Keynesian Theory of Employment

M. Keynes was a great economist of 20th century. The employment theory propounded by him has great importance in the modern economic world. J.M. Keynes not only criticized the classical theory of employment but also propounded a new theory of employment by publishing his famous book, “General theory of Employment, Interest and Money” in 1936. The new theory of employment propounded by him is known as the Keynesian theory of employment.

Keynesian theory of employment proved that the classical theory of employment has failed in the world. This classical theory of employment could not solve the problems seen during the great depression of 1930’s. At that time, the classical model has failed and people were found unemployed even if they were ready to work at the market rate of wage. Consequently, supply could not create its own demand. This proved J.B. Say’s law of market to be false.

Keynesian theory has provided a clear concept about the problems and solutions of the economy. According to Keynes’ theory of employment, unemployment in the economy is created due to decrease in the effective demand. Therefore, the main cause of unemployment is the decrease in consumption and investment. Keynes used the concept of aggregate demand and aggregate supply function to explain the determination of effective demand. The aggregate demand and aggregate supply are considered as two blades of a scissor, the equality of which determines the level of employment in the economy in a particular period of time.

The logical starting point of Keynes’ theory of employment is the principle of effective demand. In a capitalist economy the level of employment depends on effective demand. Thus, unemployment results from a deficiency of effective demand and the level of employment can be raised by increasing the level of effective demand. Hence, Keynesian theory of employment is also known as ‘principle of effective demand’ or ‘Demand Deficiency Theory’.


Keynesian theory of employment is based on the following assumptions:

(1) The Short Period:

            Keynes was writing about the short period problem of depression. Therefore, he made the specific assumption of short-period so as to concentrate on the problem at hand. Keynes assumed that the techniques of production and the amount of fixed capital used remain constant in the model of his theory. In his view, short period is that in which new investments do not change the technique, the organization and equipment. This considerably simplified his analysis, for he could thereby take employment and output as moving together in the same direction.

(2) Perfect Competition:

            He assumed that there is a fairly high degree of consumption in the markets. Or if there is some monopoly element somewhere, then its degree remains unchanged.

(3) Operation of Diminishing Returns:

            Further, directly flowing from his assumption of unchanging techniques was his a assumption of the operation of diminishing returns to productive resources or increasing costs.

(4) Absence of Governmental part in Economic Activity:

            The government is assumed to play no significant role either as a taxer or as a spender. He ignored the fiscal operations of the government in his analysis to highlight the causes of and remedies for instability of the pure capitalist economy.

(5) A Closed Economy:

            Keynes further assumed that the Economy under analysis is a closed one; that is, he did not explicitly recognise in his analysis the influence of exports and imports. This considerably simplified his work.

(6) Static Analysis:

            The ‘General Theory’ does not trace out the effect of the future on the present economic events clearly. Its analysis remains comparatively static, though at times Keynes introduced expectations in his analysis.

Keynes states that increase in employment depends on increase in aggregate demand. Aggregate demand increases though increase in investment, increase in government expenditure and so on. So, demand is much more important in Keynesian theory. Effective demand is said to exist at the point where aggregate demand is equal to aggregate supply. According to Keynes, in the short-run, the determination of the level of employment and income depends upon the effective demand of goods. His theory is built upon the basic idea of ‘Effective Demand’ which determines employment. The effective demand in turn depends upon consumption and investment, which depends upon marginal efficiency of capital and the rate of interest.

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