Chapter 2 income and employment

1. Income and Employment

2. Presented By:
Md. Shaifullar Rabbi
BBA & MBA (Major in THM,FBS,DU)
Coordinator & Lecturer
Dept. of Tourism & Hospitality Management
Daffodil Institute of IT(NU)

3. Income and Employment Theory
Income and employment theory, a body of economic
analysis concerned with the relative levels of output,
employment, and prices in an economy. By defining the
interrelation of these macroeconomic factors,
governments try to create policies that contribute to
economic stability.
Two Important Theories of Income and Employment: Two
important theories of income and employments are:
1. Classical Theory of Income and Employment
2.2. Keynesian Theory of Income and Employment!

4. Classical Theory of Income and Employment
The theory is ascribed to early
Classical economists like Adam
Smith, Ricardo, and Malthus and
neo-classical like Marshall, Pigou
and Robbins.
They believe-
1. An economy, as a whole, always
function at level of full
employment
2. Supply creates it own demand
3. Flexible system of prices, interest

5. Keynesian Theory of Income and Employment
With this background, Keynes, a British
Economist, propounded his own theory and in
1936, brought out his famous book “General
Theory of Income, Interest and Money” which
brought about a revolution in economic
thought. This led to the emergence of
Macroeconomics as a separate branch of
economics.
1. An economy can be equilibrium even at less
than full employment level
2. Demand creates its own supply
3. Equilibrium of income and employment is
determined by aggregate demand and
aggregate supply

6. Effective Demand
Effective demand represents that aggregate demand or
total spending (consumption expenditure and investment
expenditure) which matches with aggregate supply
(national income at factor cost).
In other words, effective demand is the signification of the
equilibrium between aggregate demand (C+I) and
aggregate supply (C+S). This equilibrium position (effective
demand) indicates that the entrepreneurs neither have a
tendency to increase production nor a tendency to
decrease production. It implies that the national income
and employment which correspond to the effective
demand are equilibrium levels of national income and
employment.

7. Determinants of Income
The determinants of effective demand and so of equilibrium level of
national income and employment are the aggregate demand and
aggregate supply.
(1)Aggregate Demand : Aggregate demand refers to the sum of
expenditure, households, firms and the government is undertaking on
consumption and investment in an economy. The aggregate demand
price is the amount of money which the entrepreneurs expect to
receive as a result of the sale of output produced by the employment
of certain number of workers.
(2)Aggregate Supply : The aggregate supply refers to the flow of output
produced by the employment of workers in an economy during a short
period. In other words, the aggregate supply is the value of final output
valued at factor cost. The aggregate supply price is the minimum
amount of money which the entrepreneurs must receive to cover the

8. Determination of Level of Employment and Income
According to Keynes, the equilibrium levels of national income
and employment are determined by the interaction of
aggregate demand curve (AD) and aggregate supply curve
(AS). The equilibrium level of income determined by the equality
of AD and AS does not necessarily indicate the full employment
level. The equilibrium position between aggregate demand and
aggregate supply can be below or above the level of full
employment as is shown in the curve.
In figure (32.3), the aggregate demand curve (C+l), intersects
the aggregate supply curve (OS) at point E1 which is an effective
demand point. At point E1, the equilibrium of national income is
OY1. Let us assume that in the generation of OY1 level of income,
some of the workers willing to work have not been absorbed. It
means that E1 (effective demand point) is an under employment
equilibrium and OY1 is under employment level of income.
The unemployed workers can be absorbed if the level of output
can be increased from OY1 to OY2 which we assume is the full
employment level. We further assume that due to spending by
the government, the aggregate demand curve (C+I+G) rises. As
a result of this, the economy moves from lower equilibrium
point E1 to higher equilibrium point E2. The OY is now the new
equilibrium level of income along with full employment. Thus E2
denotes full employment equilibrium position of the economy.
Thus government spending can help to achieve full
employment. In case the equilibrium level of national income is
above the level of full employment, this means that the output
has increased in money terms only. The value of the output is

9. Importance of Effective Demand
The principle of effective demand is the most important contribution of J.M. Keynes. Its
importance in macro economics, in brief, is as under:
(i) Determinant of employment. Effective demand determines the level of employment in
the country. As effective demand increases employment also increases. When effective
demand falls, the level of employment also decreases.
(ii) Say's Law falsified. It is with the help of the principle of effective demand that Says Law
of Market has been falsified. According to the concept of effective demand whatever is
produced in the economy is not automatically consumed. It is partly saved. As a result,
the existence of full employment is not possible.
(iii) Role of investment. The principle of effective demand explains that for achieving full
employment level, real investment must equal to the gap between income and
consumption. In other words, employment cannot expand, unless investment expands.
Therein lies the importance of the concept of effective demand.
(iv) Capitalistic economy. The principle of effective demand makes clear that in a rich
community, the gap between income and expenditure is large. If required investment is
not made to fill this gap, it will lead to deficiency of effective demand resulting in
unemployment.

