can be extended beyond E as in an S and I diagram) which
touches the S curve at E1. Thus, OY1 is the equilibrium level of employment and income.
This is the level of underemployment equilibrium, according to Keynes. If OY2 is assumed to be
the full employment level of income, then the equality between saving and investment will take
place at E2 where I2E2 investment equals Y2E2 savings.
Keynesian Theory of Employment and Income in terms of the Equality of

Aggregate Supply and Aggregate Demand
The Keynesian theory of employment and income is also explained in terms of the equality of
aggregate supply (C+S) and aggregate demand (C+I). Since unemployment results from the
deficiency of aggregate demand, employment and income can be increased by increasing
aggregate demand. Assuming the propensity to consume to be stable during the short-run,
aggregate demand can be increased by increasing investment. Once investment increases,
employment and income increase. Increased income leads to a rise in the demand for
consumption goods which leads to a further increase in employment and income.
Once set in motion, employment and income tend to rise in a cumulative manner through the
multiplier process till they reach the equilibrium level. According to Keynes, the equilibrium level
of employment will be one of under-employment equilibrium. This is because when income
increases consumption also increases, but relatively less than the increase in income. This
behaviour of the consumption function widens the gap between income and consumption which
ordinarily cannot be filled up due to the lack of required investment. The full employment
income level can only be established if the volume of investment is increased to fill the
income-consumption gap corresponding to the full employment.
Keynesian Model of Under-Employment Equilibrium

The Keynesian cross model of under-employment equilibrium is explained in the below figure
where income and employment are on the horizontal axis and consumption and investment on the
vertical axis. Autonomous investment is taken as the first assumption. C+I is the aggregate
demand curve plotted by adding to consumption function C an equal amount of investment at all
levels of income. The 45° line is the aggregate supply curve. The economy is in equilibrium at
point E where the aggregate demand curves C+I intersect the 45° line. This is the point of effective
demand where the equilibrium level of income and employment OY1 is determined.
This is the level of under-employment equilibrium and not of full employment. There are no
automatic forces that can make the two curves cross at a full employment income level. If at all,
it happens to be at a full-employment level, it will be accidental. Keynes regarded the under-

employment equilibrium level as a normal case and the full employment income level as a special
case.
Suppose OYF is the full employment income level.

To reach this level, autonomous investment is
increased by I1 so that the C+I curve shifts
upward as C+I+I1, curve. This is the new
aggregate demand curve which intersects the
45° line (the aggregate supply curve) at E1, the
higher point of effective demand corresponding
to the full employment income level OYF.
This also reveals that to get a needed increase in

employment and income of Y1YF, it is the
multiplier effect of an increase in investment by
I1 (=I2 in Panel C of the second figure) which
leads to an increase in employment and income
by Y1YF through successive rounds of investment.

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SEBI Grade A 2020: ECONOMICS: DETERMINATION OF OUTPUT & EMPLOYMENT

www.practicemock.com 1 info@practicemock.com 011-49032737

Classical Theory of Output & Employment ......................................................................... 3

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Assumptions of Classical Theory of Output & Employment:

Determination of Output & Employment as per the Classical

So, total output (Q) is a function (f) of capital stock (K),

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Keynes’ Theory of Output & Employment

As per Keynes, employment can be increased by increasing consumption and/or investment. As

www.practicemock.com 4 info@practicemock.com 011-49032737

www.practicemock.com 5 info@practicemock.com 011-49032737

Keynesian Theory of Employment and Income in terms of the Equality of

Keynesian Model of Under-Employment Equilibrium

www.practicemock.com 6 info@practicemock.com 011-49032737

Suppose OYF is the full employment income level.

This also reveals that to get a needed increase in

www.practicemock.com 7 info@practicemock.com 011-49032737

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