Theory of Income and

Employment

S. Siva Kumar

Classical theory of income and

employment

The classical theory assumes the existence of full employment

without inflation.
Given wage-price flexibility, there are automatic forces in the
economic system that tend to maintain full employment, and
produce output at that level.
Says Law of Market- is the core of the classical theory of
employment.
J.B.Say, 19th century French Economist enunciated the proposition
that supply creates its own demand.
This is known as Says Law.

Cont

It is production which creates markets for goods.

It is a product which creates markets for other goods
The law is applicable to a barter economy.
A very act of supplying goods implies a demand for them.
In such a situation there can not be general overproduction.
All the income earned by the factors owner is spend in buying
commodities.
What is not spent is saved which is automatically invested. Thus,
saving must equal investment.
If there is any divergence between the two, the equality is
maintained through the mechanism of rate of interest.

Cont

To classical economist, interest is the reward for saving.

The higher the rate of interest, the higher the saving and vice versa.
On the contrary, lower the rate of interest, the higher the demand
for investment funds, and vice versa.
Pigous Version- Formulated in terms of labour market.
Unemployment results from rigidity in the wage structure and
interferences in the working of the free market economy.
the key to full employment in an economy is the reduction in
money wage.

Keynesian theory of Output Income and

employment

In the Keynesian theory, employment depends upon effective

demand.
He used the term effective demand to denote the total demand for
goods and services at various levels of employment.
There can be a level of employment where aggregate demand
equals aggregate supply. This is the point of effective demand.
Effective demand results in output. Output creates income.
Income provides employment.
He regards employment is the function of income.
Effective demand is determined by two factors, the aggregate
supply function and the aggregate demand function.

Cont

Keynes assumes that the aggregate supply function to be stable

during short run, he concentrates his entire attention upon the
aggregate demand function to fight depression and unemployment
Employment depends on aggregate demand which in turn is
determined by consumption demand and investment demand.
Aggregate demand is determined by consumption and investment.
Employment can be increased by increasing consumption and / or
investment.
Consumption depends on income C(Y) and consumption can be
increased by raising the propensity to consume in order to
increase income and employment.
But propensity to consume remain constant during short run.
Employment thus depends on investment. It in turn depends on
rate of interest and the marginal efficiency of capital.

Cont

Investment can be increased by a fall in the rate of interest and or

a rise in the MEC.
In the Keynesian analysis, the equilibrium level of employment
and income is determined at the point of equality between saving
and investment.
It is also explained in terms of the equality of aggregate supply
(C+S) and aggregate demand (C+I).
Since unemployment results from deficiency of aggregate
demand, employment and income can be increased by increasing
aggregate demand (Consumption expenditure and investment
expenditure).
Aggregate demand can be increased by increasing investment.
Once investment raises, employment and income increase.

OX axis Income and employment is measured

OY axis- Consumption and investment is measured
OY3 is underemployment
OY1 is full employment. To attain government should increase
autonomous investment to the tune of AE1.