Iems: Keynes’s Theory of Employment

Keynes’s Theory of Employment

Classical economists were of the view that there is always full employment in the economy or there is always a tendency towards full-employment in the economy. This view of them was based upon their belief in Say’s Law of Markets. They thought that when there is unemployment in the economy, then, given the free and perfect competition in the economy, certain economic forces automatically operate in such a way that the condition of full-employment is restored. During the period 1929-33, there occurred great depression in the capitalist countries which caused huge unemployment of labour and other resources in those countries and as a result level of national income fell down.

Due to this depression many factories were closed in these countries and factories which were working were also not being used to their full productive capacity. In other words, there appeared a good deal of excess productive capacity in these economies. As a result of unemployment, low income and production created by depression, people had to undergo a good deal of sufferings. This condition of depression and unemployment did not seem to disappear automatically

Therefore, people’s belief in the classical economic thought regarding the tendency to full-employment was shaken. Thus, the classical theory of full employment was proved empirically wrong. In this background, Keynes wrote his book “General Theory of Employment. Interest and Money” in which he challenged the validity of the classical theory of employment: Not only did he criticise the classical theory of full- employment and proved it wrong but also presented a new theory of income and employment which is generally believed to be correct and valid by modern economists.

Keynes brought about such a fundamental and important change in our economic thought at that time the Keynesian theory was generally known as new economics at that time. By being impressed by the fundamental and revolutionary nature of change in our economic theory by Keynes, many economists called his General Theory of Employment, Interest and Money as the Keynesian Revolution. We explain below the outline of the Keynes’s theory of employment.

We have critically examined the classical theory of employment and the Say’s law of markets on which the classical theory is based. Keynes in his eminent work “General Theory of Employment, Interest and Money” not only criticised the classical Say’s law but also propounded a new theory of income and employment. Keynes in his work put forward a more systematic and realistic analysis of the determinants of employment in an advanced capitalist economy and the factors which lead to unemployment.

Keynes tried to prove that full-employment is not the normal feature of an advanced capitalist economy and that underemployment equilibrium is its normal feature. Keynes also invented new tools and concepts of economic analysis in terms of which he propounded his theory of income and employment. These new tools and concepts are propensity to consume, multiplier, marginal efficiency of capital and liquidity preference. Here we will explain only the outline of the Keynesian theory of income and employment

It is important to note that Keynesian theory of income and employment is a short run theory because Keynes assumes that the amount of capital, the size of population and labour force, technology, efficiency of labourers, etc., does not change. That is why in Keynesian theory; the amount of employment depends upon the level of national income and production. This is because, given the amount of capital, technology and labour efficiency, increase in income and output can be obtained by employment of more labour.

Therefore, in the Keynesian short run, the higher the level of national income, the greater the amount of employment, and lower the level of national income, the lower the amount of employment. Hence the Keynes’ theory of employment determination is also the Keynes’ theory of income determination. But it is important to note that the factors that determine the level of income are the same as those that determine the level of employment; only the diagrams used to show their determination are different. It is important to note that Keynes thought that prices and wages do not adjust quickly to balance demand and supply. Therefore, in his theory of income and employment he assumes that prices remain constant.

Keynes’s Theory of Employment: Principle of Effective Demand:

At the outset, it may be noted that in Keynesian theory of income and employment determination, principle of effective demand occupies a significant place. In an advanced capitalist economy, the level of employment depends upon the level of aggregate effective demand, the greater the level of effective demand, the greater the amount of employment in the economy. How many men will be employed by an individual firm depends upon the number of persons employed which will make maximum profits.

Likewise, in the whole economy, how many men will be employed by firms or entrepreneurs in the economy depends upon the fact that they make their individual profits. In the whole economy, the amount of employment is determined by aggregate supply and aggregate demand. We will now discuss below these concepts of aggregate supply and aggregate demand functions and will show how they determine the equilibrium level of employment.

Aggregate Supply Function:

When entrepreneurs employ some people they incur some cost of production. If the proceeds obtained from the sale of output produced by a certain number of people employed is greater than the cost of production incurred, it will be worthwhile to employ them. The cost of production incurred on the employment of a certain number of labourers must be received by the entrepreneur, otherwise they will not produce and provide employment to labour.

At any given level of employment of labour, aggregate supply price is the total amount of money which all the entrepreneurs in the economy taken together must expect to receive from the sale of the output produced by the given number of labourers employed. In other words, aggregate supply price is the total cost of production incurred by employing a contain given number of labourers. It is obvious that if the cost of production incurred by the entrepreneur in employing a certain number of labourers is not covered, they will reduce the amount of employment offered.

As the amount of employment of labour increases, the total cost of production will also increase. Therefore, aggregate supply price will rise as more labour is employed to produce goods and services. Keynes’s aggregate supply function (curve) shows the relationship between the number of workers employed and the receipts which all firms in the economy must get if it is just worth employing those prices, remaining constant.

In other words, Keynes’s aggregate supply function (curve) shows the relationship between the number of workers employed and the aggregate supply price. Thus we can construct a schedule or curve of aggregate supply showing aggregate supply price at different levels of employment.

Let us now explain in detail the factors on which aggregate supply curve depends. The aggregate supply curve depends ultimately on the physical and technical conditions of production (that is, capital stock, the state of technology and the nature of production function). However, physical and technical conditions remain constant in the short-run. Hence, given these technical conditions, the level of output can be increased only by increasing employment of labour.

But, when output and employment are increased, more cost of production is incurred. Whether production is subject to the law of increasing, diminishing or constant returns, when more workers are employed to increase production, more cost has to be incurred since additional workers are to be paid wages. Hence, more workers will be employed only if the entrepreneurs must expect to receive greater revenue so as to cover the rise in cost incurred. Therefore, the aggregate supply curve slopes upward to the right.

The slope of the aggregate supply curve (function) depends on the physical or technical conditions of production. If the technical conditions are such that with the increase in output, marginal cost of production does not rise, the aggregate supply curve will be a straight line. On the other hand, if technical conditions are such that diminishing returns occur with the increase in employment of labour, marginal cost of production will rise with the increase in the level of output. This will make the slope of aggregate supply curve to increase with the increase in employment of labour.

Besides, if with the increase in employment of labour, wage rate of labour rises, the slope of aggregate supply curve will increase with the employment of more labour. It is however worth noting that Keynes thought in conditions of depression/recession when huge unemployment of labour prevailed in the economy, with the increase in labour employment to produce more, wage rate will remain constant.

Assuming that marginal cost of production rises with the increase in employment of labour, upward rising aggregate supply curve AS with increasing slope as more labour is employed is shown in Fig. 4.1. This aggregate supply curve (function) depicts rising aggregate supply price at various levels of labour employment.

We have said that the aggregate supply is determined by the physical and technical conditions prevailing in the economy, that is, the quantity and quality of labour, stock of capital and raw materials available in the economy and the state of technology. As these changes, or as production technology is improved, AS curve will also change. But in the analysis of 2
the determination of employment in the advanced capitalist economies in the short run aggregate supply curve can be assumed to be given and constant.

This is for the simple reason that in times of depression the main problem of advanced capitalist economies is how to employ idle manpower and capital resources to increase production by raising demand and not that how the productive capacity be raised by augmenting the stock of capital or by improving the techniques of production. That is why Keynes assumed the AS curve to be constant and paid greater attention to the factors determining aggregate demand.

The need of the moment in times of recession is to increase aggregate demand so that the equilibrium is achieved at full-employment level. When aggregate demand is increased, the aggregate demand curve will shift upward and it will intersect the AS curve more on the right, i.e., the number of men employed will increase.

When the full-employment level has been reached, then, given the stock of fixed capital and the prevailing technology, output and employment cannot be further increased by increasing aggregate demand. Under such conditions increase in aggregate demand will only result in inflation. In such a situation, it becomes necessary to cause a rightward shift in the aggregate supply curve by making addition to the stock of capital and effecting improvements in production technology. This will contain the inflationary pressures. In other words, efforts should be made to increase aggregate supply when full-employment level has already been achieved and the economy is in the grip of inflation.

The curve of aggregate supply price AS starts from the point of origin and slopes upward to the right. In the beginning aggregate supply price curve AS rises slowly, afterwards it rises rapidly. This curve AS shows that as the number of men employed is increased, the aggregate supply price rises slowly in the beginning and rapidly afterwards. This is because cost of production rises as more people are employed and further due to the operations of law of diminishing returns total cost of production increases at an increasing rate.

