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Classical Theory of Employment

The word, classical economists, was first used by Karl Marx to define the thoughts and perceptions of various economics
experts, such as Ricardo and Adam Smith.
The classical economists did not propound any particular theory of employment. However, they have given a number of
assumptions. There are two main assumptions of classical theory of employment, namely, assumption of full
employment and flexibility of price and wages. Let us study these two broad features in detail.

Assumption of Full Employment:

In simpler terms, full employment refers to an economic condition in which every individual is employed. In economics
terminology, full employment signifies the market condition where the demand for labor is equivalent to the supply of
labor at every level of real wage. Therefore, full employment is the employment level at which every individual who
desires to work at the prevalent wage rate gets employed.

Some of the definitions of full employment given by different economists are as follows:
According to Lerner, “Full employment is a situation in which all those who are able to and want to work at the existing
rate of wage get work without any due difficulty.”
The classical economists had a notion that labor and other resources are utilized completely or fully employed.
According to classical economists, over-production is a general condition of an economy. Therefore, the condition of
unemployment does not occur in the economy.
According to them, if the condition of unemployment occurs, it is a temporary or abnormal condition in the economy. In
addition, classical economists also propounded that the condition of unemployment occurs due to the interference of
government or private organizations in normal mechanism of market forces.

Flexibility of Price and Wages:

 The classical economists believed that there is always a condition of full employment of resources in an
economy. Besides this, they also advocated that the flexibility or adjustments in price of products and wages of
individuals facilitate the condition of full employment.
 For example, in case of over-production, the prices of products decrease, which further leads to an increase in
demand and rate of consumption. Consequently, employment opportunities would increase and unemployment
would eliminate.
 The classical economists also propounded another approach of reducing unemployment, which signifies that the
condition of full employment can be achieved by cutting down wages. This would result in increase in demand
for labor and lead to the condition of full employment.
Say’s Law:
Say’s Law was given by J.B. Say, who was a French economist of early nineteenth century. The basic assumptions of
Say’s law are as follows:
1. Optimum Allocation of Resources: There is optimum allocation of resources as they are allocated to different channels
of production in terms of proportionality and equality of marginal products.
2. Perfect Equilibrium: Commodity prices and factor prices are determined in perfect equilibrium of their demand and
supply.
3. Perfect Competition: There is perfect competition prevailing in the commodity market as well as factor market. Thus,
commodity prices are equal to average costs and factor prices are equal to marginal productivities.
4. Market Economy: There is free enterprise economy.
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5. Laissez-Faire Policy of the Government: There is no government intervention in the economic field. The government
follows a laissez-faire policy to facilitate automatic adjustment and smooth working of the market mechanism in the
capitalist economic system.
6. Elastic Market: The size of the market has no limits. Thus, there is automatic expansion of the market with an increase
in output offered for sale.
7. Market Automatism: The free market economy and its working of price mechanism provide due scope to labor supply
and the rising population also stimulates capital formation. In an expanding economy, new workers and firms will be
automatically absorbed into the productivity channels by their own products in exchange without displacing or
supplanting the existing firms and workers.
8. Circular Flow: The circular flow of money is regular and continuous without any leakages. This implies that saving is
nothing but another form of spending on capital goods. Savings are, thus, automatically invested.
9. Savings-Investment Equality: Since all savings are automatically invested, savings always equal investment. Savings-
investment equality is the basic condition of equilibrium in the economy. It is maintained by interest flexibility.
10. Long-term: The economy’s equilibrium process is perceived from the long-term point of view.

