Determination of Income and

Employment
Classical Propositions
Prominent proponents
David Ricardo, James Mill, A C Pigou, J B
Say
Propositions
An economy is always in equilibrium
It always enjoys full employment
Money plays insignificant role
Underlying Assumptions
Closed economy
Demand and supply interact freely; no
government control/regulation
Consumers choose to maximize
satisfaction
Producers produce to maximize profits
Wages and prices are flexible
Economy in equilibrium-
Says Law
J B Say
Supply creates its own demand
Explains self correcting mechanism in
case of overproduction or
underproduction
Disequilibrium, if exists, is temporary


Economy at full employment
equilibrium
In case there is unemployment, wage
flexibility will drive the labour demand
and supply close to each other so that no
involuntary unemployment prevails

If demand for labour exceeds its
availability, wage flexibility will again
restore labour market equilibrium
Money is insignificant

Money acts as a medium of exchange

Money aids transactional efficiency
Do you see anything wrong in
the Classical propositions?
Meaning: Output/Income
Actual Output : The output and therefore
the income which is generated in the
economy at the prevailing level of
employment

Potential Output: The level of output
which the economy would produce if all
the factors were fully employed
Output/Income
In short run, actual
output may deviate
from potential output

Short Run
fluctuations define
the business cycles
that are experienced
by economies all over
the world

In long run, actual
output potential
output

Also, potential output
grows over time as
the economys stock
of factor inputs grows
TROUGH/RECESSION
Low prices
Low profits
High unemployment
Low wages, interest
Pessimism prevails
Economic suffering

RECOVERY/EXPANSION
Low prices induce materialization of consumer
demand
This induces demand for capital goods
Sales recover in all sectors
Employment improves
Prices recover, wages scale up, interest rates
increase.

BOOM/PEAK
Sales grow, production facilities are expanded,
inventories grow
Unemployment is low, employees feel more
secure, factors experience near full employment,
command high prices
Healthy profits allow firms to pay good wages
and employees are able to afford goods, revival
of consumption
Hectic activity everywhere/overheated economy





DECLINE/CONTRACTION
Economy has experienced the peak and now
begins to slow down
Extremely high prices discourage new ventures
Eventually the expansion in demand, new hiring
and new lending come to a halt
Unintended piling of inventories, prices have to
be lowered, profits turn into losses, layoffs and
bankruptcies are prevalent
What is the contrast in the
objective of a firm and the
objective of an economy?
A firm aims at equilibrium
output
An economy wants full
employment level of output
Keynesian Proposition
J M Keynes
Involuntary Unemployment prevails in
the economy
Underemployment equilibrium output is
routine rather than an exception
Wage and price flexibility is questionable
Unemployment - Variants
Voluntary Unemployment
Seasonal Unemployment
Frictional Unemployment
Structural Unemployment
Disguised Unemployment
Cyclical Unemployment
Keynesian Model (Short Run)
Assumptions: All prices and wages are
fixed at given levels; involuntary unN
t

prevails
Supply expands to meet demand if
operating at < full N
t
level
Actual output = Aggregate demand (in
equilibrium)

Aggregate Demand

In a two sector economy:
AD = C + I
Consumption Function: C = f (Y)
C = a + bY
Show this graphically
What are the savings in this case?

Propensity to consume/save
Average propensity to consume willingness to
use a proportion of income for consumption

Marginal propensity to consume proportion of
additional consumption out of the additional
income

APC +APS = 1
MPC +MPS = 1
Factors influencing propensity to
consume

Base level of income
Stability of income receipts
Prices
Future expectations
Credit facilities
AD
Investment demand means the firms desired
additions to their physical capital and
inventories

Investment demand depends upon the current
guesses about future demand for their output

Assume: I = I
According to Keynes..
Investment is independent of current
national income levels
Investment is dependent on
Rate of interest to be paid on the
borrowings made for spending on capital
goods
Marginal efficiency of capital
Equilibrium
Given the assumptions, the output market is in
SR equil. when AD or planned aggregate
spending equal the output that is actually
produced
AD = Y
If AD < Y, there is unplanned addition to stocks
If AD > Y, there is unplanned reduction in stocks

Equilibrium - Graphically
Examples
Let C = 100 + 0.75Y and I = 200
Find equilibrium level of NY

Another example -
Let C = 8 + 0.7Y
I = 22
Find equilibrium Y
If I =-9, find the new equilibrium Y

Multiplier
A change in autonomous spending
changes the national income/output by a
multiple of the initial change; this
multiple is known as the multiplier
Defined as : the ratio of change in
equilibrium output to change in
autonomous spending
Multiplier, k = 1 / (1 b)

Paradox of Thrift
When AD is low and the economy has
spare resources, paradox of thrift shows
that a reduction in the desire to save will
increase the spending and increase the
equilibrium income level.

So, society will benefit from higher
output and employment



Show this Paradox graphically
In this 2 sector model
Discouraging HH saving is tough, so C is
adversely affected and therefore Y
Firms may not invest as demand may not
be forthcoming, this also adversely affects
Y
The economy will settle at an
underemployment equilibrium !