Assumptions
- The theory is applicable in advanced capitalistic Economy
- Assumption of short period
- Assumption of Perfect competition
- Closed economy
- It ignores the role of Government as a spender and Taxer
- No time lag
- Money also act as a store of value
- Labour is the only variable factor of production
- Under Employment Equilibrium
Saving depends upon income and Investment depends upon Rate of Interest
Keynes has strongly criticised the classical theory in his book ‘General Theory of Employment, Interest and Money’. His theory of employment is widely accepted by modern economists. Keynesian economics is also known as ‘new economics’ and ‘economic revolution’. Keynes had invented new tools and techniques of economic analysis such as consumption function, multiplier, marginal efficiency of capital, liquidity preference, effective demand, etc. In the short run, it is assumed by Keynes that capital equipment, population, technical knowledge, and labour efficiency remain constant. That is why, according to Keynesian theory, volume of employment depends on the level of national income and output. Increase in national income would mean increase in employment. The larger the national income the larger the employment level and vice versa. That is why, the theory of Keynes is known as ‘theory of employment’ and ‘theory of income’.
Theory of Effective Demand:
According to Keynes, the level of employment in the short run depends on aggregate effective demand for goods in the country. Greater the aggregate effective demand, the greater will be the volume of employment and vice versa. According to Keynes, the unemployment is the result of deficiency of effective demand. Effective demand represents the total money spent on consumption and investment. The equation is:
Effective demand = National Income (Y) = National Output (O)
The deficiency of effective demand is due to the gap between income and consumption. The gap can be filled up by increasing investment and hence effective demand, in order to maintain employment at a high level. According to Keynes, the level of employment in effective demand depends on two factors:
- Aggregate supply function, and
- Aggregate demand
(a) Aggregate supply function:
According to Dillard, the minimum price or proceeds which will induce employment on a given scale is called the ‘aggregate supply price of that amount of jobs.
If the output does not fetch a sufficient price so as to cover the cost, the entrepreneurs will employ less number of workers.
Therefore, different numbers of workers will be employed at different supply prices.
Thus, the aggregate supply price is a schedule of the minimum amount of proceeds required to induce varying quantities of employment.
We can have a corresponding aggregate supply price curve or aggregate supply function, which slopes upward to right.
(b) Aggregate demand function:
The essence of the aggregate demand function is that the greater the number of workers employed, the larger the output. That is the aggregate demand price increases as employment increases, and vice versa.
The aggregate demand is different from the demand for a product. The aggregate demand price represents the expected receipts when a given volume of employment is offered to workers.
The aggregate demand curve or aggregate demand function represents a schedule of the proceeds of the output produced by different methods of employment.