1

Module 2
Theory of Employment and Consumption and Investment function

1. Classic assumption

The classical economists had, in their approach to macroeconomics issues, assumed certain macro
aspects of the economy to be given. They provided deductive logic but little empirical support to
their views on macroeconomic issues. Their views were called by Keynes as ‘postulates of the
classical economics.
The main postulates of the classical economics are described below.

I. There is Always Full Employment

The classical economists postulated that all employable resources—labour and capital—of a country are
always fully employed in the long run. If there is unemployment at any time, then there is a tendency
towards full employment, provided there is no external or government interference with the
functioning of the economy.

In the classical view, full employment does not mean that all the resources are fully employed—there
might be frictional and voluntary unemployment in the state of full employment.

II. The Economy is Always in the State of Equilibrium

The classical economists postulated that an economy is always in the state of equilibrium. They believed
that full employment of resources generates incomes, on the one hand, and goods and services, on the
other. The value of goods and services is always equal to incomes generated through the process of
production.
The income earners spend their entire income on goods and services produced. This implies that the
entire output of goods and services is sold out. There is no general overproduction and there is
no general underproduction over a period of production.

In the Keynesian terminology,

In the classical system, the aggregate demand is always equal to aggregate supply in the long run, and
the economy remains in stable equilibrium.

The classical postulates of full employment and equilibrium of the economy are based on the
assumption that the economy works on the principles of laissez-faire. The laissez-faire system has
the following features:

(i) There is no government control or regulation of private enterprises, if any, it is limited to

ensure free competition;

(ii) There are no monopolies and restrictive trade practices—if there are any, they are eliminated
by law;
 2

(iii) There is complete freedom of choice for both the consumers and the producers; and

(iv) Market forces of demand and supply are fully free to take their own course depending on
the demand and supply conditions

III. Money does not Matter

The classical economists treated money only as a medium of exchange. In their opinion, the role of
money is only to facilitate the transactions. It does not play any significant role in determining the output
and employment.
The levels of output and employment are determined by the availability of real resources, that is, labour
and capital.

SAY’S LAW: THE FOUNDATION OF CLASSICAL

MACROECONOMICS

Say’s law states that “supply creates its own demand” or “supply calls forth its own demand.”
The logic behind this law is that supply of goods itself generates sufficient income to generate a
demand equal to the supply of goods. This is how supply creates its own demand. The significance
of this simple law is that it is regarded as the core of ‘classical’ macroeconomic thought.

This law can be explained in the context of both a Barter System and A Monetised Economy.

In a barter economy, people tend to specialise in the production of goods or services which they
can produce relatively more efficiently, though they consume many other goods and services. They
acquire other goods and services they consume in exchange for their own produce. When they
offer their produce in barter for other goods, they create demand for other goods

in this kind of an economy, there cannot be overproduction or underproduction. The reason is,
in a barter economy, people produce goods for own consumption. They produce what they consume and
they produce as much as they consume.

Say’s law applies equally well to the Monetized Economy. Unlike barter system, money is used
as medium of exchange in an monetized economy, that is, goods are bought and sold with the use
of money. In an monetized economy, the logic of ‘supply creates its own demand’ works somewhat
differently.

It follows that if there is production, there is income, and if there is income, there is demand for
goods including demand for goods whose production creates income. Thus, supply creates its own
demand in a market economy.

Two Major Conclusions of Say’s Law

No General Overproduction or Underproduction

The classical reformulation of Say’s law states

 3

In a capitalist economy, total supply always equals total demand and that there cannot be
‘general underproduction’ or ‘general overproduction.’ In the opinion of classical economists,
underproduction and overproduction, if any, are only transitory. Underproduction and overproduction,
if ever, are caused by external factors, i.e., foreign factors affecting the economy, and are
always minor and temporary. That is, there might be short-term imbalances in the demand for and
supply of some goods and services caused by the exogeneous factor. The short-term demand supply
imbalance is corrected and equilibrium restored in a capitalist economy by the market forces.
When there is underproduction, demand exceeds supply. Excess demand leads to rise in prices
which reduces demand, on the one hand, and encourages supply, on the other. Similarly, when there
is overproduction, prices tend to decrease. Decrease in price results in decrease in supply, on the
one hand, and increase in demand, on the other. This process of demand-and-supply adjustment
restores the equilibrium. Thus, in the long run, a market economy will always be in equilibrium.
A simple proof of the ‘classical’ long-run equilibrium can be described as follows.