Once all the men willing to get employment are employed, then we have a state of full employment. When the state of full employment is reached further increases in aggregate demand or expenditure will be unable to increase employment further since output of goods and services cannot be increased further as no more labour is available for production after full-employment level is reached. Therefore, aggregate supply curve assumes a vertical shape after full-employment is reached. In Fig. 4.1, ONF is the level of full-employment at which aggregate supply curve assumes a vertical shape.

Dig 4.1

Aggregate Demand Function:

It is aggregate demand function which plays a more important role in the determination of employment. Aggregate demand function (curve) shows for each possible level of employment the total sum of money (proceeds) which all the firms or entrepreneurs in the economy actually expect to receive from the sale of output produced by those workers employed in the economy.

The amount of expenditure actually expected when a given number of workers are employed to produce goods and services is called aggregate demand price. Like the aggregate supply price, aggregate demand price also varies at different levels of employment. This is because at different levels of employment different income levels would be generated and at different income levels, expenditure, especially consumption expenditure, would be different.

Aggregate demand has the following four components:

(1) Consumption demand,

(2) Investment demand,

(3) Government expenditure, and

(4) Net Exports (that is, exports – import

In this introduction to the theory of employment, we confine ourselves to the consumption demand and investment demand.

Thus the factors which determine aggregate demand are the factors which determine consumption demand and investment demand. Consumption demand depends on disposable income on the one hand and propensity to consume on the other. Propensity to consume depends on some subjective factors such as willingness to save, desire to imitate others’ higher levels of living and objective factors such as price level, taxation policy of the Government, rate of interest.

Given these factors, changes in which cause a shift in the entire consumption function, the higher the level of disposable income, the greater the amount of consumption demand. As regards investment demand, according to Keynes, it is determined by rate of interest on the one hand and marginal efficiency of capital on the other. While rate of interest is more or less sticky, it is changes in marginal efficiency of capital (i. e., expected rate of return) that cause frequent changes in inducement to invest.

Marginal efficiency of capital means expected rate of profit by the entrepreneurs from the investment they propose to undertake. When prospects for profit making in future are bright, there will be more investment. If investors become pessimistic about profit earning in future, they will undertake less new investment.

But what are the factors on which business expectations about opportunities of making profits depend. The expected rate of profits (which Keynes calls marginal efficiency of capital) of business men depends on their estimates of consumer demand for goods, taxation policy of the Government, expectations regarding changes in technology. It is worth noting that it is due to the frequent changes in business expectations that investment demand is volatile. When business men become pessimistic about profit earning, investment declines which lowers aggregate demand.

On the other hand, when entrepreneurs become bullish or optimistic, they undertake new investment on a large scale which raises the level of aggregate demand of the economy. On the other hand, consumption function, according to Keynes, remains stable in the short run. However, amount of consumption demand increases as the income rises in the short run.

Therefore, we can construct a schedule or curve of aggregate demand showing different aggregate demand prices at different levels of employment. The curve of aggregate demand is shown by the curve AD in Fig. 4.1. The aggregate demand price curve also rises from left to right. It will be seen in Fig. 4.1 that when ON1 number of men are employed, the aggregate demand price is OH and when ON2 men are employed, aggregate demand price is OM.

Determination of the Equilibrium Level of Employment by Effective Demand:

In Fig. 4.1 we have shown together aggregate supply curve and aggregate demand curve. The amount of employment is measured along the X-axis and the receipts or proceeds obtained at various levels of employment are measured along the Y-axis. As said above, aggregate supply curve shows the revenue or receipts which must be received by the entrepreneurs so as to provide employment to different numbers of workers, whereas aggregate demand curve shows proceeds or receipts which entrepreneurs actually do expect to receive at different levels of employment and production.

These aggregate demand and the aggregate supply curves determine the level of employment in the economy. Given that the perfect competition prevails in the economy, then so long as opportunities to earn profits or make money exist, the entrepreneurs will increase the level of employment.

The opportunities to make profits exist if aggregate demand price is greater than the aggregate supply price for a given number of employment. For example, in Figure 4.1 at ON1 number of persons employed aggregate demand price OH exceeds aggregate supply price OC.

Therefore, it is profitable to offer employment to ON1 workers. Therefore, so long as aggregate demand price exceeds aggregate supply price, the entrepreneurs will go on employing extra workers. When at a level of employment aggregate demand price becomes equal to aggregate supply price, then after this it will be no more profitable to employ workers. Since beyond this point aggregate supply price will exceed aggregate demand price, the cost of production incurred on employing a certain number of people will not be covered. Therefore, when aggregate demand price falls short of aggregate supply price, employment of labour will fall.

Equilibrium level of employment is determined by the intersection of aggregate demand curve and the aggregate supply curve, where the amount of money which the entrepreneurs actually expect to receive from employing a certain number of workers is equal to the amount of money which they must receive. In other words, the employment of labour will be in equilibrium at the level at which aggregate demand price equals aggregate supply price.

It will be seen from Fig. 4.1 that aggregate supply curve and aggregate demand curve intersect at point E and therefore ON2 level of employment is determined. It will be noticed that at less than ON2 level of employment, aggregate demand curve AD lies above the aggregate supply curve AS showing that it is profitable to expand the amount of employment. However, beyond ON2 amount of employment, the aggregate demand curve AD lies below aggregate supply curve AS, which shows that it is no more profitable to employ extra workers beyond ON2. We, therefore, conclude that ON2is the equilibrium level of employment which will be determined by aggregate demand curve AD and aggregate supply curve AS.

Effective Demand and Determination of Employment:

We are now in a position to explain more clearly what effective demand means and how it is important for determination of employment and output in the economy. We have seen that the magnitude of employment in the economy is determined by the equilibrium between aggregate demand and aggregate supply. There is an aggregate demand function for an economy which shows aggregate demand price at varying levels of employment.

But of these varying levels of employment the aggregate demand which at a level of employment is also equal to the aggregate supply is called effective demand. In other words, effective demand is that aggregate demand price which becomes’effective1 because it is equal to aggregate supply price and thus represents a position of short-run equilibrium. There are several other points on the aggregate demand curve but what distinguishes effective demand from all these points is that at this point the aggregate demand price is equal to aggregate supply price. On all other points, aggregate demand price is either more or less than aggregate supply price.

It is thus clear that employment in the economy in the short run is determined by effective demand. The higher the level of effective demand, the greater is the volume of employment, and vice versa. Unemployment is due to the deficiency of effective demand and the basic remedy to remove this unemployment is to raise the level of the effective demand. The classical economists believed that effective demand was always large enough to ensure full employment. But Keynes proved that it was not so and that is why the phenomenon of unemployment is common in free-market capitalist economies.

Under-employment Equilibrium: The Problem of Demand Deficiency:

It is not necessary that the equilibrium level of employment is always at full employment. Equality between aggregate demand and aggregate supply does not necessarily indicate the full employment level. The economy can be in equilibrium at less than full employment or, in other words, an under-employment equilibrium can exist.

The classical economists denied that there could be an equilibrium at less than full employment, because they believed that supply would always create its own demand and therefore no problem of deficiency of aggregate effective demand would be experienced. Keynes demolished the classical thesis of full employment both on theoretical grounds and on the basis of illustrations from real life.

Dia4.2

It will be seen from Fig. 4.2 that in the situation of equilibrium at the employment level ON2 the N2NF persons remain unemployed. Thus equilibrium at E represents under-employment equilibrium (or, in other words, less than full-employment equilibrium).

It is important to note that N2NF persons are involuntarily unemployed, they are willing to work at the existing wage rates but are unable to find jobs. It is important to remember that, according to Keynes, this unemployment is due to deficiency of aggregate demand.

This unemployment will be removed and full-employment equilibrium will be reached if through increase in investment demand or increase in consumption, or increase in both, aggregate demand curve shifts upward so that it intersects the aggregate supply curve at point R as depicted in Fig. 4.2. It will be seen that, with the intersection of aggregate demand and aggregate supply curves at point R, equilibrium is established at full-employment level

According to Keynes, aggregate demand price and aggregate supply price will be equal at full- employment only if investment demand is sufficient to cover the gap between the aggregate supply price corresponding to full-employment level and the consumption expenditure out of income at the full-employment level. The view of Keynes is that when investment demand falls short of this gap between full-employment income and consumption recession occurs resulting in the emergence of involuntary unemployment.

