Keynesian Theory of Income and Employment

Keynes's break from the classical view

In his 1936 work The General Theory of Employment, Interest and Money, John Maynard Keynes rejected Say's Law directly. He argued that savings and investment are undertaken by different sets of people for different motives — households save out of habit, caution or for future needs, while firms invest based on expected profitability — and there is no automatic mechanism guaranteeing that planned investment will equal planned saving at the full-employment level of income. He also observed that in a modern economy wages and prices are "sticky" downward (held up by contracts, trade unions and social convention), so the labour market does not clear itself the way classical theory assumed. The result is that an economy can settle into an equilibrium with involuntary unemployment — a state where willing workers cannot find jobs at the going wage, and it persists because nothing in the system pushes it back to full employment on its own.

The principle of effective demand

The central concept of Keynesian theory is effective demand — the point of intersection of the Aggregate Demand (AD) function and the Aggregate Supply (AS) function, at which entrepreneurs' expected sales proceeds just equal their expected costs of production. Effective demand is the level of aggregate demand that entrepreneurs actually expect to realise, and it is this expected demand — not any automatic "supply creates its own demand" identity — that determines how much output firms choose to produce and, therefore, how much employment they offer. Because effective demand can settle at a level below what is needed for full employment, an economy can remain stuck in under-employment equilibrium indefinitely unless something raises aggregate demand.

A simple two-sector income model

In the simplest closed economy with no government (two sectors — households and firms), aggregate demand is the sum of consumption and investment expenditure:

Consumption is assumed to depend on the level of income through the consumption function:

where $a$ is autonomous consumption (spending that occurs even at zero income), $b$ is the marginal propensity to consume (MPC) — the fraction of an extra rupee of income that is spent on consumption — and $Y$ is national income. Investment $I$ is treated as autonomous, i.e., independent of the current level of income, denoted $\bar{I}$.

Equilibrium income is where aggregate demand equals aggregate output (income):

Solving for $Y$:

The investment multiplier

An increase in autonomous investment does not raise income by an equal amount — it raises it by a multiple, because the additional income earned by the first round of spending is itself partly re-spent, generating a second round of income, and so on, in a diminishing chain. The investment multiplier ($k$) measures this magnified effect:

where MPS (marginal propensity to save) is the fraction of extra income that is saved, so that $MPC + MPS = 1$. The higher the MPC (the smaller the leakage into saving at each round), the larger the multiplier, and the greater the eventual rise in income for a given initial increase in investment.

Paradox of thrift …