Q.Explain Keynes's theory of income and employment determination.
John Maynard Keynes, writing in response to the Great Depression, rejected the classical view (Say's Law) that a market economy automatically gravitates to full employment. In its place he put the principle of effective demand.
Effective demand is the level of aggregate demand at which entrepreneurs' expected sales proceeds (the aggregate demand price) equal their expected costs of production (the aggregate supply price). At this point, firms have no incentive to expand or reduce output further, so the level of output — and correspondingly the level of employment — actually offered in the economy is fixed. Crucially, this equilibrium level of income need not correspond to full employment: it can settle at a level with involuntary unemployment, because nothing in Keynes's model guarantees that aggregate demand will be exactly high enough to employ every willing worker.
The formal model. In the simplest two-sector economy (households and firms, no government), aggregate demand is . Consumption follows the consumption function , where is autonomous consumption, is the marginal propensity to consume (MPC), and investment is treated as autonomous (). Equilibrium income is where output equals aggregate demand:
The multiplier. A rise in autonomous investment (or, by the same logic, government spending) raises income by more than the initial rise, because the extra income earned is partly re-spent in successive rounds. This magnified effect is the investment multiplier:
Why unemployment can persist. Two features of the real world, absent from classical theory, explain why effective demand can settle below full employment: (i) saving and investment decisions are made by different economic agents (households vs. firms) for different motives, so there is no guarantee they will be equal at the full-employment level of income; and (ii) wages and prices are sticky downward in practice (due to contracts, trade unions, social convention), so the labour market does not automatically clear the way classical theory assumed.
Policy implication. Since private consumption and investment may not generate enough effective demand on their own, Keynes argued that the government should use fiscal policy — increasing its own expenditure, or cutting taxes — to raise aggregate demand and pull the economy back toward full employment, even if this means running a budget deficit in the short run. This is the theoretical justification for active government intervention in the economy, a sharp departure from the classical laissez-faire position.
Keynes's theory determines income and employment at the point where aggregate demand (C+I) equals aggregate output — effective demand — which can settle below full employment because saving and investment need not be automatically equal and wages/prices are sticky. A change in autonomous spending changes income by the multiplier 1/(1-MPC), which is why Keynes recommended active government fiscal policy to raise employment during a slump.
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