According to him, when inducement to invest in capitalist countries declines due to the fall in marginal efficiency of capital (i.e., expected rate of profit), aggregate demand falls so that equilibrium is established at less than full-employment level. As a result, output and income of the community also fall.

Summary of Keynes’s Theory of Employment:

After explaining Keynes’s theory of employment at some length, we are now in a position to describe it in a summary form bringing out relationship between various elements or factors that go to determine the equilibrium level of employment.

1. Level of output or income of a country depends on the level of employment. Given the capital stock and technology, greater the employment of labour, the higher the level of aggregate output or national income.

2. The level of employment depends on the magnitude of effective demand which is the sum of consumption demand and investment demand at the point where supply curve aggregate intersects the aggregate demand curve.

3. Aggregate supply of an economy depends on physical and technical conditions of production. Since these factors do not change much in the short run, aggregate supply curve remains constant in the short run. Aggregate supply curve slopes upward to the right as level of employment increases. This is because with the increase in labour employment, the greater cost has to be incurred.

4. Aggregate demand in a simple Keynesian model consists of consumption demand and investment demand. Since the consumption demand increases with the increase in labour employment, aggregate demand curve also slopes upward to the right. In the Keynes’s model, investment demand is regarded as autonomous of changes in income or employment.

5. Consumption demand depends on propensity to consume on the one hand and disposable income on the other. Propensity to consume of a community does not change much in the short run. Therefore, consumption function which relates consumption demand with the level of income remains stable in the short run.

6. Investment demand depends on the rate of interest and marginal efficiency of capital. According to Keynes, rate of interest is determined by supply of money and the state of liquidity preference. Marginal efficiency of capital (i.e., expected rate of profit) depends on the expected future yields or profit expectations of entrepreneurs on the one hand and replacement cost of capital on the other.

7. According to Keynes, while rate of interest is more or less sticky it is frequent changes in profit expectations of the entrepreneurs, that is, changes in marginal efficiency of capital that cause a great deal of fluctuations in investment by entrepreneurs. Investment demand is thus highly volatile and causes recession or depression when it falls, and boom and prosperity when it increases significantly.

Involuntary Unemployment: Keynes’s Money-Wage Rigidity Model:

According to Keynes, due to money wage rigidity, that is, downward inflexibility of money wages results in involuntary unemployment of labour. The workers are rendered unemployed because at a given wage rate supply of labour exceeds demand for labour.

Keynes believed that money wage would not change sufficiently in the short run to keep the economy at full employment. Classical economists believed that money wage rate is perfectly flexible and adjusts to bring demand for and supply of labour in equilibrium and keep the economy at full employment level.

To understand money wage-rigidity which results in unemployment we have to examine why labour market does not clear through reduction in money wages, Keynes gave three reasons for the stickiness of money wage rate. It may be noted that stickiness or rigidity of money wage implies that money wage rate will not quickly change, especially in the downward direction to keep equilibrium at full employment level.

Causes of Money Wage Rigidity:

1. Money Illusion:

The first reason why firms fail to cut wages despite an excess supply of labour is that workers will resist any move for cut in money wages though they might accept fall in real wages brought about by rise in prices of commodities. Keynes attributed this to money illusion on the part of the workers. By money illusion it is meant that workers fail to realise that value of money, that is, its purchasing power in terms of commodities, changes when prices rise.

They regard money such as a rupee as something which has a stable value or purchasing power that a rupee is a rupee and a dollar is a dollar with fixed real purchasing power. Therefore, while they would strongly oppose and resist any cut in money wages, they would not resist much if their real wages are reduced through rise in prices of commodities with money wages remaining constant. Thus Keynes wrote, “Whitest workers will usually resist a reduction of money wages, it is not their practice to withdraw their labour whenever there is a rise in the price of wage goods.”

There are two reasons for existence of money illusion:

(i) First reason for the existence of money illusion is that workers of a firm or industry think that though rise in prices reduce their real wages, but that this rise in prices equally affect workers in other industries so that their relative wages as compared to those employed in other industries remain the same.

Therefore, workers who are more concerned with their relative position with other workers will strongly resist the cut in their money wages, while they will not oppose so strongly their cut in real wages through rise in the general price level.

(ii) The second reason for strong resistance to cut in money wages is that the workers blame their own employers for this, whereas they think that a cut in real wages through rise in prices in general is the outcome of the working of general economic forces over which strikes in an industry would have little effect. However, it does not necessarily m

mean that trade unions remain silent spectators if they feel that changes in Government policy adversely affect their economic interests.

From the above two reasons given for money illusion it follows that if additional employment can be created by lowering real wages, it is more practical to do so through bringing about rise in general price level rather than by cutting money wages.

2. Wage Fixation through Contracts:

In most of the free market economies such as those of USA and Great Britain, wages are fixed by the firms through contracts made with the workers for a year or two. There is little possibility of changing money wages fixed through contracts when the situation of either labour surplus or shortage emerges. For workers organised into trade unions wages are even rigid.

Through collective bargaining by trade unions with the employers wage scales are fixed for 3 to 4 years by contract. Money wages cannot be changed when either surplus or shortage of labour emerges during the period of the contract. Trade unions of workers never accept wage cuts even if some of union workers remain unemployed. Thus the sticky or rigid money wages lead to the existence of involuntary unemployment. This means that labour market does not clear in the short run.

3. Minimum Wage Laws:

Another reason for money wage rigidity or, what is also called money-wage stickiness, is the intervention by the Government in fixing minimum wages below which employers are not permitted to pay wages to the workers.

4. Efficiency Wages:

Another factor which accounts for money-wage rigidity is that employers themselves are not interested in lowering wages as high wages make workers more efficient and productive. The adverse effect of lower wages on workers’ efficiency may explain the unwillingness on the part of employers to cut money wages despite the excess supply of or unemployment of workers at higher money wages.

We have explained above the practical difficulties pointed out by Keynes and his followers which are faced by firms in reducing wages and which therefore explain money-wage rigidity or stickiness. The sticky or rigid money wages above the equilibrium level cause unemployment of labour.

Price Flexibility and Rigid Money Wage: Keynes’s View of Involuntary Unemployment:

In Keynes’ contractual view of labour market, it is assumed that whereas prices are free to vary, the money wage is fixed. It is important to note that Keynesians do not believe that money wage rate is completely fixed or sticky. What do they actually mean by sticky wages is that money wages do not fall quickly to bring demand for and supply of labour in equilibrium at full employment.

In their view money wages are very slow to adjust sufficiently to ensure full employment of labour when there is a decline in aggregate demand resulting in lowering of prices of products. As a consequence, involuntarily unemployment comes into existence. It may be further noted that Keynes was particularly concerned with downward rigidity of money wages at which the demand for labour exceeds the supply of labour and consequently unemployment or excess supply of labour emerges.

It is important to note that Keynes accepted the classical theory of labour demand according to which firms demand labour up to the point at which real wage rate (that is, money wage rate divided by the price level or, W/P) is equal to the marginal product of labour. At a higher real wage rate, less amount of labour will be demanded and, at a lower real wage rate, more labour will be demanded or employed. In other words, demand curve of labour is downward sloping. Keynes’ theory of involuntary unemployment based on price flexibility and money wage rigidity is deplicted in Figure 4.3.

Dia 4.3

In panel (b) of Fig. 4.3 short-run aggregate supply curve AS and aggregate demand curve AD0 have been drawn and through their interaction determine price level P0 and the level of real GNP equal to Y0. It is important to note that short-run aggregate supply curve AS has been drawn with a given fixed money wage rate, say W0. In panel (a) of Figure 4.3 the level of labour employment N0 shows the number of jobs when the economy is producing Y0 level of national output in panel (b) corresponding to the equilibrium between aggregate supply AS and aggregate demand AD0 at price level P0, with a fixed money wage and the level of GNP equal to Y0. The labour market must be in equilibrium at point E0 or real image rate W0/P0 at which N0 workers are demanded and employed. All those who are willing to get jobs at the real wage rate W0/P0 are in fact demanded and employed. Thus, equilibrium at E0 or at level of employment N0 represents full-employment equilibrium.

