Determination of income and employment

U N I T - III D I ETERMINATION OF NCOME AND E MPLOYMENT 4 C HAPTER (cid:1) (cid:6)(cid:7) (cid:6) (cid:6)(cid:1) (cid:2)(cid:2)(cid:3)(cid:4)(cid:2)(cid:1)(cid:5)(cid:4) (cid:4)(cid:8)(cid:1)(cid:9)(cid:7) (cid:1)(cid:9)(cid:7) (cid:2)(cid:2)(cid:3)(cid:4)(cid:2)(cid:1)(cid:5)(cid:4) (cid:10) (cid:6) (cid:6)(cid:8) (cid:11)(cid:12)(cid:12)(cid:13)(cid:14) (cid:15)(cid:9) (cid:1)(cid:16)(cid:3)(cid:17)(cid:4)(cid:16)(cid:17)(cid:9)(cid:17)(cid:8)(cid:15)(cid:16)(cid:10) Introduction measures the output of goods and It is an established principle in services. The Y-axis measures the macroeconomics that the aggregate price level. demand and the aggregate supply Aggregate Supply together determine the level of aggregate output of goods and services, aggregate Aggregate supply is the total supply of employment and the general price level goods and services in the economy. In in an economy. Therefore, as the first respect of aggregate supply there is no step, the meaning of the concepts of such clear-cut relationship with the aggregate demand and aggregate price level. In macroeconomics we have supply are explained below. two different kinds of aggregate supply concepts based on two different sets of Aggregate Demand assumptions. They are: (a) the Classical Aggregate demand is the total demand concept of aggregate supply, and (b) the for goods and services in the economy. Keynesian concept of aggregate supply. The aggregate demand is usually We shall take up these two concepts one related to the price level. An inverse by one. relationship could be assumed between Classical Concept of Aggregate these two variables. That is, the greater Supply the price level the lower the aggregate demand and vice versa.1 Figure 4.1 In the Classical2 concept, the aggregate shows the aggregate demand curve. supply is perfectly inelastic with In the Figure 4.1, the curve AD is the respect to the price level. This means aggregate demand curve. The X-axis that changes in the price level have no 1 Explanation of specific reasons for the downward sloping nature of the aggregate demand curve is beyond the scope of this book. It may be dealt with during higher studies in economics. 2 The Classical school of economics ranged from Adam Smith in the 18th century to A. C. Pigou in 20th century. The Classical approach to macroeconomics (all writings on macroeconomics prior to that of John Maynard Keynes) believed that the economy would normally be in a state of full- employment equilibrium. The reason for this belief was their acceptance of Say’s law of markets. Say’s law, in brief, maintained the impossibility of any deficiency in aggregate demand. 42 INTRODUCTORY MACROECONOMICS Pricelevel Pricelevel AS AD Output Q* Output Fig 4.1: Aggregate Demand Curve Fig 4.2: Classical Aggregate Supply Curve effect on the aggregate supply. The aggregate supply would always be at classical aggregate supply curve is the full-employment level. The shown in Figure 4.2. theoretical foundation of this concept The X-axis measures the output. of aggregate supply was based upon The Y-axis measures the price level. the assumptions of (a) Say’s law of The curve AS is the aggregate supply markets and (b) wage-price flexibility. curve. Q* is the full-employment level Say’s Law of Markets of output of goods and services. The aggregate supply curve is a vertical Say’s law of markets (named after the 18th line at the full-employment level of century French economist Jean Baptiste output. This means that changes in the Say) was one of the main propositions of price level have no effect on the Classical theory (Clip 4.1). Say’s law states aggregate supply. that ‘supply creates its own demand’. If The full-employment level of output goods are produced then there will of goods and services is the largest automatically be a market for them. This output that the economy is capable of means that there cannot be a general producing, when all resources are fully ‘overproduction’ or ‘glut’ in an employed. However, under the state of economy that is based on a market full-employment, there could be a system of production and exchange.4 situation of temporary unemployment Correspondingly, there cannot be a which is known as ‘frictional deficiency in aggregate demand. unemployment’.3 Say felt that people do not work for The long tradition of the Classical the sake of doing work, because work school of economics believed that the is considered to be unpleasant. People 3 Frictional unemployment is a temporary unemployment of people who move between jobs. Since it takes time for a person to switch from one job to another, at any one point of time, there will be a short period of temporary unemployment, which is called frictional unemployment. 