No Unemployment Under Classical System

As mentioned earlier, classical economists postulated that, in a capitalist economy, full employment is a
normal affair. It means that there cannot be general unemployment in a capitalist economy. In their
opinion, full employment ensures that actual output equals the potential output. Full employment
coincides with equilibrium level of output. In classical view, total production is always sufficient to
maintain the economy at the level of full employment in a free market economy. Unemployment, if any,
is a temporary phenomenon.
Whenever there is unemployment, wages decrease. Decrease in wage rates makes employment of
labour more profitable. This results in increase in demand for labour and unemployment disappears.

However, classical economists did not rule out the existence of voluntary and frictional unemployment
in the state of full employment.

In their opinion, voluntary unemployment arises when:

(a) potential workers are unwilling to work at the prevailing wage rate or at a slightly lower
wage rate,
(b) workers go on strike (unpaid) for higher wages,
 4

(c) rich persons are unwilling to work, that is, the idle rich,
(d) some persons prefer leisure or idleness to better life, that is, the case of very poor,
mendicants, sadhus and sanyasins.

Frictional unemployment arises when workers remain temporarily out of job due to labour
market imperfections, immobility of labour, seasonal nature of occupation as in agricultural activities,
technological changes, natural calamities, wars, and so on.
The existence of voluntary and frictional unemployment was consistent with the classical postulate
of full employment.

CLASSICAL THEORY OF EMPLOYMENT: A FORMAL

MODEL OF SAY’S LAW

The classical model of employment as reconstructed by Keynesians consists of two components:

(i) Aggregate production function, and

(ii) Labour supply and labour demand functions

The Aggregate Production Function

The aggregate production function is central to the classical model as it determines simultaneously
the aggregate output and employment. According to the classical economists, the national output
of a country at any point in time depends on the capital and labour employed. The aggregate
production function used in the reconstructed classical model can be expressed as:

Y = f ( K, L)

where Y = aggregate real output, K = capital (fixed), and L = amount of labour (homogeneous) required to
produce Y.
 5

The classical production function (5.1) assumes

(i) the stock of capital (K) is fixed,
(ii) technology of production used by the firms is given, and
(iii) population is constant.

Obviously, classical production function has been constructed in a short-run framework. The
national output in the short-run is therefore the function of the employment of labour drawn from
the constant population. The model assumes also that the use of successive units of labour is subject
to the law of diminishing returns

In other words, marginal productivity of labour, defined as MPL = ∆Y/∆L, decreases with
an increase in employment.
According to the classical view, the level of output at which MPL = 0
marks the level of maximum possible level of employment and national output.
 6

The Labour Market: Labour Supply and Demand

According to the classical theory of employment, the level of full employment is determined by the
equilibrium of the labour market. The level of full employment is determined where labour supply equals
labour demand. In fact, equilibrium levels of both employment and wage rate are determined
by the equilibrium of the labour market. Equilibrium of the labour market is illustrated by labour
supply and labour demand curves. Therefore, before we explain the determination of employment
in the neo-classical model, let us explain the derivation of the labour supply and demand curves.
7
8
 9

The MRPL curve represents the labour demand curve. As this curve show, labour demanded
increases with decrease in the wage rates. For example, if real wage rate per day is Rs 80, the
demand for labour is 2 workers as at this employment level MRPL = MW. Similarly, if wage rate
decreases to Rs 40 per day, demand for labour increases to 4 workers. The labour demand curve
will now be used, along with labour supply curve, to explain the determination of the labour
employment and output.
 10

An important feature of the classical model is that factors operating on the supply side of the
market determine the level of employment and output. As shown above, labour market equilibrium
is determined by the demand for and supply of labour. The labour demand curve is, however,
derived from the production function based on a given technology determined exogenously. The
labour demand curve is therefore, in a sense, a datum, i.e., a given fact or law. According to
classical theory, it is the labour supply, which is a function of real wages, that plays a more
important role in the determination of the labour market equilibrium and employment. And,
employment determines the level of output. Thus, in the classical model, employment and output are
determined solely by the factors operating on the supply side of the labour market.