Now consider again panel (b) of Fig. 4.3 suppose due to fall in marginal efficiency of capital there is reduction in investment demand which along with its multiplier effect causes a leftward shift in the aggregate demand curve AD. Since Keynes believed that with a fixed money wage rate aggregate supply curve AS is given and remains unchanged, it will be seen from panel (b) of Fig. 4.3 that new aggregate demand curve AD1 and the fixed aggregate supply curve AS intersect at point K determining new equilibrium lower price P1 and smaller real GNP equal to Y1. Keynes asserted that the economy would remain stuck at point K with less than full-employment level of output Y1 and lower price level P1 Now, a glance at panel (a) of Fig. 4.3 shows that with fixed money image W0 and lower price level P1 (P1 < P0), the real wage rate rises to W0/P1.

It will be seen from panel (a) of Fig. 4. 3 that at this higher real wage rate W0/P1 the smaller amount of labour N1 will be demanded and employed by all firms in the economy. However, at this higher wage rate W0/P1 (with money wage rate fixed at W0), RT number of workers are rendered unemployed. It is in this way that Keynes explained that with money wage rate remaining fixed at the level W0 and with flexible prices, the fall in aggregate demand results in persistent involuntary unemployment. Thus, by explaining the emergence of persistent involuntary unemployment Keynes made a fundamental departure from the classical view of a free market economy which denied the existence of involuntary unemployment except for a short time.

Consumption Function: Concept, Keynes’s Theory and Important Features!

Introduction:

Given the aggregate supply, the level of income or employment is determined by the level of aggregate demand; the greater the aggregate demand, the greater the level of income and employment and vice versa.

Keynes was not interested in the factors determining the aggregate supply since he was concerned with the short run and the existing productive capacity. We will also not explain in detail the factors which determine the aggregate supply and will confine ourselves to explaining the determinants of aggregate demand.

Aggregate demand consists of two parts—consumption demand and investment demand. In this article we will explain the consumption demand and the factors on which it depends and how it changes over a period of time. Consumption demand depends upon the level of income and the propensity to consume. We shall explain below the meaning of the consumption function and the factors on which it depends.

The Concept of Consumption Function:

As the demand for a good depends upon its price, similarly consumption of a community depends upon the level of income. In other words, consumption is a function of income. The consumption function relates the amount of consumption to the level of income. When the income of a community rises, consumption also rise.

How much consumption rises in response to a given increase in income depends upon the marginal propensity to consume. It should be borne in mind that the consumption function is the whole schedule which describes the amounts of consumption at various levels of income.

We give below such a schedule of consumption function:

Table

Consumption function should be carefully distinguished from the amount of consumption. By consumption function is meant the whole schedule which shows consumption at various levels of income, whereas amount of consumption means the amount consumed at a specific level of income. The schedule described above reflects the consumption function of a community i.e., it indicates how the consumption changes in response to the change in income.

In the above schedule it will be seen that at the level of income equal to Rs. 1200 crores, the amount of consumption is Rs. 900 crores. As the national income increases to Rs. 1500 crores, the consumption rises to Rs. 1125 crores. Thus, with a given consumption function, amount of consumption is different at different levels of income.

The above schedule of consumption function reveals an important fact that when income rises, consumption also rises but not as much as the income. This fact about consumption function was emphasised by Keynes, who first of all evolved the concept of consumption function. The reason why consumption rises less than income is that a part of the increment in income is saved.

Therefore, we see that when income increases from Rs. 1000 crores to Rs. 1100 crores, the amount of consumption rises from Rs. 750 crores to 825 crores. Thus, with the increase in income by Rs. 100 crores, consumption rises by Rs. 75 crores; the remaining Rs. 25 crores are saved. Similarly, when income rises from Rs. 1100 crores to Rs. 1200 crores, the amount of consumption increases from Rs. 825 crores to Rs. 900 cror

Here also, as a result of increase in income by Rs. 100, the amount of consumption has risen by Rs. 75 crores and the remaining Rs. 25 crores has been saved. The same applies to further increases in income and consumption. We shall see later that Keynes based his theory of multiplier on the proposition that consumption increases less than income and this theory of multiplier occupies an important place in macroeconomics.

Consumption demand depends on income and propensity to consume. Propensity to consume depends on various factors such as price level, interest rate, stock of wealth and several subjective factors. Since Keynes was concerned with short-run consumption function he assumed price level, interest rate, stock of wealth etc. constant in his theory of consumption. Thus with these factors being assumed constant in the short run, Keynesian consumption function considers consumption as a function of income. Thus

C= f(Y)

In a specific form, Keynesian function can be written as:

C = a + f(Y)

where a and b are constants. While a is intercept term of the consumption function, b stands for the slope of the consumption function and therefore represents marginal propensity to consume.

Keynesian consumption function has been depicted by CC’ curve in Fig. 6.1 in which along the X-axis national income is measured and along the Y-axis the amount of consumption is measured. In this figure, a line OZ making 45° angle with the X-axis, has been drawn. Because line OZ makes 45° angle with the X-axis every point on it is equidistant from both the X-axis and Y-axis.

Therefore, if consumption function curve coincides with 45° line OZ it would imply that the amount of consumption is equal to the income at every level of income. In this case, with the increase in income, consumption would also increase by the same amount.

As has been said above, in actual practice consumption increases less than the increase in income. Therefore, in actual practice the curve depicting the consumption function will deviate from the 45° line. If we represent the above consumption schedule by a curve, we would get the propensity to consume curve such as CC in Fig. 6.2

It is evident from this figure that the consumption function curve CC’ deviates from the 45° line OZ. At lower levels of income, the consumption function curve CC lies above the OZ line, signifying that at these lower levels of income consumption is greater than the income.

It is so because at lower levels of income, a nation may draw upon its accumulated savings to maintain its consumption standard or it may borrow from others. As income increases, consumption also increases and at the income level OY0, consumption is equal to income.

Dia 6.1

Beyond this, with the increase in income, consumption increases but less than the increase in income and therefore, consumption function curve CC lies below the 45° line OZ beyond Y0. An important point to be noted here is that beyond the level of income OY0, the gap between consumption and income is widening. The difference between consumption and income represents savings. Therefore, with the increase in income, saving gap also widens and as we shall see later, this has a significant implication in macroeconomics.

fig 6.2

It is useful to point out here that when the consumption function of a community changes, the whole consumption function curve changes or shifts. When propensity to consume increases, it means that at various levels of income more is consumed than before.

Therefore, as a result of increase in propensity to consume of the community, the whole consumption function curve shifts upward as has been shown by the upper curve C’C’ in Fig. 6.2. On the contrary, when the propensity to consume of the community decreases, the whole consumption function curve shifts downward signifying that at various levels of income, less is consumed than before.

Average and Marginal Propensity to Consume:

There are two important concepts of propensity to consume, the one being average propensity to consume and the other marginal propensity to consume. They should be carefully distinguished, for they are equal in some cases but different in others. Consider Table 6.1, where we have calculated the average and marginal propensity to consume in columns 3 and 4. As seen above, consumption changes as income change

Now, how much consumption changes in response to a given change in income depends upon the average and marginal propensity to consume. Thus, propensity to consume of a community can be known by the average and marginal propensity to consume. Average propensity to consume is the ratio of the amount of consumption to total income. Therefore, average propensity to consume is calculated by dividing the amount of consumption by the total income. Thus,

APC = C/Y, where

APC stands for average propensity to consume,

C for amount of consumption, and

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F for the level of income.

In the Table 6.1 it will be seen that at the level of income Rs 1000 crores, consumption expenditure is equal to Rs. 750 crores. Therefore, average propensity to consume is here equal to 750/1000 = 0.75. Likewise, when the income rises to Rs. 1200 crores, consumption rises to Rs. 900 crores.

Therefore, the average propensity to consume will be 900/1200 = 0.75. In this schedule of consumption function, the average propensity to consume is the same at all levels of income. Keynesian consumption function CC is shown in Fig. 6.3.

Dia 6.3

Average propensity to consume at a point on the consumption function curve can be obtained by measuring the slope of the ray from the origin to that point. For example, at income level OY1 corresponding point on the consumption function curve is A. Therefore, at OY1 income level, average propensity to consume (APC) is the slope of the ray OA.

Similarly, at income level OY2, average propensity to consume is the slope of the ray OB. It will be observed from Fig.6.3 that slope of OB is less than that of OA. Therefore, average propensity to consume at income level OY2 is less than that at income level OY1. In other words average propensity to consume has declined with the increase in disposable income.

Non-Linear Consumption Function: Average and Marginal Propensity to Consume:

In the consumption function depicted in Fig. 6.3, though average propensity to consume (C/Y) declines, marginal propensity to consume which equals ΔC/ΔY remains constant since consumption function curve CC’ is a straight line and therefore its 6

slope (ΔC/ΔY) is constant.