4 Gardner Ackley, Macroeconomics, Collier Macmillan, 1978 AGGREGATE DEMAND AND AGGREGATE SUPPLY IN MACROECONOMICS 43 work only in order to obtain goods and produces. Therefore, each person’s services that yield satisfaction or utility. production constitutes his or her In an economy that is characterised demand for other goods; hence, for the by division of labour and exchange of entire community, aggregate demand goods and services, people do not equals aggregate supply. Say’s law produce all the goods and services they implies that an increase in output will wish to consume. Instead, they produce generate an equal increase in income only those goods and services in which and spending. Thus, income and they are relatively the most proficient, product can always be at full- and exchange the surplus (over their employment level. Output will only be own needs) for the produce of others. limited at the point where, for every In such a system, the very act of individual, the satisfaction of a little production is itself the demand for other more leisure outweighs the sacrifice of goods. The amount demanded of other a little more goods that could have goods is equal to the value of the been obtained. At this point, any surplus goods (that is the quantity of ‘unemployment’ will be ‘voluntary’ i.e. goods over and above that required for people consciously decide not to work self-consumption) that each man at the prevailing wage rate. Clip 4.1 THE LIFE OF JEAN BAPTISTE SAY Jean Baptiste Say (1767 – 1832) was a statesman in the reign of Napoleon Bonaparte, a businessman, and an economist. He founded the French Classical School of Economics, which had notable names such as Frederic Bastiat amongst its followers. Say wrote a book titled Treatise on Political Economy in 1803, which found widespread fame, ran into five editions, and was used as a textbook in the American colleges of the times. He began lecturing on Political Economics in 1816 and published his Catechism of Political Economy in 1817. In 1819, he was appointed to the Chair of Industrial Economy at the Conservatoire National des Arts et Métiers. In 1828 he published a six-volume book titled ‘A Complete Course in Practical Political Economy’. In 1831, he was appointed as Professor of Political Economy at the College de France, a post he held until his death in 1832. Say was partly responsible for the introduction of the concept of an ‘entrepreneur’ into economic theory, and also the division of the fundamental factors of production into three – land, labour and capital. His greatest claim to fame was his ‘loi des débouches’ or ‘law of markets’. His law became famous when J. M. Keynes accused the Classical economists of being misled by accepting it as the mainstay of their macroeconomic theory. 44 INTRODUCTORY MACROECONOMICS According to this approach, the ensuring full employment. Price full-employment level of income and flexibility ensures that the markets for product are ensured by full flexibility all goods and services are in equilibrium in wages and prices. Therefore, the – in every market the supply equals market automatically adjusts itself to demand. This means that the aggregate full-employment output. We shall supply of all goods and services equals explain below the meaning of wage- the aggregate demand for all goods and price flexibility. services. Thus, Say’s law of markets and Wage-price Flexibility wage-price flexibility ensures automatic Wage-price flexibility means that (real) market adjustment so that the economy wages5 and prices are flexible, that is, always produces the full-employment they can increase or decrease freely and level of output. Thus, the Classical quickly. The effect of wage-price aggregate supply curve is a vertical line flexibility is that the market for labour at the full-employment level of output. and the markets for goods and services It is perfectly inelastic with respect to will always be in equilibrium, i.e. prices, that is, output is always constant demand will be equal to supply in all at the full-employment level regardless markets. of the prevailing price level (Fig. 4.2). Suppose that the market for labour Keynesian Concept of Aggregate (or for a good or service) is in Supply disequilibrium due to condition of excess demand (or excess supply). In the Keynesian approach, the Wage-price flexibility will enable the aggregate supply is perfectly elastic wage rate (or the price) to increase with respect to the price level. This (decrease) in order to eliminate the means that the firms are willing to excess demand (excess supply), and produce any amount of output at the thus bring the market back into prevailing price level. equilibrium by equating demand and The Keynesian approach developed supply. against the background of the Great Wage flexibility ensures that the Depression of the 1930’s. The Great market for labour is always in Depression witnessed falling levels of equilibrium, i.e. supply of labour output, prices and employment (see equals demand for labour. This means Appendix 4.1). that everyone who wants employment Keynes understood aggregate at the prevailing wage rate gets it – thus supply to be perfectly elastic with 5 Real wages refer to the purchasing power of workers’ wages in terms of goods and services. It is measured by the ratio of the money wage