FOR SOLVED PREVIOUS PAPERS OF INDIAN ECONOMIC SERVICE KINDLY CONTACT US ON OUR WHATSAPP NUMBER 9009368238
FOR SOLVED PREVIOUS PAPERS OF ISS KINDLY CONTACT US ON OUR WHATSAPP NUMBER 9009368238
FOR BOOK CATALOGUE
CLICK ON WHATSAPP CATALOGUE LINK https://wa.me/c/919009368238
Keynesian Theory of Employment and Output
1. Introduction
📌 The Keynesian Theory of Employment and Output was developed by John Maynard Keynes in his 1936 book, The General Theory of Employment, Interest, and Money. Keynes challenged classical economic theories, which assumed that markets naturally adjust to full employment.
🔹 Key Ideas:
✔ Demand drives output and employment, not supply.
✔ Markets are not always self-correcting; unemployment can persist.
✔ Government intervention is necessary to boost demand and ensure full employment.
🚀 Why is it important? Keynes’ theory shaped modern macroeconomics and influenced policies during economic downturns like the Great Depression and the 2008 financial crisis.
2. Criticism of Classical Theories
📌 Before Keynes, Classical economists (like Adam Smith and David Ricardo) believed in Say’s Law, which states: “Supply creates its own demand.”\text{“Supply creates its own demand.”}
✔ They argued that market forces automatically lead to full employment through wage and price adjustments.
✔ If unemployment existed, wages would fall, making labor cheaper, encouraging firms to hire more workers.
🔹 Keynes’ Critique:
❌ Wages are “sticky” – Workers resist wage cuts, leading to persistent unemployment.
❌ Uncertainty causes low investment – Businesses may not invest, even if interest rates fall.
❌ Demand shortages can persist – Consumers may not spend enough to buy all the goods produced.
3. Keynesian Theory of Employment and Output
📌 Keynes argued that employment and output depend on aggregate demand (AD), not just supply-side factors.
✔ Total output (Y) is determined by total demand for goods and services.
✔ If demand is low, firms reduce production and lay off workers, leading to unemployment.
✔ The government must stimulate demand to restore full employment.
📌 Key Equation: Y=C+I+G+(X−M)Y = C + I + G + (X – M)
where:
- CC = Consumption
- II = Investment
- GG = Government spending
- (X−M)(X – M) = Net exports (exports – imports)
✔ If AD is low, output (Y) falls, leading to unemployment.
✔ If AD increases, firms produce more, creating jobs.
🚀 Example: During the Great Depression, businesses cut production because demand was low, leading to massive unemployment. Keynes argued that the government should increase spending to boost demand.
4. Components of Aggregate Demand (AD)
📌 Keynes identified four major components that influence total demand:
🔹 1. Consumption (C)
✔ Households spend money based on their income.
✔ The Marginal Propensity to Consume (MPC) determines how much of extra income is spent.
📌 Equation: C=C0+cYC = C_0 + cY
where:
- C0C_0 = Autonomous consumption (spending even if income = 0)
- cc = MPC (fraction of additional income spent)
- YY = National income
🚀 Example: If a worker earns $100 extra and spends $80, the MPC = 0.8.
✔ If people save too much, demand falls, leading to low output and unemployment (Paradox of Thrift).
🔹 2. Investment (I)
✔ Businesses invest in capital (machines, buildings) based on:
- Expected profits 📈
- Interest rates 📉
✔ Keynes’ insight: Investment is volatile and depends on business confidence (Animal Spirits).
🚀 Example: During a recession, firms expect low profits and stop investing, worsening unemployment.
🔹 3. Government Spending (G)
✔ Government intervention is necessary when private demand is weak.
✔ Keynes argued that the government should increase spending (G) to stimulate demand.
🚀 Example: During the 2008 financial crisis, the US government introduced stimulus packages to boost spending.
✔ Multiplier Effect: ΔY=11−MPC×ΔG\Delta Y = \frac{1}{1 – MPC} \times \Delta G
✔ A $10B increase in government spending can increase total income (Y) by more than $10B.
🔹 4. Net Exports (X – M)
✔ If exports rise (more foreign demand), AD increases.
✔ If imports rise (money leaves the economy), AD falls.
🚀 Example: A weak domestic currency boosts exports, increasing demand and employment.
5. Keynesian Unemployment and the Role of Policy
📌 Why does unemployment exist?
✔ In recessions, firms cut production, leading to “involuntary unemployment”.
✔ Even if wages fall, businesses won’t hire unless demand increases.
🔹 1. Fiscal Policy
✔ Keynes recommended higher government spending and lower taxes to boost demand.
✔ Government projects (e.g., infrastructure, public services) create jobs.
🚀 Example: The New Deal (1930s) increased public works spending, reducing unemployment.
✔ Criticism: Increases in government spending may cause debt if not managed properly.
🔹 2. Monetary Policy
✔ Lower interest rates encourage borrowing and investment.
✔ Keynes was skeptical about monetary policy in severe recessions (liquidity trap).
🚀 Example: In Japan (1990s), low interest rates failed to boost spending due to lack of consumer confidence.
✔ Criticism: If interest rates are near zero, monetary policy becomes ineffective.
6. Keynes vs. Classical Economics
| Feature | Classical Theory | Keynesian Theory |
|---|---|---|
| Role of Government | Minimal (Laissez-Faire) | Active intervention needed |
| Unemployment | Short-term, wages adjust | Can persist for long periods |
| Say’s Law | Supply creates demand | Demand drives supply |
| Focus | Long-run growth | Short-run demand management |
| Price/Wage Flexibility | Flexible, adjusts quickly | Sticky, slow to adjust |
| Policy Recommendation | Free markets | Fiscal and monetary policies |
7. Keynesian Model in Action
📌 Keynesian policies are used during economic downturns.
🚀 Examples:
✔ Great Depression (1930s): Keynesian policies (New Deal) helped revive the economy.
✔ 2008 Financial Crisis: Governments increased spending and cut interest rates.
✔ COVID-19 Pandemic: Stimulus packages provided direct cash transfers and business support.
✔ Criticism:
❌ High government spending may cause inflation and debt.
❌ Assumes that government intervention is always effective, which is not always true.
8. Conclusion
✔ The Keynesian Theory revolutionized economics by showing that demand drives output and employment.
✔ Keynes argued that markets are not always self-regulating and that government intervention is needed.
✔ Fiscal policy (government spending and taxation) is the most effective tool for managing recessions.
✔ Keynesian ideas continue to influence economic policies worldwide, especially during crises.