The Collapse of the Classical Economics

The classical economics prevailed until the Great Depression and it had prevailed because it was
never put to test by big changes in economic conditions over time. However, the Great Depression
proved that the very basic postulates of the classical economics were fundamentally wrong. Look
at the two basic postulates of the classical economics.
 11

One of the fundamental postulates of the classical economics is that if there is perfect competition
in both product and labour markets, then
(i) the economy is always in equilibrium, and if some
external forces create disequilibrium, market forces of demand and supply bring it soon back to
the equilibrium, and
(ii) there is always full employment, and unemployment, if any, is either frictional or voluntary, i.e., those
who are unwilling to work at the prevailing wage rate would remain unemployed.
The second basic postulate of the classical economics is the Say’s law that, ‘supply creates its
own demand’. It implies that the aggregate demand is always equal to aggregate supply and there
is no demand deficiency, except for a short period of disturbance.
It is ironical that classical thoughts and theories failed to hold when classical postulates were
really in existence in the world economy. If market conditions were ever close to the classical
perception of perfect competition, it was between the First World War and the Great Depression.
Yet, the Great Depression took place.

2. Keynesis theory of Employment

THE CONCEPTS AND FUNCTIONS

3. The Aggregate Supply Function

 12

The Aggregate Demand Function: Two-sector Model

The Consumption Function

The consumption function is one of the most important functions used in macroeconomics and the
most important function used in the Keynesian theory of income determination. A consumption
function is a functional statement of relationship between the consumption expenditure and its
 13

The Linear Aggregate Consumption Function

Although Keynes postulated a non-linear consumption function, it is now a convention in the modern
interpretation and analysis of Keynesian macroeconomics to use a linear aggregate consumption function
of the following form.
C = a + bY
14
15
16
17
 18

Graphical Presentation of Income Determination

The determination of national income in a two-sector model based on the numerical example given
above is presented graphically in Fig. 6.6. The AS-schedule represents the aggregate supply curve. It gives
a hypothetical growth path
 19

of national income on the assumption that the society spends its entire income on consumer and
capital goods, that is, the aggregate expenditure is always equal to the aggregate supply. In reality,
however, the households consume a part of their income and save a part of it. Their savings may
not always find a way to investment. For, households’ plan to save may not always match with
firms’ plan to invest. Therefore, savings may not always be equal to investment. This means that
the aggregate demand may not always equal the aggregate supply.
20
 21

THE CHANGE IN AGGREGATE DEMAND AND

THE MULTIPLIER

In the preceding sections, we have explained the Keynesian theory of income and output determination
in a simple two-sector model. It may be inferred from the income determination analysis that
a change in aggregate spending will shift the equilibrium from one point to another and a shift in

the equilibrium will reflect change in the level of national income. An increase in aggregate spending
makes the aggregate demand schedule shift upward. As a result, the equilibrium point would shift
upward along the AS schedule causing an increase in the national income. Likewise, a fall in the
aggregate spending causes a fall in the national income. This relationship between the aggregate
spending and the national income is simple and straightforward. However, our analysis so far tells
us only the direction of change in the national income resulting from the change in the aggregate
demand. It does not quantify the relationship between the two variables, i.e., it does not tell us the
magnitude of change in the national income due to a given change in the aggregate spending.

The two specific questions that need to be answered are: (i) Is there any specific relationship
between the change in aggregate demand and the change in the national income? and (ii) If yes,
then what determines this relationship and the magnitude of change in the national income? The
answer to these questions is provided by the theory of multiplier. The theory of multiplier occupies
a very important place in the analysis of national income behaviour in response to the changes in
its determinants. It is also an important tool to analyse the effects of changes in the monetary and
budgetary policies of the government.
Before we begin our discussion on the multiplier theory, let us note that a shift in the aggregate
demand in a modern economy may be caused by the change in business investment, government
spending, taxes, export and import. Accordingly, we have investment multiplier, government expenditure
multiplier, tax multiplier, balanced budget multiplier, fiscal multiplier, export multiplier and
import multiplier. In this section, we are concerned with change in aggregate demand due to change
in business investment and investment multiplier
22
23
24
 25

The process through which paradox of thrift works to reduce savings is the process of reverse
multiplier because increased saving is virtually a withdrawal from the circular flow of income. This
implies that savings are not invested either because there is full employment or people do not want
to invest due to high rate of risk. This leads to inverse multiplier. If people decide to increase their
savings by cutting down their consumption expenditure, demand for consumer goods and services