Some of the implications of Say’s Law are discussed in the following points:
(a) Self-adjusting economy:
 Assumes that market forces adjust themselves for the stabilization of an economy and do not require any
controlling authority for this purpose. Say’s Law also assumes that in a self-adjusting economy, the condition of
disequilibrium is momentary or for a shorter duration of time and the condition of equilibrium persists.
 For example, if there is a condition of over-production, then prices would fall, which would automatically lead to
increase in demand. Consequently, the problem of surplus of products would solve and demand and supply
would remain equal. Such a condition is termed as equilibrium condition.
 Similarly, in the condition of unemployment, wages would fall. In such a case, it would be beneficial for
organizations to hire more labor to reduce unemployment. In this manner, an economy can adjust itself without
any controlling units.
(b) Laissez-faire Approach:
 States that there is no interference of the government in the economic activity. The law assumes that if
government intervenes in the self-adjusting economy, then it would create the state of disequilibrium.
 In the absence of government intervention, the condition of disequilibrium would be for a shorter duration and
tend to be solved by the free implication of market forces. Therefore, government should not create hurdles in
the normal working of an economy.
(c) Over-production:
 Assumes that the condition of over-production does riot exist in an economy in general. This is because of the
reason that if there is over-production, then the prices would fall immediately and the demand would increase
without any time lag.
 As a result, the surplus of products would disappear from the market. According to the law, over-production
may arise in an industry in specific conditions, which is also not permanent and can be resolved by market
forces.
(d) Unemployment:
 Concludes that the condition of unemployment cannot exist in normal economic conditions. This is because as
the unemployment arises, wages would fall. In such a case, organizations would prefer to hire new employees,
which would result in eliminating unemployment.
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 The law also assumes that there should neither be any intervention of government to regulate the rate of wages
nor any role of trade unions. According to Say’s Law, the condition of unemployment exists only under some
specific conditions, but this condition is momentary.
(e) Money Supply:
 Assumes that whole income is spent on consumer goods and the whole amount of savings is invested
immediately. Thus, money comes back to organizations only. According to Say’s Law, there is always a closed
economy and there is no interference of government, such as subsidies, taxes, and tariffs.
(f) Limitless Productive Activities:
 Assumes that the productive activities in an economy are limitless. In simple terms, the activities related to
economic development can be performed to any extent as aggregate demand cannot be nil. This leads to
unlimited economic development opportunities for under-developed countries.
Concept of Equality of Savings and Investment:
 According to Say’s Law, there would always be a certain amount of total spending for keeping the available
resources fully employed. The income generated by various factors of production is spent on consumer goods. In
addition, some part of this income is also saved.
 However, according to classical economists, the amount of saving is utilized for investment purposes. This is
because of the reason that saving and investment are equal and are interchangeable concepts. It helps in
maintaining the flow of income in an economy. As a result, supply of a product is able to create demand for the
product.
The assumptions of classical theory of employment with respect to the concept of savings and investment are as
follows:
(a) Flexibility in Interest Rate:
Assumes that rate of interest is directly affected by the supply of saving and inversely affected by the demand of
investment. According to classical economists, the fluctuations in the economy can be managed by market forces
themselves to bring the economy back at equilibrium position.

The relationship between the rate of interest (ROI) and the demand of investment (I) is shown in Figure-1:
In Figure-1, II represents the demand of investment while SS represents the supply of saving. At point P, II intersects SS,
which implies that demand of investment gets equal to the supply of saving. Therefore, P is the point of equilibrium at
which the interest rate is Oi with the investment and saving quantity of OQ.

When the investment increases to I’, then the rate of interest becomes Oi’ and economy reaches to new equilibrium
point that is P’. Therefore, it can be concluded that economy would always be in equilibrium and there would be no
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situation of unemployment in the economy. In addition, the rate of interest helps in bringing back the equilibrium
condition of an economy when there is a gap between savings and investment.
(b) Flexibility in Wage Rate:
Assumes that full employment condition can be achieved by cutting down the wage rate. Unemployment would be
eliminated when wages are determined by the mechanism of economy itself.

Figure-2 shows the relationship between wage rate and employment:

In Figure-2, when the wage rate is OW, then the employment is ON. As the wage rate is reduced to OW, then the
employment has increased to ON’. Prof. Pigou has taken this theory as base for developing the solution of
unemployment problem.

(c) Balanced Budget:

Assumes that the intervention of government in economic activities should be negligible. In addition, the government
should balance its income and expenditure. The classical economists advocated that the government should follow the
laissez-faire approach of economy.

Criticism of Classical Theory:

a. States that supply creates its own demand that is not possible if certain part of income is saved and aggregate
revenue is not always equal to aggregate cost
b. Considers that the employment can be increased by decreasing the wage rate, which is not true in the real world
c. Assumes that rate of interest helps in maintaining equilibrium between savings and investments, which is not true in
practical applications
d. Infers that the economy can be adjusted on its own and it does not require any government intervention, which is not
possible
e. Considers that the wages and prices are very much flexible, which is not true in the real world economy
f. Regards money as a medium of exchange only; however, money plays an important role in the economy
g. Fails to explain the occurrence of trade cycles.

