5.2 Keynes’ Employment Theory

(A) Keynesian Revolution: It was in the year 1936 that Lord John Maynard Keynes’ General Theory of Employment, Income and Rate of Interest was first published. It is the first ever full account of macroeconomic activities. Keynes’ theory is an outstanding piece of analysis, which is considered a landmark in the history of economic science. It contains a variety of novel scientific ideas. It is a major breakthrough in the classical tradition and an entry into a modern Keynesian school of economics. His followers Harrod, Domar, Kaldor, Mrs. Robinson, Solow etc. have ever since widened the scope of macroeconomic analysis. After the publication of the General Theory both economic practice and policy making have changed fundamentally. It is not without reason that the theory has come to be known as 'Keynesian Revolution'. The revolutionary impact of the theory has been variously demonstrated. Keynes has introduced a variety of new tools of analysis. His equations of income and expenditure, consumption function, law of marginal propensity to consume (MPC), multiplier operations, investment function and marginal efficiency of capital (MEC), identity between savings and investment, and his pure monetary liquidity preference theory of interest accompanied by speculative motive for demand for money are some of his new contributions.

Keynes denied the classical belief that the free enterprise system is a self regulating one and asserted that such a system requires periodic intervention of the public authority to avoid fluctuations and instability in economic activities. Besides, Keynes replaced the classical partial equilibrium by a more general equilibrium to ensure the full employment level of output and employment. Keynes was building an entirely new structure of economic analysis to study and redress the problem of unemployment. It was therefore essential for him to bring out weaknesses and inadequacies of the classical approach to the problem of unemployment.

(B) Critique of Say’s Law: Keynes’ criticism of the classical theory in general and Say’s Law in particular is the first step in the direction of the new theory. Say’s Law of the markets is a truism only under barter economic system. In that case whatever goods are produced are either sold in the market or are utilized for self-consumption. Hence supply and demand are always equated. There cannot be a general surplus or glut of the goods. Though this works well under barter conditions it is no more true in a modern economy where almost every transaction is carried out with money in the form of currency or credit. In such an economy buyers and producers or even sellers are not directly collecting together to carry out the exchange activity but messages are sent through the medium of money.

The classical approach is essentially partial and a microeconomic piece of analysis. It looks at the problem of employment and unemployment from the perspective of an individual producer and employer. Therefore it regards unemployment only as a temporary and voluntary condition. It rules out any possibility of large-scale involuntary condition of general unemployment. But in reality one noticed frequent occasions of economic fluctuations and widespread unemployment conditions throughout the 19^th century and early 20th century. The latest example of it is in the form of the period of the Great Depression (1929-33) which rendered 40 percent or more of the labor force unemployed in western countries and other parts of the world. All these events make it evident that the classical theory was far from the reality. This is essentially true because the problem of unemployment is not partial but general, not voluntary but involuntary and not micro but macro in its nature. Therefore it needs to be analyzed in its proper perspective and handled differently. Unemployment, as we understand today, was not a problem for classics which is unfortunately not true.

Moreover, the classical solution to tackle unemployment, in whatever form they conceived it, is totally inadequate and unsatisfactory. They have relied entirely on a cut in the rate of interest and wage rates. These are self-defeating polices. Any cut in wage rates will result in widening the gap of unemployment instead of correcting it in modern times. This is because of the fact that any attempt to cut wage rates at the bottom of the depression period will cause a considerable portion of the aggregate or effective demand to reduce further causing a more severe unemployment situation. This can be illustrated with the help of a simple example:

Let’s assume that a small fruit seller sells 20kg of fruit at a market price of $10 on a daily basis. Thus his daily turnover is $200 (20 ´ 10) of which the only cost of production is in the form of wage rate. If he employs 10 laborers at a daily rate of $15, then the total wage payment is $150 (10 ´ 15). The fruit seller therefore earns a daily profit of $50 (200 - 150). If for some reason the demand for fruit that he sells reduces, then he will have to reduce the price say from $10 to $8. In this new situation his total daily turnover goes down to $160 and at the old cost of production, his profit margin declines to $10 (160-150). The fruit seller is not satisfied with this. Therefore he may reduce the number of his workers from 10 to 8 and bring down the cost of production from $150 to $120 (8 ´ 15). The two workers are then rendered unemployed. If the unemployed laborers insist on their re-employment, the producer will lay down the condition that wage rate of all the workers will be reduced from $15 to $11. If the workers accept this then the total wage bill will be $110 (10 ´ 11) which restores the seller’s profit of $50 (160 - 110) as before. It appears that even with reduced demand and fall in the price of fruit, unemployment of workers has been avoided with the help of a cut in the wage rate. But this in only a momentary and superficial solution. The workers’ total income has

now reduced from $150 to $110 as a result of which they can spend less and reduce demand for every other commodity that they consume. Therefore initially the problem of depressed demand and unemployment which was faced by a single seller will eventually become a general and wider problem faced by all other dealers. Instead of curbing it, the wage cut solution will therefore increase the problem of unemployment. Though this example is oversimplified and hypothetical yet it helps to bring out gist of the Keynes’ Criticism of Classical theory.