But it is not necessary that marginal propensity to consume should be the same at all levels of income. We have constructed below another schedule of consumption function in which marginal propensity to consume declines with the increase in income.

Dia 6.4

It will be seen from Table 6.2 that at the level of income of Rs. 100 crores, marginal propensity to consume is 0.9, and when income rises to Rs. 1500 crores, the marginal propensity to consume has declined to 0.5. When with the increase in income both marginal propensity to consume and average propensity to consume decline, then the curve of consumption function is not a straight line but has a shape as shown in Fig. 6.4.

From any point on the propensity to consume curve CC we can find out average propensity to consume by joining that point with the point of origin by a straight line whose slope will measure the average propensity to consume.

In Fig. 6.4, if we have to find out average propensity to consume at point A on the consumption function curve CC’, we connect point A with the origin by a straight line. Now, the slope of the line OA i.e., AY1/OY1 will indicate the average propensity to consume.

Similarly, at point B of the given consumption function CC’, the average propensity to consume will be given by the slope of the line OB which is equal to BY2/OY2. The glance at the figure will show that the slope of the line OB is smaller than the slope of the line OA. Therefore, average propensity to consume at point B or at income level OY2 is less than that at point A or income level OY1.

Table 6.2. Non-Linear Consumption Function: Average and Marginal Propensity to Consume:

Table 6.2

Marginal Propensity to Consume:

The concept of marginal propensity to consume is very important, because from it we can know how much part of the increment in income is consumed and how much saved. Marginal propensity to consume is the ratio of change in consumption to the change in income.

Thus:

MPC = ΔC/ΔY

where, MPC stands for marginal propensity to consume,

ΔC for change in consumption, and

ΔY for change in income.

Marginal propensity to consume needs to be carefully distinguished from average propensity to consume. Whereas average propensity to consume is the ratio of total consumption to total income, i.e., C/Y, the marginal propensity to consume is the ratio of change in consumption to the change in income, i.e. ΔC/ΔY.

The concept of marginal propensity to consume can be easily understood with the aid of Table 6.2, in column 4 of which we have calculated the marginal propensity to consume at various levels of income. In this schedule when income rises from Rs. 1000 crores to Rs. 1100 crores, the consumption increases from Rs. 950 crores to Rs. 1040 crores. Here the increment in income is Rs. 100 crores and the increment in consumption is Rs. 90 crores. Therefore, marginal propensity to consume which is ΔC/ΔY is here equal to 90/100 or 0.9.

Similarly, when national income rises to Rs. 1200 crores and as a result consumption increases from Rs. 1040 crores to Rs. 1120 crores, the marginal propensity to consume is now equal to 80/100 or 0.8. In Table 6.2, it will be seen that marginal propensity to consume declines as the income rises.

It is worth noting that when with the increase in income average propensity to consume declines, marginal propensity to consume is less than average propensity to consume. This is- in accordance with the usual relationship between the average and marginal quantities. This is evident from Table 6.2.

Dia 6.5

But when average propensity to consume remains constant as in Table 6.1, marginal propensity to consume is equal to it. In Table 6.1, average propensity to consume remains constant at 0.75 and from its 4th column it will be seen that marginal propensity to consume is also 0.75.

Marginal propensity to consume can be estimated by drawing the tangent at a point on the consumption function. Consider Fig. 6.5 where curve CC depicting the consumption function has been drawn. Marginal propensity to consume at point A on this will be equal to the slope of the tangent tt’ drawn at this point.

Similarly, marginal propensity to consume at point B on it is given by the slope of the tangent JJ’ drawn at this point. It will be seen that slope of the tangent JJ’ is less than the slope of the tangent tt’. Therefore, marginal propensity to consume at point B on the consumption function CC in Fig. 6.5 is smaller than the marginal propensity to consume at point A on this consumption function.

Thus, marginal propensity to consume is declining with the increases in income in the non-linear consumption function curve CC in Fig. 6.5. Thus when marginal propensity to consume declines with the increase in income, consumption function is non-linear whose slope declines as income rises. Non-linear consumption function is shown in Fig. 6.5 where the slope of the propensity to consume curve CC declines as income increases.

In Fig. 6.1 and Fig. 6.3 propensity to consume curve is a straight line i.e., the slope of the consumption function curve remains constant. Therefore, marginal propensity to consume which is given by the slope of the propensity to consume curve remains constant in Fig. 6.1.

It is worth noting that marginal propensity to consume is neither zero nor equal to one. It has been found by empirical studies that marginal propensity to consume varies between zero and unity. If the marginal propensity to consume was zero, then the whole of the increment in income would have been saved and the consumption function curve would have a horizontal shape.

As we have seen before, this is not so realistic. On the other hand, if the marginal propensity to consume was equal to unity, then the whole of the increment in income would be consumed and in that case consumption function curve would have coincided with 45° line.

Saving Function:

As mentioned above, consumption increases as income increases but less than the rise in income. We will now explain what happens to saving when income increases. Saving is defined as the part of income which is not consumed because disposable income is either consumed or saved.

Thus,

Y = C + S

S = Y – C

where Y = Disposable income, C = Consumption, S = Saving

Like consumption, saving is also a function of income. Thus, saving function can be written as

S= f(Y)

Saving function is a counterpart of a consumption function, Therefore, given a particular consumption, function, we can derive the corresponding saving function. Let us take the Keynesian consumption, namely, C = a + bY. We can derive saving function corresponding to it.

Since Y = C + S

S = Y – C

Now, substituting the above Keynesian function for C in (i) we have

S = Y – (a + bY)

= Y – a – bY

= – a + Y – bY

= – a + (1 – b) Y

Note that (1 – b) in the above saving function in (ii) is the value of marginal propensity to save where b is the value of marginal propensity to consume. Let us give a numerical example. Suppose the following consumption function is given.

C = 150 + 0.80 Y

S = Y – C

Substituting the given consumption function for C we have

S = Y – 150 – 0.80 Y

= – 150 + Y – 0.80 Y

= 150 + (1 – 0.80) Y

= – 150 + 0.20 Y

Note that 0.20 represents marginal propensity to save. It also follows from above that the sum of marginal propensity to consume and marginal propensity to save is equal to one (MPC + MPS – 1). It is important to distinguish between average propensity to save and marginal propensity to save.

Average propensity to save:

An important relationship between income and saving is described by the concept of average propensity to save. (APS). Average propensity to save is the proportion of disposable income that is saved (i.e. not consumed). Mathematically

APS = Savings/Disposable Income = S/Y

Like the average propensity to consume (APC) average propensity to save also generally varies as income increases. As seen above, average propensity to consume (APC) falls as income increases. This implies that average propensity to save will increase as income rises.

Let us derive an important relationship between average propensity to consume and average propensity to save.

Restating below the relation that income is either consumed or saved:

C + S = Y

Dividing both sides by disposable income Y we have

C/Y + S/Y + Y/Y = 1

Since C/Y is average propensity to consume and S/Y is average propensity to save, we have

APC + APS = 1

or APS = 1 – APC

This means for example, that if a society consumes 75 per cent of its disposable income, that is, APC = 0.75, then it will save 25 per cent of its disposable income or its average propensity to save (APS) will be 0.25 (1 – 0.75 = 0.25).

In Fig. 6.6 we have drawn the saving curve SS in the panel at the bottom. The saving curve SS shows the gap between consumption curve CC and the income curve OZ in the upper panel of Fig. 6.6. It will be seen that up to income level OY1 consumption exceeds income, that is, there is dissaving.

Beyond income level OY1, there is positive saving. It is worth mentioning that as average propensity to consume (APC) falls with the increase in income in the upper panel average propensity to save rises as income increases. Thus with the increase in income not only the absolute amount of saving increases, the average propensity to save also increases.

Dia 6.6

Marginal Propensity to Save (MPS):

Whereas average propensity to save indicates the proportion of income that is saved, marginal propensity to save represents how much of the additional disposable income is devoted to saving. The marginal propensity to save is therefore change in savings induced by a change in the disposable income.

Thus,

MPS = ΔS/ΔY

For example, if disposable income increases from rupees 10,000 to 12,000 and this causes planned savings to increase by Rs. 500 crores, marginal propensity to save is:

MPS = 500/2000 = 1/4 = 0.25

Since the additional income is either consumed or saved, the sum of marginal propensity to consume and marginal propensity to save is equal to one.