KEYNES'S THEORY OF AGGREGATE DEMAND

Introduction - John Maynard Keynes is often referred to as the father of macroeconomics. His pioneering work "The
General Theory of Employment, Interest and Money" published in 1936, provided a completely new approach to the
modern study of macroeconomics. It served as a guide for both macroeconomic theory and macroeconomic policy
making during the Great Depression and the period later. The General Theory was a beginning of a new school of
thought in macroeconomics which was referred to in later period as Keynesian Revolution in macroeconomic analysis.
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The notion of “effective demand” and its influence on economic activity was the central theme in Keynes's Theory of
Effective Demand. While refuting the Classical theory which believed in strong general tendency of market mechanism
to move output and employment towards full employment, Keynes explained that, in some situations, no strong
automatic mechanism moves output and employment towards full employment levels. Keynes was the first economist
to advocate the role of government especially fiscal policy, as the primary means of stabilizing the economy.

Meaning of Aggregate Demand

The concept of aggregate demand (AD) refers to the total demand for goods and services in an economy. AD is related
to the total expenditure flow in an economy in a given period. It consists of the following:
 Consumption demand by the households (C )
 Investment demand, i.e., demand for capital goods (I) by the business firms.
 Government expenditure (G)
 Net income from abroad (X – M).
Thus symbolically,
AD = C + I + G + (X-M)

Keynes's Theory of Aggregate Demand

 According to Keynes full employment is not a normal situation as stated in the Classical theory. He argued that
economy's equilibrium level of output and employment may not always correspond to the full employment level
of income. It is possible to have macroeconomic equilibrium at less than full employment. If current level of
aggregate demand (expenditure) is not adequate to purchase all the goods produced in the economy (i. e . a
situation of excess supply) then output will be cut back to match the level of aggregate demand.
 Keynes's theory of the determination of equilibrium income and employment focuses on the relationship
between aggregate demand (AD) and aggregate supply (AS). According to him equilibrium employment (income)
is determined by the level of aggregate demand (AD) in the economy, given the level of aggregate supply (AS).
Thus, the equilibrium level of employment is the level at which aggregate supply is consistent with the current
level of aggregate demand.
 The theory believes that "demand creates its own supply" rather than the Classical claim of "supply creates its
own demand".
In the following sections we discuss Keynes' concepts of aggregate demand function, aggregate supply function
and finally, the point of effective demand.

Aggregate Demand Function

Aggregate demand or what is called aggregate demand price is the amount of total receipts which all the firms expect to
receive from the sale of output produced by a given number of workers employed. Aggregate demand increases with
increase in the number of workers employed. The aggregate demand function curve is a rising curve as shown in Fig. 1.
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Figure.1: Aggregate Demand Function

It can be seen that total expected receipts is D1L1 at OL1 level of employment. Total expected receipts increase to D2L2
with increase in the level of employment to OL2. OLf is the full employment level. Initially the aggregate demand
function (ADF) rises sharply as increase in the number of employment leads to increase in society's expenditure,
thereby, increasing producer's expected sales receipts. There is no much increase in employment, income, expenditure
and therefore producer's expected sales receipts as the economy reaches near full-employment. The ADF curve
becomes perfectly elastic (horizontal) as the economy reaches near full-employment.

Aggregate Demand In Keynes’ theory of income determination is society’s planned expenditure. In a laissez-faire
economy it consists of consumption expenditure (C)and investment expenditure (I).
Thus AD = Planned Expenditure = C + I
where,
 C = f (Yd)and Yd is level of disposable income (Income minus Taxes)
 I is exogenous in the short run.
The short-run aggregate demand function can be written as
AD= C+I

Aggregate Supply Function

 Aggregate supply price refers to the total amount of money that all organizations in an economy should receive
from the sale of output produced by employing a specific number of workers. In simpler words, aggregate
supply price is the cost of production of products and services at a particular level of employment.
 It is the total amount of money paid by organizations to the different factors of production involved in the
production of output. Therefore, organizations would not employ the factors of production until they can
recover the cost of production incurred for employing them.
 A certain minimum amount of price is required for inducing employers to offer a specific amount of
employment. According to Dillard, “This minimum price or proceeds, which will just induce employment on a
given scale, is called the aggregate supply price of that amount of employment.”
 Obviously, aggregate supply price increases with increase in the number of workers employed. The aggregate
supply function curve is a rising curve and at full employment (OLf) it becomes perfectly inelastic (vertical) as
shown in Fig. 2.

