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Keynesian theory of employment
During the “Great Depression” in the late 1920s, the validity of classical economic theories completely collapsed as they failed to correct the disequilibrium in the economic activities. Although the classical economists advocated that demand created its own supply, savings were equal to investment, full employment prevailed, business cycles were temporary in nature and unemployment was a short term phenomenon, and that these disturbances could be easily corrected by varying the interest rates or by reducing the wage rate, nothing of the sort happened in 1919. Therefore, the then American President Hoover introduced various policy measures to correct the prevailing economic situations, all of which ended up being too little and too la te. As a result, he was forced to resign and President Roosevelt took over on
04-03-1933. In 1936, the Keynesian ‘General Theory of Employment, Interest and Money’ completely changed the classical economic thought. This led to the emergence of the Keynesian revolution, which completely transformed the old economic thought based on the monetarist’s approach to an entirely new approach that was based more on fiscal economics. The latter came to be popularly known as the ‘welfare oriented economic policy’ (Dewett 2005). 1.1.6 Principles of effective demand The Keynesian approach was directed to redeem the capitalists’ economy from the conditions of great depression. Hence, it is also better known as a solution to the “depression economics”. According to Keynes, depression occurred as a consequence of lack of ‘effective demand’, which is the point at which aggregate demand equals the aggregate supply. Therefore, the level of ‘effective demand’ was to be increased, which in turn would raise the level of other economic variables. This may be expressed as:- ∆Q= ∆N = ∆Y ↓ ← Effective Demand
where, ∆Q = aggregate output, ∆N = aggregate employment in an economy, and ∆Y = aggregate income in an economy. Effective demand comprises two important elements, viz., aggregate demand function (ADF) and aggregate supply function (ASF). ∆Q= ∆ N = ∆ Y ↓ Effective Demand
Aggregate supply function : Adam smith, ‘the father of economics’ laid emphasis on human behaviour, especially the concept of self-love. Human beings are rational
constraints. A seller tries to maximize sales, and thus the profits by minimizing cost. A producer estimates the market demand, so as to adjust the production process. The basis of Keynesian economic principle is also the same. Diagram
- 4 shows the determination of employment caused by the interaction between
ADF and ASF.
Y E 2 ASF ADF E I ADF E 1 & ASF
0 N 1 N N 2 X
Diagram 4: Level of Employment
At the equilibrium level E, ADF = ASF. At this point, the level of employment is ON, where the equilibrium output and income also occur, reflecting the level of effective demand. When ADF > ASF, economic activities will rise and lead to higher levels of employment, output and income. The Keynesian multiplier and acceleration effects lead to acceleration in economic activities. As a consequence, production will increase, leading to a rise in employment from ON 1 to ON. Thus, the economy would move to the equilibrium point E. Multiplier refers to the change in income caused by a change in investment, i.e., ∆Y/∆I. Meanwhile, accelerator refers to the change in investment caused by a change in income and consumption, i.e., ∆I/∆Y. On the other hand, when ASF > ADF and the economy move away from E to E2, production would fall and unemployment would emerge to the extent of
ON^2_._^ As a result, the economy would revert back to the equilibrium point E and unemployment would fall from ON 2 to employment level ON. When employment is ON, which is less than the full employment point, the government can raise ADF through autonomous investment, assuming ASF to be constant. 1.1.7 Keynesian theory The Keynesian theory states that employment is a function of income. Since both income and employment are determined by the level of effective demand, greater the national income, the greater would be the volume of employment. The Keynesian theory may be summarized in the form of the following flow chart.
Effective Demand, Employment, Income
Income Prope nsity to cons ume
Money Supply
Rate of Interest
Liquidity Preference
Marginal
Efficiency of Capital
Supply Price Expected yield The Keynesian model of income and employment determination is illustrated by diagram – 5.
N at io n al In
OM, the rate of interest is determined at Or. Given the marginal efficiency of capital (MEC) curve and Or rate of interest, OI is the volume of investment determined. Given OI level of investment and the marginal propensity to consume, reflected by curve C in diagram (ii), the national income is determined at OY. In other words, the economy will be at equilibrium at OY level of income. Diagram (i) shows that
OY level of national income creates ON volume of employment. Assuming ONF^ to be the level of full employment, the OE equilibrium represents less than full employment level. 1.2 Inflationary and Deflationary Gaps
Inflation is the rise in price without a corresponding increase in the supply of goods and services at a given time. In the process, the values of commodities rise, while the value of money declines during inflation. By now it is understood that equilibrium need not necessarily occur at the full employment level and that it can also occur at less than full employment level. Therefore, the equilibrium level of national income or employment has no particular feature. For, an equilibrium level may involve both unemployment and waste of national resources, if the investment is insufficient to ensure full employment. Therefore, the desirable level of equilibrium is the one which is achieved at full employment or near full employment. This level may be achieved when investment opportunities equal full employment savings. As a result, there can be inflationary gap or deflationary gap. a) Inflationary gap:
When consumption and investment expenditures are greater than the full employment GNP level, it gives rise to inflationary gap. Under this circumstance, consumer demand for goods and services are greater than its supply. Thus, when inflationary gap occurs, national income, output and employment cannot increase any further. The rise in demand for goods and services results in increased price level. In other words, inflationary gap would occur when the scheduled investment exceeds the full employment saving. Under such a situation,
the demand for goods would be more than what the economic system can produce. This would lead to a rise in the prices, which would result in an inflationary situation. Thus, when the full employment
Inflationary Gap A E
C+ I+ G
B C+ I
C
0 QF Q X Output Diagram 6: Inflationary Gap
In the diagram, C, I and, G represent consumption, investment and government expenditures respectively. The C+I+G line represent the total expenditure in an economy. It intersects the 45° line at E, at which the total real output is Q. Q F represents the full employment limit to real output. The real income cannot reach Q, because at QF the total demand C+I+G exceed the total output, showing a gap of AB. This gap AB is known as the inflationary gap in the Keynesian sense.
b) Deflationary gap: Deflationary gap occurs when the total aggregate demand fails to create full employment. The Diagram - 7 shows the deflationary gap.