MPC + MPS = 1

This can be mathematically proved as under

From C + S = Y, it follows that any change in income (AF) must induce either change in consumption (AC) or change in saving (AS). Thus.

ΔC + ΔS = ΔY

Dividing both sides by ΔY we have

ΔC/ΔY + ΔS/ΔY = ΔY/ΔY = 1

MPC + MPS = 1

The concept of marginal propensity to save is graphically shown at the bottom of Fig. 6.6. It will be seen from this figure that when disposable income increases from OY1 (say Rs. 10,000) to OY2 (say Rs. 12,000), that is, ∆Y = Rs. 2000, the saving increases by Y2T, (Rs. 500), that is, ΔS is Rs. 500. Thus marginal propensity to save (MPS) is

ΔS/ΔY = Y2T/Y1Y2 = 500/2000 = 1/4 = 0.25

Keynes’s Theory of Consumption:

Keynes in his “General theory”, published in 1936, laid the foundations of modern macroeconomics. The concept of consumption function plays an important role in Keynes’ theory of income and employment. Keynes mentioned several subjective and objective factors which determine consumption of a society. However, according to Keynes, of all the factors it is the current level of income that determines the consumption of an individual and also of society.

Since Keynes laid stress on the absolute size of current income as a determinant of consumption, his theory of consumption is also known as absolute income theory of consumption. Further, Keynes put forward a psychological law of consumption, according to which, as income increases consumption increases but not by as much as the increase in income. In other words, marginal propensity to consume is less than one.

1> ΔC/ΔY>0

While Keynes recognized that many subjective and objective factors including interest rate and wealth influenced the level consumption expenditure, he emphasised that it is the current level of income on which the consumption spending of an individual and the society depends.

To quote him:

“The amount of aggregate consumption depends mainly on the amount of aggregate income. The fundamental psychological law, upon which we are entitled to depend with great confidence both a priori from our knowledge of human nature and from (the detailed facts of experience is that men (and women, too) are disposed, as a rule and on an average to increase their consumption as their income increases, but not by as much as the increase in their income.”

In the above statement about consumption behaviour, Keynes makes three points. First, he suggests that consumption expenditure depends mainly on absolute income of the current period, that is, consumption is a positive function of the absolute level of current income. The more income in a period one has, the more is likely to be his consumption expenditure in that period. In other words, in any period the rich people tend to consume more than the poor people do. Secondly, Keynes points out that consumption expenditure does not have a proportional relationship with income.

According to him, as the income increases, a smaller proportion of income is consumed. The proportion of consumption to income is called average propensity to consume (APC). Thus, Keynes argues that average propensity to consume (APC) falls as income increases.

The Keynes’ consumption function can be expressed in the following form

C = a + bYd

where C is consumption expenditure and Yd is the real disposable income which equals gross national income minus taxes, a and b are constants, where a is the intercept term, that is, the amount of consumption expenditure at zero level of income. Thus, a is autonomous consumption. The parameter b is the marginal propensity to consume (MPC) which measures the increase in consumption spending in response to per unit increase in disposable income. Thus

MPC = ΔC/ΔY

Since the average propensity to consume falls as income increases, the marginal propensity to consume (MPC) is less than the average propensity to consume (APC). The Keynesian consumption function is depicted in Figs. 6.3.

In Fig. 6.3 we have shown a linear consumption function with an intercept term. In this form of linear consumption function, though marginal propensity to consume (ΔC/ΔY) is constant, average propensity to consume is declining with the increase in income as indicated by the slopes of the lines OA and OB at levels of income Y1 and Y2 respectively. The straight line OB drawn from the origin indicating average propensity to consume at higher income level Y2 has a relatively less slope than the straight line OA drawn from the origin to point A at lower income level Y1.

The decline in average propensity to consume as the income increases implies that the proportion of income that is saved increases with the increase in national income of the country. This result also follows from the studies of family budgets of various families at different income levels. The fraction of income spent on consumption by the rich families is lower than that of the poor families. In other words, the rich families save a higher proportion of their income as compared to the poor families.

The assumption of diminishing average propensity to consume is a significant part of Keynesian theory of income and employment. This implies that as income increases, a progressively larger proportion of national income would be saved. Therefore, to achieve and maintain equilibrium at full-employment level of income, increasing proportion of national income is needed to be invested.

If sufficient investment opportunities are not available, the economy would then run into trouble and in that case it would not be possible to maintain full-employment because aggregate demand will fall short of full-employment output. On the basis of this increasing proportion of saving with the increase in income and consequently, the emergence of the problem of demand deficiency, some Keynesian economists based the theory of secular stagnation on the declining propensity to consume.

Determinants of Propensity to Consume:

The important question is on what factors the propensity to consume of a community depends. In other words, what are the factors that determine the level and position of the propensity to consume or the consumption function? Keynes divided the factors determining the propensity to consume into two groups: the first group of factors was called by him as subjective factors and the second group was named by him as objective factors. We shall explain below in detail these subjective and objective factors which affect the consumption function of a community.

Subjective Factors:

Among the subjective factors are included those factors which induce and prompt people to save some part of their income. First, people save because they want to provide for unforeseen contingencies, such as illness, unemployment, accidents, etc. Secondly, people are induced to save because they want to provide for the expected future needs such as education of the children, marriages of their children, etc.

Thirdly, several people wish to save from their current incomes so that they may be able to use accumulated savings for investment which will increase their future income. Investments will bring them more income in the form of more profits and interest. Fourthly, people are motivated to save so that they can accumulate large wealth which will increase their social status.

With increased wealth they would think themselves to be economically more independent and they could buy many things with more wealth. Further, many individuals also save so that they can use them for speculative purposes and other business projects.

Besides, several people are prompted to save for the sake of leaving a good fortune for their heirs and children. Lastly, many people save because of their miserly instinct and habits. The accumulation of more wealth gives them a great psychic satisfaction.

The above subjective factors increase the propensity to save and therefore reduce the propensity to consume. These subjective factors play a crucial rule in determining the level and shape of the consumption function. However, Keynes pointed out and rightly so that some subjective factors raise the propensity to consume.

The desire for ostentation generally leads to greater consumption expenditure. People have a natural in stint to imitate others’ consumption habits. As pointed out by Duesenberry, people in lower and middle income ranges imitate the consumption standards of the higher income groups and this increases their propensity to consume. This has been called demonstration effect which is a great subjective or psychological force that works in raising the propensity to consume.

Subjective factors also lead the business firms to save much or little from their incomes.

Many of the subjective factors which influence the savings of the firms are the following:

(1) Enterprise:

Many business industrial firms desire to save a part of their current income so that they can make investment in new enterprises and carry out expansion in the future. Business firms generally save a good part of their income for their further expansion.

(2) Liquidity:

Business firms also are induced to save so that they can face contingencies in the future. If they have good amount of liquid wealth in their hands, they would be able to meet the emergent situations more successfully. More cautious and farsighted firms will save more than others on this count.

(3) Successful Management:

Many managers of the business firms are motivated to save more because they want prove themselves successful managers. With the investment of the saved money, the income of a firm increases and their managers are regarded as successful.

(4) Financial Prudence:

Business firms desire to save for making up the depreciation in plant and machinery. Since after some years

business firms have to replace their plant and machinery, if a good part of their current income is not saved, it would not be possible for them to replace plant and machinery.

If the firms put aside a greater part of their income for depreciation or replacement purposes, they would pay lower dividends to the shareholders and this will generally lower the propensity to consume of a community.

On the other hand, if the firms keep a relatively small amount for depreciation, they will pay larger amounts as dividends to the shareholders and this will generally increase the propensity to consume of the community. Lastly, firms also want to save because they have to repay their debts.

Objective Factors:

Keynes mentioned the following six types of objective factors which influence the consumption function:

(1) Changes in the General Price Level: Real Balance Effect:

The general price level is an important factor which influences the consumption of a community. When the general price level increases or, in other words, when inflation occurs, the consumption function shifts downward. This is because the rise in the general price level, real value (that is, purchasing power) of people’s money balances and financial assets with fixed monetary values declines.

This causes a downward shift in the consumption function. This is called real balance effect. Similarly, when the general price level falls, real value of money balances and financial assets increases. This will induce people to consume relatively more out of their current income. This will cause an upward shift in the consumption function.

(2) Fiscal Policy:

Fiscal policy of the Government, especially taxation policy affects the propensity to consume of the country. By levying excise duties, sales tax, the Government can cut down the consumption and thereby increase savings of the community.