10. Criticism on Keynesian Theory
From mid 1970 onward, the Keynesian theory of employment came under
sharp criticism from the monetarists. Milton Frsadman, the Chief advocate
of monetarists rejected the Keynesianism as a whole. The monetarists
returned back to the old classical theory for the explanation of the rise in
general price level and stated that inflation is always and every where a
monetary phenomenon.
The monetarists are of the view that J. M. Keynes laid more emphasis on
the determinants of aggregate demand and to a greater extent ignored
the determinants of aggregate supply. The monetarists encouraged the
supply side policy and thus favored free enterprise economy for solving
the problems of unemployment and inflation.
J. R. Hicks describes Keyne's 'General Theory' as depression economics.
Further, the 'General Theory of Keynes is applicable to the developed
economies. The Keynesians concepts are not very useful for policy

11. What is considered full employment in
the United States?
A government or economy often defines full
employment as any rate of unemployment
below a defined number. If, for example, a
country sets full employment at a 5%
unemployment rate, any level of unemployment
below 5% is considered acceptable. Full
employment, once attained, often results in an

12. Policies that help to achieve full employment
1. The Federal Reserve Board needs to target a full employment with wage growth
matching productivity: The most important economic policy decisions being made about
job growth in the next few years are those of the Federal Reserve Board as it determines
the scale and pace at which it raises interest rates.
2. Targeted employment programs : Even at 4 percent unemployment, there will be many
communities that will still be suffering substantial unemployment, especially low-wage
workers and many black and Hispanic workers. To obtain full employment for all, we will
need to undertake policies that can direct jobs to areas of high unemployment.
3. Public investment and infrastructure : There is widespread agreement that we face a
substantial shortfall of public investment in transportation, broadband, R&D, and
education. Undertaking a sustained (for at least a decade) program of public investment
can create jobs and raise our productivity and growth. In the early years this program
would most effectively create jobs if we borrowed to finance it, but as we approach full
employment we can raise revenues to cover its costs.

13. Policies that do not help us reach full employment
1.Corporate tax reform: There are many false claims that corporate tax reform is needed
to make us competitive and bring us growth. First off, the evidence is that the corporate
tax rates U.S. firms actually pay (their “effective rates”) are not higher than those of other
advanced countries. Second, the tax reform that is being discussed is “revenue neutral,”
necessarily meaning that tax rates on average are actually not being reduced; for every
firm or sector that will see a lower tax rate, another will see a higher tax rate.
2. Cutting taxes: There will surely be many efforts in this Congress to cut corporate taxes
and reduce taxes on capital income (e.g., capital gains, dividends) and individual marginal
tax rates, especially on those with the highest incomes. It’s easy to see how those
strategies will not work.
3. Raising interest rates: There are those worried about inflation who are calling on the
Federal Reserve Board to raise interest rates soon and steadily thereafter. Their fears are,
in my analysis, unfounded. But we should be clear that those seeking higher interest rates
are asking our monetary policymakers to slow economic growth and job creation and
reflect a far-too-pessimistic assumption of how far we can lower unemployment,
seemingly aiming for unemployment at current levels or between 5.0 and 5.5 percent.

14. Inflationary Gap
It is useful and important to understand the concept
of inflationary gap because with it we are able to
know the main cause of the rise in general level of
prices. The equilibrium of an economy is established
at the level of full-employment when aggregate
demand or total expenditure is equal to the level of
income corresponding to full-employment. This
happens when the amount of investment is equal to
the saving gap corresponding to full-employment
level of income.

15. Deflationary Gap
In the theory of income and employment, the
concept of deflationary gap occupies an
important place, since in a capitalist economy
unemployment and depression occur due to this
gap. According to Keynesian theory of income
and employment, equilibrium at the level of full-
employment is established when aggregate
demand consisting of consumption demand plus
investment demand plus government demand (C
+ I + G) is equal to the national income at the