John Maynard Keynes was the main critic of the classical macro economics. He in his book ‘General Theory of Employment, Interest and Money’ out-rightly rejected the Say’s Law of Market that supply creates its own demand. He severely criticized A.C. Pigou’s version that cuts in real wages help in promoting employment in the economy. He also opposed the idea that saving and investment can be brought about through changes in the rate of interest. In addition to this, the assumption of full employment in the economy is not realistic.
So long as the economy was operating smoothly, the classical analysis of aggregate economy met no serious opposition. However, Great Depression of 1930’s created problems of increasing unemployment, reducing national income, declining prices and failing firms increased in intensity. The classical model miserably failed to explain and provide a workable solution for how to escape the depression.
It was at that time when J.M. Keynes wrote his famous book ‘General Theory’. In it he presented an explanation of the Great Depression of 1930’s and suggested measures for the solution. J.M. Keynes also presented his own theory of income and employment.
According to Keynes:
“In the short period, level of national income and so of employment is determined by aggregate demand and aggregate supply in the country. The equilibrium of national income occurs where aggregate demand is equal to aggregate supply. This equilibrium is also called effective demand point“.
What is Effective Demand?
Effective demand represents that aggregate demand or total spending (consumption expenditure and investment expenditure) which matches with aggregate supply (national income at factor cost).
In other words, effective demand is the signification of the equilibrium between aggregate demand (C+I) and aggregate supply (C+S).
This equilibrium position (effective demand) indicates that the entrepreneurs neither have a tendency to increase production nor a tendency to decrease production. It implies that the national income and employment which correspond to the effective demand are equilibrium levels of national income and employment.
Unlike classical theory of income and employment, Keynesian theory of income and employment emphasizes that the equilibrium level of employment would not necessarily be full employment. It can be below or above the level of full employment.
Determinants of Income:
The determinants of effective demand and so of equilibrium level of national income and employment are the aggregate demand and aggregate supply.
(1) Aggregate Demand (C+l):
Aggregate demand refers to the sum of expenditure, households, firms and the government is undertaking on consumption and investment in an economy. The aggregate demand price is the amount of money which the entrepreneurs expect to receive as a result of the sale of output produced by the employment of certain number of workers. An increase in the level of employment raises the expected proceeds and a decrease in the level of employment lowers it.
The aggregate demand curve AD (C+I) would be positively sloping signifying that as the level of employment increases, the level of output also increases, thereby increasing of aggregate demand (C+l) for goods. The aggregate demand (C+l), thus, depends directly on the level of real national income and indirectly on the level of employment.
(2) Aggregate Supply (C+S):
The aggregate supply refers to the flow of output produced by the employment of workers in an economy during a short period. In other words, the aggregate supply is the value of final output valued at factor cost. The aggregate supply price is the minimum amount of money which the entrepreneurs must receive to cover the costs of output produced by the employment of certain number of workers.
The aggregate supply is denoted by (CS) because a part of this is consumed (C) and the other part is saved (S) in the form of inventories of unsold output. The aggregate supply curve, (C+S) is positively sloped indicating that as the level of employment increases, the level of output also increases, thereby, increasing the aggregate, supply. Thus, the aggregate supply (C+S) depends upon the level of employment through the economy’s aggregate production function.
Determination of the Level of Employment and Income:
According to Keynes, the equilibrium levels of national income and employment are determined by the interaction of aggregate demand curve (AD) and aggregate supply curve (AS). The equilibrium level of income determined by the equality of AD and AS does not necessarily indicate the full employment level. The equilibrium position between aggregate demand and aggregate supply can be below or above the level of full employment as is shown in the diagram below.
In figure (32.3), the aggregate demand curve (C+I), intersects the aggregate supply curve (C+S) at point E1 which is an effective demand point. At point E1, the equilibrium of national income is OY1. Let us assume that in the generation of OY1 level of income, some of the workers willing to work have not been absorbed. It means that E1 (effective demand point) is an under employment equilibrium and OY1 is under employment level of income.
The unemployed workers can be absorbed if the level of output can be increased from OY1 to OY2 which we assume is the full employment level. We further assume that due to spending by the government, the aggregate demand curve (C+I+G) rises. As a result of this, the economy moves from lower equilibrium point E1 to higher equilibrium point E2. The OY is now the new equilibrium level of income along with full employment. Thus E2 denotes full employment equilibrium position of the economy.
Thus government spending can help to achieve full employment. In case the equilibrium level of national income is above the level of full employment, this means that the output has increased in money terms only. The value of the output is just the same to the national income at full employment level.
Importance of Effective Demand:
The principle of effective demand is the most important contribution of J.M. Keynes. Its importance in macro economics, in brief, is as under:
(i) Determinant of employment. Effective demand determines the level of employment in the country. As effective demand increases employment also increases. When effective demand falls, the level of employment also decreases.
(ii) Say’s Law falsified. It is with the help of the principle of effective demand that Says Law of Market has been falsified. According to the concept of effective demand whatever is produced in the economy is not automatically consumed. It is partly saved. As a result, the existence of full employment is not possible.
(iii) Role of investment. The principle of effective demand explains that for achieving full employment level, real investment must equal to the gap between income and consumption. In other words, employment cannot expand, unless investment expands. Therein lies the importance of the concept of effective demand.
(iv) Capitalistic economy. The principle of effective demand makes clear that in a rich community, the gap between income and expenditure is large. If required investment is not made to fill this gap, it will lead to deficiency of effective demand resulting in unemployment.
Criticism on Keynesian Theory:
From mid 1970 onward, the Keynesian theory of employment came under sharp criticism from the monetarists. Milton Friedman, the Chief advocate of monetarists rejected the Keynesianism as a whole. The monetarists returned back to the old classical theory for the explanation of the rise in general price level and stated that inflation is always and every where a monetary phenomenon.
The monetarists are of the view that J.M. Keynes laid more emphasis on the determinants of aggregate demand and to a greater extent ignored the determinants of aggregate supply. The monetarists encouraged the supply side policy and thus favored free enterprise economy for solving the problems of unemployment and inflation.
J.R. Hicks describes Keyne’s ‘General Theory’ as depression economics. Further, the ‘General Theory of Keynes is applicable to the developed economies. The Keynesians concepts are not very useful for policy purposes in less developed countries.