Likewise, when the Government reduces taxes, consumption of the people increases and this raises the propensity to consume. Rationing and price control by the Government also affects the propensity to consume, as was witnessed during the Second World War.

In the modern times, pursuing of the welfare state policy by the Government under which progressive taxes have been levied on the rich people and the revenue obtained from them have been spent to provide many social security benefits and amenities to the poor people, has tended to raise the consumption function.

(3) Rate of Interest:

Rate of interest also affects the propensity to consume and save. It is generally believed that higher rate of interest induces the people to save more and this results in reducing their propensity to consume. But this is not true in the case of all the people. Some individuals are of such a type who wants a certain fixed income in the future.

And when the rate of interest rises these individuals consume more and save less because with higher rate of interest they can obtain the given fixed income with lesser savings. Therefore, when the rate of interest rises such individuals save less than before. Thus, it cannot be said with certainty whether with the changes in the rate of interest the propensity to consume of the whole community will change or not.

(4) Stock of Wealth:

The stock of wealth owned by the households in the economy is also an important factor that determines propensity to consume. In wealth we include not only real assets such as land, houses, automobiles but also financial assets such as cash balances, saving and fixed deposits with banks, stocks and bonds possessed by households. The greater the amount of wealth accumulated by households in the economy, the greater is generally the propensity to consume (i.e. the greater the amount of consumption out of any level of current income).

The important motive of the people to save is to accumulate wealth. Generally speaking, the greater the wealth which people have accumulated, the weaker is the incentive to save further. In other words, the other things remaining the same the increase in wealth generally causes an upward shift in the consumption function and decrease is wealth causes a downward shift in the consumption function.

An important example which is often cited to emphasise the importance of wealth as a determinant of consumption is the stock market crash of 1929 in England (i.e. drastic fall in share prices) which substantially reduced the financial wealth of the households overnight resulting in shifting the consumption function downward.

(5) Credit Conditions and Consumer Indebtedness:

The availability of easy credit causes an increase in consumption and shifts the consumption function upward. It is now a common experience in India that in recent years lowering of lending interest rates by Indian banks on loans for houses, cars, computers and other durable consumer goods has greatly increased the consumption of the people and shifted consumption function upward.

On the other hand, tightening of credit produces an opposite effect, that is, causes a downward shift in the consumption function, Furthermore, the recent increase in facilities of Credit Cards by banks and their acceptance buy sellers of consumer goods have also worked to shift the consumption function upward in India.

Similarly, the level of consumer indebtedness also greatly affects the propensity to consume of the people. If the households are heavily indebted, say 25 to 30 per cent of their current, they are committed to save (i.e. consume less) to that extent so that they are able to pay their installments of previous credit taken. Thus, the greater the degree of indebtedness of households in the economy, the higher will be the consumption function curve and vice versa.

(6) Income Distribution:

Lastly, distribution of income in a society also determines the level of consumption function. If national income is more unequally distributed, the lower will be the propensity to consume. This is because propensity to consume of the rich is relatively less as compared to that of the poor. Therefore, if inequalities in income distribution increase, this reduces the consumption out of any given level of national income and thus causes a downward shift in the consumption function.

(7) Windfall Gains and Losses:

Windfall gains and losses also affect the propensity to consume. When the prices of the shares go up, the shareholders begin to think themselves better off and this raises their consumption. On the other hand, when the prices of the shares go down, the shareholders have to suffer sudden losses and they begin to think themselves relatively poorer than before. This induces them to reduce their consumption. We thus see that the windfall gains and losses affect the propensity to consume.

(8) Change in Expectations:

Changes in the expectations of the people also influence the propensity to consume. When people expect that war will break out in the near future and they expect prices to go up, then they will try to spend more on goods so as to meet the needs of the immediate future.

This raises the consumption function in the current period. On the other hand, when people expect the prices to fall they reduce their current consumption so that they should spend more when the prices actually fall.

We have explained above various subjective and objective factors which taken together determine the consumption function of a community. It is worth noting that propensity to consume does not generally change in the short run, because it depends more on psychological and institutional factors which change only in the long run.

The institutional factors which determine the distribution of income in the society are important forces determining the consumption function. And these institutional factors do not change in the short run. Therefore, Keynes was of the view that consumption function remains stable in the short run.

Important Features of Keynes’ Consumption Function:

In macroeconomics, Keynes’s consumption function plays a highly important role. Therefore, it is essential to state its important features.

The following are the important features of Keynes’s consumption function:

1. First, absolute level of current income is the important factor that determines consumption of the community. Increase in national income causes an increase in consumption. On the other hand, classical economists thought that it was rate of interest that primarily determined saving and consumption of the community. A rise in rate of interest induces the people to save more and thus to reduce their level of consumption.

According to Keynes, though rate of interest is one of the factors that determine consumption of the community, he did not consider it a very important determinant of it. By considering level of current income as the most important factor determining consumption and saving, Keynes made a significant contribution to the macroeconomic theory.

2. The second important feature of Keynes’ consumption function is that marginal propensity to consume is less than one but greater than zero (0 < MPC < 1). As has been explained above, the feature of Keynes’s consumption function that marginal propensity to consume is less than one is known as Keynes’s psychological law of consumption. According to this law, as income increases, consumption increases but not as much as the increase in income.Keynes’s theory of multiplier is based on the marginal propensity to consume being less than one but greater than zero.

3. In Keynes consumption function, namely, C = a + by, as income increases, average propensity to consume (APC) falls. Keynes was of the view that rich people relatively save a higher proportion of their income so that at higher levels of income average propensity to consume (APC), that is, proportion of total consumption to national income falls as national income rises.

4. Another important feature of consumption function as put for

forward by Keynes is that it remains stable in the short run. Consumption function, according to Keynes, depends on various institutional factors such as distribution of income and wealth and psychological factors such as willingness to save.

Since there cannot be much changes in these institutional and psychological factors, consumption function remains stable in the short run, that is, it does not shift upward or downward. Therefore, Keynes in his theory explains the determination of income and employment in the short run by considering that the consumption function is stable

We shall critically examine Keynes’s consumption function and compare it with other theories of consumption function.

Consumption Function Puzzle: Keynes’ Consumption Function and Kuznets Findings:

Empirical studies of long-term times series data of the US economy for the period 1869- 1938 made by the noted American economist Kuznets estimated a consumption function which contradicts Keynes’ consumption function which was found to be correct on the basis of cross- section studies of household budget data and short-term time series data.

This contradiction between Kuznets empirical findings and Keynes’ consumption function has been called consumption function puzzle. Efforts have been made by several economists to resolve this puzzle and new theories of consumption function have been put forward to resolve the conflict between Keynes’s consumption function and Kuznets’s findings.

To compare the Keynes’ and Kuznets’s consumption functions, it will be useful to write them in algebraic form and graphically represent them.

Keynes’s consumption function can be algebraically written as below:

C = a + bY

where a is a positive intercept term which is also called autonomous consumption as it does not vary with income. The constant a shows that even when income is zero, a certain consumption is present. This is possible when in any year a community can live either on its past savings or borrow from other communities. Keynes’ consumption function is shown in Fig. 6.7.

Secondly, b in the consumption function represents marginal propensity to consume (ΔC/ΔY). The above mentioned Keynes’s consumption function (C = a + bY) shows that average propensity to consume (C/Y) falls as income increases. This can be known by comparing slopes of the rays OA an OB at income levels Y1 and Y2 respectively in Fig. 6.7.

Kuznets’s Consumption Function:

On the other hand, Kuznets found that consumption function is of the following form:

C = bY

Dia 6.8

In Kuznets’ consumption function there is no intercept term (that is, autonomous consumption). This is shown in Fig. 6.8 where it will be seen that Kuznets consumption function curve starts from the origin and is very near to 45° line depicting that the propensity to consume (b) is very high. From his empirical study Kuznets estimated that average propensity to consume was nearly 0.9.

Besides, by dividing the entire period (1869-1933) into three over lapping 30 years sub-periods Kuznets found that the proportion of consumption to income (that is, average propensity to consume) was nearly the same and equal to about 0.87 in all the three sub-periods.