Figure.2: Aggregate Supply Function

It can be seen that aggregate supply price or the cost of production is S1L1 at OL1 level of employment. It increase to
S2L2 with increase in the level of employment to OL2. Initially, the aggregate supply function (ASF) rises slowly as labor
is abundant thereby leading to slow increase in the cost of production. Labor cost rises sharply as the economy reaches
near full-employment. The ASF therefore rises sharply and at full employment (OLf) it becomes perfectly inelastic
(vertical).
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Determination of Equilibrium Level of Employment

According to Keynes equilibrium level of employment (income) in the short run is determined by the level of effective
demand. The higher the level of effective demand, the greater would be the level of income and employment and vice
versa. This is shown in Fig. 3.
Fig.3 shows the ADF and ASF together. As discussed above the ADF shows the amount of total receipts which all the
firms expect to receive from the sale of output produced by a given number of workers employed and the ASF shows the
amount of total receipts which all the firms must expect to receive from the sale of output produced by a given number
of workers employed. Entrepreneurs expand output as long as there are opportunities to make profits.

Figure.3: Determination of Equilibrium Employment

It can be seen that up to OL level of employment, aggregate demand price is greater than aggregate supply price (ADF >
ASF). Producers expect greater returns than the cost of production. As such, producers expand output up to OL level of
employment. Thus at any level of employment up to OL, there would be expansionary tendency in the economy and
therefore rise in the level of employment.
Beyond OL level of employment, aggregate demand price is less than aggregate supply price (ADF < ASF). Producers
expect less returns than the cost of production. As such, producers prefer to cut down output. Thus at any level of
employment beyond OL, there would be contractionary tendency in the economy and therefore fall in the level of
employment.
At OL level of employment aggregate demand price equals aggregate supply price (ADF = ASF). Now there is no tendency
towards economic expansion or contraction. Thus OL is the equilibrium level of employment. Point 'E' is called the point
of effective demand. It represents that level of aggregate demand price that is equal to aggregate supply price and thus
reaches short run equilibrium position.

It can be seen that equilibrium point 'E' is established at less-than-full employment equilibrium and there is LLf amount
of involuntary unemployment in the economy. It is important to note that according to Keynes this unemployment is
due to deficiency of aggregate demand. At full employment level there exist a gap between the full-employment level of
aggregate supply price and the corresponding level of aggregate demand price.

Role of Fiscal Policy in achieving Full-Employment Equilibrium

According to Keynes, full-employment can be achieved by removing the gap between aggregate supply price and
aggregate demand price. However, he rejected the Pigouvian wage-cut solution to pull the ASF downwards to achieve
full-employment. This, according to him, would further lower the aggregate demand, if the income of potential
customers is reduced. The economy, in short, will be caught in a vicious circle of high unemployment and low demand.
On the other hand, the policy to push the ADF upwards will push the economy into a virtuous cycle of high demand and
high employment. This is shown in Fig. 4.
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Figure.4: Determination of Full-Equilibrium Employment

It can be seen that the gap between the full-employment level of aggregate supply price and the corresponding level of
aggregate demand price is now filled by shifting the ADF upwards to ADF'. The economy is now at full-employment
equilibrium point E' and equilibrium employment is OLf.

Keynes argued that adequate economic stimulus to shift the ADF upwards can be created through:
1. The Monetary Policy: A reduction in interest rates
2. The Fiscal Policy: A rise in government expenditure
However, to Keynes, monetary policy would be less effective under the conditions of economic depression. It is a
situation when community's liquidity preference curve is absolutely elastic (horizontal). Therefore, interest rate, which is
already at low levels, cannot be lowered further through the expansion of money supply. Thus, expansionary monetary
policy would fail to generate economic stimulus by picking up investment. On the other hand, expansionary fiscal policy
would be more effective to achieve upwards shift in the aggregate demand and thereby full employment and output.
Keynes developed the theory of investment multiplier to explain the impact of government expenditure on income and
employment.
Thus, Keynes advocated government's intervention through countercyclical fiscal policies. He suggested
expansionary fiscal policy or deficit spending when a nation's economy suffers from recession or is caught in the vicious
cycle of high unemployment and low aggregate demand, and contractionary fiscal policy by increasing taxes or cutting
back on government outlays to suppress inflation in boom times. He argued that governments should solve problems in
the short run rather than waiting for market forces to do it in the long run, because, "in the long run, we are all dead."
The short-run aggregate demand function can now be written as:
AD = C+I+G
where, G is government policy variable.