rate to the price level as measured by some price index. See the glossary for the meaning of the terms price level and price index. In the Classical framework, the real wage rate is equal to the marginal product of labour. AGGREGATE DEMAND AND AGGREGATE SUPPLY IN MACROECONOMICS 45 respect to price, that is, the producers Pricelevel AS were willing to supply any amount of goods and services at the fixed price level. The theoretical foundations of the perfectly elastic aggregate supply curve were the assumptions of (a) wage- price rigidity and (b) constant marginal product of labour. This is quite opposite to the principles of Classical economics. Output Wage-price rigidity meant that Q* (money) wages and prices were rigid, Fig 4.3: Keynesian aggregate i.e. they were not free to increase or supply curve decrease. Constant marginal product of labour meant that every increment of increases in production are possible labour employed produced the same since all resources have been fully increment to output. employed. At this point, the aggregate Rigid wages when coupled with supply curve becomes perfectly constant marginal product of labour inelastic with respect to price. The lead to rigid prices. This is because Keynesian aggregate supply curve is each unit increment to output costs the shown in Figure 4.3. same to produce. The cost of The X-axis measures the level of production of each additional unit of output. The Y-axis measures the price output is the incremental quantity of level. Q* is the full-employment level of labour employed to produce that output. The Keynesian aggregate additional unit of output, multiplied by supply curve is perfectly elastic with the wage rate. Since marginal product respect to prices until the full- of labour is constant, every additional employment level of output. Once the unit of output requires the same full-employment level of output has increment in labour employed. Thus, been reached, no further increases in constant marginal product of labour production are possible since all and constant wage rate means that the resources have been fully employed. cost of production of the incremental At this point, the aggregate supply unit of output is also constant. Since curve becomes perfectly inelastic with production is carried out at constant respect to price. cost, the aggregate supply curve is Now, one implication of wage rigidity perfectly elastic with respect to prices is that it may hinder the attainment of i.e. output can be expanded till the full full-employment. If wages are rigid at employment level without any change some level where the supply of labour is in the price level. greater than the demand for labour, then Once the full-employment level of there will be involuntary unemployment output has been reached, no further to the extent of the excess supply of 46 INTRODUCTORY MACROECONOMICS labour. Involuntary unemployment Equilibrium occurs when those who seek The equilibrium between aggregate employment at the going wage rate do demand and aggregate supply occurs, not get it. The rigid wage rate, due to its when at a particular price level, the failure to adjust downward in order to aggregate demand is equal to the eliminate the excess supply of labour, is aggregate supply. At equilibrium, the thus hindering full employment. If full- total output of goods and services employment cannot be attained (due to produced equals the total demand for the rigidity of wages, and therefore the those goods and services. The particular presence of involuntary unemployment), price level at which equilibrium occurs then the economy will not be able to is known as the equilibrium price level. produce the full-employment level The level of aggregate employment of output. corresponding to the equilibrium level Having now introduced the concept of aggregate supply is the equilibrium of aggregate demand and the two level of employment. concepts of aggregate supply, we may This equilibrium may be of two now analyse the concept of types– full-employment equilibrium, and macroeconomic equilibrium. under-employment equilibrium. Clip 4.2 The Life of John Maynard Keynes John Maynard Keynes (1883 – 1946) was the eldest son of the British economist John Neville Keynes, who was the Registrar of Cambridge University. Keynes graduated from Cambridge University in 1905 with a mathematics tripos and embarked upon a high-flying career which would see him at various points of time as an Economist, Adviser to the Government, Editor, and Professor of Economics. For two years from 1906 to 1908 he served in the India Office of the British Government. From 1909 to 1915 he was a lecturer at King’s College, Cambridge during which period he wrote ‘Indian Currency and Finance’ in 1913. In 1912 he became the editor of the Economic Journal, a post he held till 1945. From 1915 to 1919 he served the British treasury, and in 1919 he wrote ‘The Economic Consequences of the Peace’, where he criticised the war reparations imposed on Germany as too high. His book ‘A Treatise on Money’ appeared