Y
C ,I, G
a) Economic factors:
Economic factors play a decisive role in a country’s economic development. For instance, the growth of a country is generally determined by the stock of capital and the rate of capital accumulation. The other economic factors which influence development are the nature of economic system, the availability of surplus food grains or food security for the people, foreign trade situations, etc. It is important to examine the role of some of these factors in economic development. i) Economic system:
The historical background and economic system of a country also influences its developmental prospects. It decides the institutional structure of a country. Laissez faire economic system was one of its earliest forms, wherein the market forces determined the economic progress. In today’s world, no country can claim to be having a pure economic system, whether capitalist or socialist. With the onset of liberalization policy, it is even more difficult to categorize countries under clear-cut economic system. The history of economic development of any country is inter-woven with the complex process of development, which has helped each of them to evolve their own path of development. Thus, economic system of a country plays a crucial role in determining the process, pace and level of development. ii) Capital formation:
The strategic role played by capital in increasing the level of production is widely recognized, more so since the development of growth economics in the post-World War II period. Capital was treated as the crucial factor of economic growth in the Harrod- Domar growth model. At present, it is widely acknowledged that capital accelerates the pace of growth of a country. It is emphasized that the principal obstacle to growth is the lack of adequate capital
for investment, without which no developmental plan can be implemented successfully. Therefore, in order to increase the level of investment, a country has to make increased savings. This is important, as this also avoids heavy reliance on foreign aid/capital, which can be risky. iii) Marketable surplus of agriculture:
The excess of agricultural output produced by the sector, over and above what is needed for the subsistence of the rural population, is known as marketable surplus. Enhanced productivity and production in agriculture is vital for the development of a country. These in turn should result in increased marketable surplus of agricultural produces. Marketable surplus is particularly important in the context of a developing country, as the rise in urban population leads to an increase in the demand for agricultural products, mainly the food grains. These increase in demand need to be met by adequate supplies, as scarcity of food in urban areas would affect the process of economic growth. This is because food shortage would force a country to import food grains, which in turn would affect the balance of payments. India suffered a similar problem till 1976-77. Due to inadequate marketable surplus during the period, the government of India was compelled to import huge quantities of food grains to support the urban population and to avert a food crisis in the country. Although this solved the then food problem, it resulted in high foreign exchange drainage, which could have been used for furthering the economic development of the country. To overcome such a problem, there are countries which have embarked upon the strategy of accelerating the pace of industrialization, so as to prevent agriculture from lagging behind. It is for this reason that Maurice Dobb observed, “There is reason to suppose that it will be the marketed surplus of agriculture which plays the crucial role in the underdeveloped country in setting the limits to the possible rate of industrialization” (Dobb 1955).
Population constitutes an important factor in economic development, which is often viewed as an obstacle to growth rather than a factor that contributes to it. The people of a country generally make positive contributions to growth by providing labour power for production. A country which is endowed with efficient and skilled labour would have high productivity that would contribute to growth. Whereas, a country with illiterate, unskilled, unhealthy and superstitious people would generally experience low growth, as its people would not have the capacity to contribute much to the development of its economy. Therefore, a country that manages its manpower properly would be able to convert its capabilities into an important factor in development. On the other hand, if human resources remain either unutilized or underutilized due to inefficient manpower management, the people would end up becoming a burden to the economy rather than making positive contributions to growth. It is due to the latter reason that in an over-populated underdeveloped country, people are considered as a growth arresting factor. ii) Social organisation:
People’s participation and cooperation in the development process of a country is a pre- condition for accelerating the growth of an economy. This participation and cooperation in development process would, however, be forthcoming only when they are assured of the fact that the benefits of growth would be distributed on a fair and just basis. But, experiences in numerous countries indicate that defective social organizations have contributed to skewed distribution of benefits of growth in society. This has resulted in some groups of the society being benefited more than the general mass. This has resulted in dissatisfaction among the latter class towards the development programmes of the government, due to which the people are reluctant to participate in the development projects initiated by the state.
India’s development experiences during the plan periods reflect such a situation, which has led to the growth of monopolies in industries and concentration of economic power in the hands of a few in the modern sector. Further, the new agricultural strategy has also been more favourable to the rich peasantry class, which has resulted in the emergence of widespread disparities in the rural sector. This indicates that the government policies of India have also resulted in development, which is far from being fair and just. This proves that India’s social organisation has failed to improve along the developmental process of the country. Therefore, although the government has been emphasizing upon participatory development since the early plan periods, not much success has been achieved by the country in this direction. Hence, there has been widespread apathy towards development planning in the country, which needs to be rectified. iii) General education and technical know-how:
During 1909 and 1949, Robert M. Solow found the contribution of education to be greater than that of any other factor in increasing the output per man hour in the United States (Solow 1957). In recent times, some of the economists like T.W. Schultz, A.K. Sen and others have stressed upon the contribution of investment in man for economic development (Schultz 1977 and Sen 1972). They call for development of human capabilities through human capital investments. Although it is difficult to subject its contributions to quantitative measurement, the results of its verifications undertaken using proxy variables provide a tentative approximation of it. Further, the direct impact of the level of technical know-how on the developmental pace of a country is widely recognized today. Advancements in the scientific and technological knowledge help man to discover more sophisticated techniques of production that would contribute to enhanced levels of productivity. In fact, Schumpeter attributed most of the capitalist
