The determination of income and employment is related to the income and employment theory. The theory is an economic analysis related to the comparative levels of output, employment, and prices in an economy. By establishing the interrelation of these three macroeconomic factors, governments and economies try to create various policies that lead to economic stability.
The contemporary interest in the income and employment theory started with the depth of the Great Depression of the 1930s in the US and Europe. At that time, economists failed to explain the persistently high levels of joblessness and the low levels of business efficiency.
John Maynard Keynes offered suggestions on income and employment theory in his book General Theory of Employment, Interest, and Money which was published in 1936. His theory provided the relationship between income, expenditure, and output.
According to the Keynesian theory, transactions are two-sided where one person’s income is another person’s expense. This relationship could be explained by a simple equation −
Y = O = D
where,
Y is the national income (i.e., the purchasing power),
O is the value of the national output, and
D is national expenditure.
This equation means that effective demand is equal to income as well as output. As consumers have only two options with their income, i.e. they can either spend or save their income, we can state that −
Y= C + S
where
C is consumption and S is savings.
Similarly, considering the output side, we can see that production is meant for only two outcomes. It can either be sold to the customers or invested in new capital equipment, such as production plants or machinery, or inventory.
So,
O = C + I
Where
C represents sales to final customers and I is investment.
Thus,
C + S = C + I
therefore,
S = I.
Although savings and investment are equated from an accounting standpoint, in reality, real planned savings and planned investment often differ from one another. Keynesians believe that economic instability usually stems from this paramount discrepancy between investments and savings.
Suppose, in one instance, savings go above their previous levels. So, there will be a reduction in present demand with a chance of an increase in future demand. Let’s suppose, by coincidence, the additional capital formation, i.e. investments, such as in inventory goes up by the same amount, and various productive resources present will keep running at the same capacity. So, there will be hardly any change in the level of activity, and the economy will stay in equilibrium. However, if capital formation falls or stays at the same level without rising, then the demand for labor will fall and, if wages do not fall, some workers will lose their jobs and some will lose some of their current income.
The fall in income in this way will further reduce consumer demand and also reduce the rate of savings. If manufacturers do not change their investment plans, equilibrium will occur at a lower level of income. In reality, then, savings are not unstable but the level of investment is a nosedive in investment and an increase in savings will both produce a deteriorating effect on the economy.
Conversely, increased investment or increased consumer spending will stimulate the economy.
This example above shows how changes in investment or savings will affect changes in national income, but it fails to show the extent of the changes. The degree of this change is measured by the “consumption function.” This function is the level of spending based on disposable income.
The primary objective of Keynes in developing the theory was to show that, under certain conditions, the economy may get stuck in a disequilibrium. Such an equilibrium may have productive resources in surplus, such as a high level of unemployment but output and income may not rise sufficiently to reach an equilibrium.
In simple terms, Keynes argued that when businesses do not want to increase investment due to low demand, extra government spending could result in new spending by the consumers and eventually establish an equilibrium. Keynesians, therefore, believe that the adoption of fiscal policies—such as incremental government expenditure or reduced taxation—is the most effective way to generate private demand.
The monetarist approach which is different from the Keynesian approach places the quantity of money in the controlling role of the performance of an economy. According to this theory, the effects of an increase or decrease in the money supply are approximately proportional to the consumption-and-savings relation.
The rules of thumb obtained from the two theories may be combined: excess overall demand for goods or an excess overall supply of money which are aspects of the same phenomenon associated with climbing income.
Similarly, an excess demand for money or an excess supply of goods can be connected with falling income. Monetarists, such as Milton Friedman, have advocated for monetary policy as the appropriate tool of government to counter economic downturns.
Both Keynesian and monetarist theories have a pair of notable shortcomings.
The first is both are theories related to the demand side and so cannot relate to the long-term prospects of economic growth.
Second, both theories assume that people can be fooled over and over again by the policies enacted whenever needed. In reality, when people learn to anticipate government policies, they tend to offset the policies and thus negate the government's actions.
It is important for governments and economists to measure the income and employment prospects of the citizens. It not only provides them a bird’s eye view of the economic well-being of a country, but it also let them form policies to correct the economy whenever required. Keeping a close eye on determinants of income and employment is therefore an indispensable duty of the governments.
It is also important to check a gradual increase in incomes of the citizens of a nation to check the overall growth of an economy. In fact, decreasing incomes and employment are a sign of an impending downturn in an economy and so, corrections must be applied by the authorities as soon as possible. In modern days, governments usually resort to the two policies mentioned above to rectify an ailing economy.
However, since economic growth needs real impetus, the policies enacted by governments must be well fact-checked to bring a change in the economic environment of a nation.
Throughout history, economists have successfully applied the Keynesian and monetary approaches to deal with recessions and depressions. In fact, government action is initiated well before the actual occurrence of these phenomena to counter economic downturns. Therefore, knowledge of income and employment scenarios is very important for the growth of an economy.
Q1. When and by whom the first theory connecting income and employment was offered?
Ans. John Maynard Keynes offered suggestions on income and employment theory in his book General Theory of Employment, Interest, and Money which was published in 1936.
Q2. What is the main assumption of the monetarist approach?
Ans. The monetarist approach places the quantity of money in the controlling role of the performance of an economy. The effects of an increase or decrease in the money supply are approximately proportional to the consumption-and-savings relation.
Q3. Mention one shortcoming that is present in both Keynesian and monetary approaches that are associated with income and employment theories.
Ans. A major shortcoming of the theories is that both are theories related to the demand side and so cannot relate to the long-term prospects of economic growth.
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