in 1930. In 1936 he wrote his revolutionary book, ‘The General Theory of Employment, Interest and Money’. In 1944, he took a leading part in the discussions at Bretton Woods, which led to the establishment of the IMF. In appreciation of his services to his country, the British Government made him the first Baron of Tilton (Lord Keynes of Tilton). He died on April 21, 1946. AGGREGATE DEMAND AND AGGREGATE SUPPLY IN MACROECONOMICS 47 Full-employment Equilibrium Point E represents the full- Full-employment equilibrium is an employment equilibrium. It is the point equilibrium state where all resources of intersection of the aggregate supply in the economy are fully utilised. The curve and the aggregate demand curve. Classical school of economics believed Corresponding to point E, the that the full-employment equilibrium equilibrium price level is P and the eq would always prevail in the economy. equilibrium level of output is Q . Since eq They recognized the possibility that aggregate supply is always at the though the economy might briefly full-employment level, the equilibrium depart from this equilibrium, it would level of output Q is also the eq be restored due to the free play of the full-employment level of output. market forces, i.e. interaction between The equilibrium is therefore a aggregate demand and aggregate full-employment equilibrium. The supply. The theoretical foundation of aggregate demand curve serves only to this belief in full-employment determine the equilibrium price level. equilibrium was based upon the assumptions of (a) Say’s law of Under-employment Equilibrium markets, and (b) wage-price flexibility. Under-employment equilibrium is a The full-employment equilibrium is state of equilibrium where resources are shown in Figure 4.4. under-employed. The idea of under- The Y-axis measures the general employment equilibrium is explained price level. The X-axis measures the in the Keynesian approach. The level of output. AD is the aggregate Keynesian approach was developed demand curve and AS is the Classical aggregate supply curve. against the background of the Great Depression of the 1930’s. When an economy is gripped by the Pricelevel AS phenomenon of depression, there is decline in economic activity. This results in under utilisation of resources, as there is no active or effective demand for output. The reason for under- employment equilibrium is a condition P E eq of deficiency of aggregate demand. Keynes understood aggregate AD supply to be perfectly elastic with respect to price that is, the producers were willing to supply any amount of Q Output eq goods and services at a given price level. Fig 4.4: Full-employment equilibrium As pointed out earlier, the theoretical 48 INTRODUCTORY MACROECONOMICS foundations of the perfectly elastic because the equilibrium level of output aggregate supply curve were the Q is less than the full-employment level eq assumptions of (a) wage-price rigidity of output Q*. and (b) constant marginal product of Given the perfectly elastic aggregate labour. supply curve, the equilibrium level of With a perfectly elastic aggregate output and employment is determined supply curve, the determination of the solely by the level of aggregate demand. equilibrium level of output and The equilibrium price level is employment depends only on the level determined by the height of the of aggregate demand. When there is aggregate supply curve above the deficient aggregate demand, that is, a X-axis. level of aggregate demand which is less The Keynesian approach to moving than the full employment level of output, the economy out of the under- there will be an under-employment employment equilibrium to full- equilibrium. employment equilibrium was to The under-employment equilibrium increase the aggregate demand by the is shown in Figure 4.5. device of increasing the government Pricelevel AS expenditure on goods and services. The increase in aggregate demand would automatically call forth an equivalent increase in aggregate supply AD without affecting the price level. The economy could thus be moved to a full- employment equilibrium by merely P E eq increasing the level of aggregate demand to that level required for the full- employment level of output. The process of altering aggregate demand Q eq Q* Output by the government, as against Fig. 4.5: Under-employment equilibrium aggregate supply, is called demand management policy. AD is the aggregate demand curve The Keynesian remedy for under- and AS is the aggregate supply curve. employment equilibrium places P is the equilibrium price level, Q is emphasis on increasing the level of eq eq the equilibrium level of output, and Q* aggregate demand for the attainment of is the full-employment level of output. the full-employment equilibrium level. Point E is an under-employment We shall therefore look at the equilibrium. It is the point of components of aggregate demand, and intersection of the aggregate demand the determination of equilibrium output curve and the aggregate supply curve. and employment in