Thus Kuznets concluded that there was no tendency for the average propensity to consume to decline as disposable income rises. Thus, rounding off Kuznets estimated propensity to consume is equal to 0.9. His consumption function presented in equation (2) can be rewritten as

C = 0.9 Y

From the above discussion it follows that implication of Keynes’s consumption function (C = a + bY) and Kuznets consumption function (C = bY) are different. Whereas in Keynes’ consumption function APC falls as income rises, in Kuznets’s function it remains constant over a long period. Further, the value of marginal propensity to consume which is less than one is much higher in Kuznets’s function as compared to that of Keynes.

The reconciliation between two types of consumption functions has been made by some economists by pointing out that whereas Keynes’s function is short-run consumption function Keznets’s function is concerned with long run and is referred to as long-run consumption function. In the long run, short run consumption function curve shifts above and therefore in the long run consumption function, propensity to consume is higher as compared to that in the short run.

Further, Friedman’s permanent Income Hypothesis and Modigliani’s Life Cycle Hypothesis have also tried to reconcile the two functions by referring to the short-run and long-run consumption behaviour of the people. We will discuss these consumption hypotheses in the appendix.

Importance of Consumption Function:

The concept of consumption function is greatly important both in theory and actual practice. To remove unemployment and to control economic fluctuations in the economy, it is very essential to adopt a proper macroeconomic policy. In the formation of such a policy, understanding of the concept of propensity of consume is very essential. Therefore, Prof. A.H. Hansen has remarked that “consumption function is epoch-making contribution of Keynes to economic theory”.

We shall explain below some of the theoretical and practical importance of this consumption function:

(1) The concept of consumption function helps us to invalidate Say’s law of classical economics. In fact, Keynes relied on his consumption function for proving the invalidity of Say’s law. According to Say’s law, every supply creates its own demand and therefore there is no problem of deficiency of aggregate demand. Therefore, general overproduction and unemployment in the economy is not possible because adequate amount of aggregate demand is ever present. Now, according to the Keynesian consumption function, when income increases consumption increases less than the increase in income and therefore saving gap emerges between income and consumption.

This saving gap implies that all output produced may not be sold and the problem of deficiency of demand will arise unless this saving gap is matched by an equal amount of investment demand. There is no guarantee that the saving done will be automatically invested or, in other words, it is not necessary that investment demand will be equal to the saving gap. Thus, the contention of the Say’s law that every supply creates its equal demand is not valid. No doubt, every supply or production creates income equal to the output produced.

But since all income is not consumed and there is no guarantee that investment will be equal to the saving so emerged, Say’s law is proved invalid. When investment is less than the saving gap corresponding to full-employment level of income, the aggregate demand is not sufficient to provide full-employment to the people and other resources. Thus, the problem of deficiency of effective demand and hence general unemployment and overproduction arises in a free enterprise capitalist economy.

(2) The concept of propensity to consume is also important because it brings out crucial significance of investment demand for determination of the level of income and employment in a capitalist economy. From the concept of propensity to consume we know that consumption increases less than the increase in income and as a result gap emerges between income and consumption.

To maintain a certain given level of income and employment, gap between income and consumption at that level must be bridged by investment expenditure otherwise it will not be possible to maintain that level of income and employment because aggregate demand would not be large enough.

This indicates the crucial importance of the investment demand in the determination of income and employment. To prevent the establishment of underemployment equilibrium in the economy or, in other words, for achieving full-employment equilibrium, investment demand must be equal to the saving gap at the level of full-employment. Keynes also showed that consumption function remains stable in the short run and therefore economic fluctuations in a capitalist economy are largely due to the fluctuations in investment demand.

Thus from the concept of propensity to consume it follows that investment demand is vitally important in determining the level of income and employment. If it were possible to raise the propensity to consume in the short run, then without raising investment, we could have raised the level of income and employment. Since propensity to consume at a given level of income generally remains stable, we have to increase investment for achieving full employment in the economy

(3) Another crucial importance of the concept of propensity to consume is that we derive the theory of multiplier from it which has great practical importance in the formulation of macro-economic policy, especially of public works in times of depression.The magnitude of multiplier is equal to the reciprocal of one minus marginal propensity to consume (K = 1/1-MPC) where K stands for multiplier and MPC for marginal propensity to consume. According to this concept of multiplier, when investment increases, income, output and employment increase by a multiple amount, depending upon the size of the multiplier.

Income increases manifold than the original investment because of the nature of consumption function. When some investment in some projects is undertaken, it leads to the increase in income of those employed in the projects but the process does not stop here.

The increases in income are further spent on consumption and this leads to further increase in income and so the chain of increases in income and consumption continues and the ultimate increase in income and employment is multiple of the original increment in investment.

If the marginal propensity to consume were equal to zero, then all increments in income brought about by additional investment would have been saved and therefore multiplier process would not have 10

worked. Since the marginal propensity to consume is greater than zero, the increase in net investment has a multiplier effect on income, output and employment. Thus, the effect of investment on income depends on the size of the multiplier which depends on the value of the marginal propensity to consume. The greater the marginal propensity to consume, the greater the size of the multiplier.

(4) From the concept of consumption function, we can also explain why there is a tendency for the marginal efficiency of capital to decline. The declining tendency of the marginal efficiency of capital is due to the nature of the consumption function. Two features of consumption function are important. First, the marginal propensity to consume is less than one which implies that as income increases, consumption increases less than this. Secondly, consumption function is stable in the short run i.e., it does not shift much in the short run.

As we know that the level of investment is a crucial factor in the determination of income and employment, fluctuations in the levels of income and employment depend primarily on the fluctuations in investment. The investment demand in the short run is determined by the rate of interest on the one hand and marginal efficiency of capital on the other. Since the rate of interest is relatively sticky, it is the marginal efficiency of capital which greatly affects the level of investment in the short run.

Marginal efficiency of capital is nothing but the expected rate of profit on investment in the future. Thus, the marginal efficiency of capital is determined by the expectations of the entrepreneurs regarding the earning of profits from capital assets in the future.

Now, the most, important fact that affects the entrepreneurs expectations regarding profit prospects and thereby the marginal efficiency of capital is the level of future consumption demand for goods and services. Their estimate of future consumption demand depends on, among others, on the population growth. If population growth of a country is expected to fall as was estimated in the early thirties when Keynes wrote his book (General Theory of Employment, Interest and Money), this would adversely affect future consumption demand which in turn would adversely affect investment in the long run, Besides, according to Keynes, average propensity to consume (APC) falls as income of a community increases overtime.

This also adversely affects inducement to invest. If there does not occur capital-using technological change, this will result in decline in investment opportunities in the long run, causing secular stagnation. Thus we see that in the Keynesian scheme of things level of investment depends upon the level of consumption demand in the long run.

Since marginal propensity to consume is less than one and also the consumption function is stable when income increases, consumption does not increase proportionately. As a result, the aggregate demand becomes deficient and the marginal efficiency of capital declines. The decline in the marginal efficiency of capital adversely affects investment which stops rising. As a result, the growth process stops and economic recession occurs.

In this way, Keynes himself and later important Keynesian economist, Prof. A.H. Hansen developed the theory of secular stagnation for the mature capitalist economies. This secular stagnation theory is based upon the assertion that investment opportunities in a capitalist economy will be exhausted soon due to the absence of the possibilities of increasing consumption demand. The meagre possibilities of increasing investment in the mature capitalist economies, according to them, were partly due to the constancy of consumption function and declining average propensity to consume which caused the marginal efficiency of capital to decline.

Theory of secular stagnation has not been found true by empirical evidence in the last over seventy years of growth in the capitalist developed countries. However, the fact that current consumption is influenced by changes in rate of interest, stock of wealth and price level and further that it is the changes current consumption level that determine short-run business expectations about future yields from investment which cause fluctuations in investment.

Together with the working of multiplier fluctuations in investment cause business cycles in a free market economy. This shows the great importance of Keynes’s consumption function and the factors that determine it.

(5) As has been explained above, Keynesian concept of propensity to consume also helps us in explaining the turning points of a business cycle. The economy swings down from the peak it reaches because with marginal propensity to consume being less than one and average propensity to consume falling consumption demand does not increase as much as the increase in income and output. Over time this causes deficiency in aggregate demand which adversely affects investment demand by private business men.

Likewise, economy’s downward movement stops and it starts recovery because marginal propensity to consume being less than one, people do not reduce their consumption as much as the reduction in their income. Even during depression people try to maintain their previous level of consumption. This ultimately induces investment for replacement of capital goods which wear out over a period of business cycle. With the working of Keynesian investment multiplier recovery from recession gathers momentum.

Iems

Friday, April 17, 2020

Keynes’s Theory of Employment

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