The General Theory of Employment by J.M. Keynes

In this article we will discuss about the General Theory of Employment by J.M. Keynes.

Keynes on Say’s Law:

Keynes was critical of the classical macroecono­mic view of how the credit market ensures that sav­ing will be equal to investment at the full-employment level of output. In the classical view, the interest rate will adjust so as to make planned saving by house­holds equal to planned investment spending by busi­ness firms.

If planned saving is always exactly offset by planned investment spending overproduction or persistent unemployment is impossible. Keynes ar­gued that although the interest rate does indeed influ­ence planned saving and planned investment, other important influences can keep the interest rate from equating planned saving and investment.

Keynes identified several motives for saving by individuals besides earning interest:

(1) To build re­serves against unforeseen events;

(2) For retirement;

(3) For an increased standard of living;

(4) To gain eco­nomic independence;

(5) To build reserves for spec­ulative purposes;

(6) To leave an inheritance; and

(7) To satisfy the urge to accumulate.

These motives, he argued, generate considerable saving that is indepen­dent of the interest rate.

Likewise, Keynes argued that the interest rate was only one factor influencing business investment decisions. He argued that firms invest only if they ex­pect to make a profit.

Based on their expectations of the rate of profit for a given investment project, busi­nesses often borrow when interest rates are high and refuse to borrow when interest rates are low. Final demand by consumers, the size and age of existing capital stock, and the availability of new technology all play an important role in determining investment demand.

If both saving and investment respond strongly to influences other than the interest rate, Keynes ar­gued, planned saving could exceed planned invest­ment spending at the full-employment level of out­put, making Say’s Law invalid.

If planned saving exceeds planned investment, the classical world said the interest rate will fall. Keynes said that the level of output and income, not the interest rate, will fall until planned saving (leakages) is again equal to planned investment (injections). Thus, prolonged, severe de­pression and unemployment are possible in a capitalist economy.

To Sum Up: According to Keynes:

Say’s Law is not necessarily valid; just because enough income is created, does not mean it will be spent.

Self-regulating markets do not necessarily guar­antee full employment.

Credit Market:

Saving and investment are influ­enced by many factors other than the rate of interest.

Labour Market:

Unions and other influences can make it difficult to adjust wages downward.

Product Market:

Large corporations may cut out­put rather than prices.

Output is determined by demand in the product market.

Employment is determined by the intersection of AS and AD (by demand for final output).

Aggregate supply can be horizontal.

Background to the Keynesian Theory of Employment:

Keynes attempted to establish the point that the level of real national income and employment is de­termined largely by the level of aggregate effective demand. This is in sharp contrast to the classical as­sumption that supply creates its own demand. In Keynesian model, the causation (sequence) is just re­versed.

It is demand which determined how much is produced and supplied. If business firms observe that they are producing more than what consumers and other firms can absorb at current price, they will be faced with a peculiar problem: involuntary increase in their inventories of finished goods.

They will be forced to cut back production and thus throw workers out of jobs. National income will continue to fall until and unless the volume of what is produced (aggregate supply or income) is equal to the value of aggregate demand (expenditure).

If firms produced more than what is required to satisfy current demand, they will observe an undesired fall in the inventories. They will thus attempt to increase production and more work­ers will automatically be employed.

It logically follows that there will be only one level of national income at which aggregate demand is equal to the total value of production. This is called the equilibrium level of income. It may be noted that the equilibrium level of income is not necessarily the full employment level of income.

Now aggregate demand which determines the level of employment has two major components: con­sumption demand and investment demand. Since in­come determination, i.e., finding out the equilibrium level of income depends on aggregate demand, we must study its components in details.

This will enable us to study the Keynesian model fully and understand the nature of the multiplier. So we have to develop the analytical tools of income and employment theory first and proceed to the modern income determination model therefore.