the Keynesian It is an under-employment equilibrium framework in the next two chapters. AGGREGATE DEMAND AND AGGREGATE SUPPLY IN MACROECONOMICS 49 SUMMARY (cid:1) Aggregate demand is the total demand for goods and services in the economy. (cid:1) Aggregate supply is the total supply of goods and services in the economy. (cid:1) The Classical aggregate supply curve is perfectly inelastic with respect to prices. The aggregate supply is always at the full-employment level of output. (cid:1) The theoretical basis of the Classical aggregate supply curve is (a) Say’s law of markets, and (b) wage-price flexibility. (cid:1) The Keynesian aggregate supply curve is perfectly elastic with respect to prices until the full-employment level of output. This means that firms are willing to supply any amount of output at the prevailing price level. (cid:1) The theoretical basis of the Keynesian aggregate supply curve is (a) constant marginal product of labour, and (b) wage-price flexibility. (cid:1) Equilibrium between aggregate demand and aggregate supply occurs when at a particular price level, aggregate demand equals aggregate supply. (cid:1) Equilibrium may be of two types – full-employment equilibrium and under- employment equilibrium. (cid:1) Full-employment equilibrium is that equilibrium where all resources are employed to their full limit. (cid:1) Under-employment equilibrium is that equilibrium where resources are not fully employed. EXERCISES 1. What is aggregate demand? 2. What is aggregate supply? 3. How is the Classical concept of aggregate supply different from the Keynesian concept of aggregate supply? 4. What is meant by equilibrium? 5. Differentiate between full-employment and under-employment equilibrium. 6. Explain: (a) voluntary, and (b) involuntary unemployment. A 4.1: T G D PPENDIX HE REAT EPRESSION In the 1930’s there was a world In the figure given below, the Y-axis depression. There was a serious measures the index of product of G-7 decline in economic activity, of countries, with 1929 as the base year unprecedented length and severity. The (see Fig A4.1). 1920’s saw a stock market boom in the Caught by surprise, firms cut back U.S. as the result of general optimism: their own plans for further purchase of businessmen and economists believed producer durable goods; firms making producer durables cut back that the newly-born Federal Reserve production and those who feared they (the Central Bank of the United States might soon be out of work cut back of America) would stabilize the purchases of consumer durables, and economy, and that the pace of firms making consumer durables faced technological progress guaranteed falling demand as well. rapidly rising living standards and Falls in prices—deflation—during expanding markets. The U.S. Federal the Depression set in motion Reserve’s attempts in 1928 and 1929 contractions in production, which to raise interest rates to discourage triggered additional falls in prices. With speculation in the stock market prices falling at ten per cent per year, brought on an initial recession. Fig A4.1 : Index of production of G-7 Countries during Great Depression AGGREGATE DEMAND AND AGGREGATE SUPPLY IN MACROECONOMICS 51 investors could calculate that they 1930’s. In fact, unemployment in Great would earn less profit investing now Britain was above 10% by 1923, and than delaying investment until next remained above 10% until 1936. year when their dollars would stretch This was a state of affairs ten per cent further. Banking sector significantly different from the classical became panicky and the collapse of the world of full employment, with only world monetary system cast doubt on temporary deviations from full everyone’s credit, and reinforced the employment. This period of high and belief that now was a time to watch and prolonged unemployment was the wait. The slide into the Depression, with cause of great debate among increasing unemployment, falling economists and policy-makers as to the production, and falling prices, cause of the unemployment and the continued. correct remedy for the problem. In the United States, the Among the debaters was one John unemployment rate rose from 3.2% of Maynard Keynes (later Lord). He the labour force in 1929 to 25.2% of propounded a revolutionary theory of the labour force in 1933, the highest macroeconomics, which blamed the level during the course of the high unemployment on a deficiency in depression. Unemployment remained aggregate demand. Aggregate demand over 10% throughout the decade. Real was too low because of inadequate GNP fell by 30% and it could not reach investment demand. Keynes theory the 1929 level again till 1939. provided an economic policy to combat Meanwhile, things were even worse unemployment – stimulate aggregate in Great Britain. The depression started demand. Keynes was in favour of fiscal even earlier there. High unemployment measures such as government began in the early 1920’s and spending on public works in order to continued into and throughout the stimulate aggregate demand.