National Income and Employment Unit Two

1. National Income and EmploymentUnit Two At the end of this unit, you should be able to: • Explain the importance of Say’s law in the neoclassical theory of employment and outline keynes’ main criticisms of the classical theory • Show how equilibrium national income is determined in the simple keynesian model, recognising the assumptions upon which the model is build • Explain and illustrate the multiplier effect and derive simple formulas for calculating the value of the expenditure and taxation multipliers • Appreciate the limitations of the simple keynesian model These notes are incomplete without having attended lectures

2. National Income and EmploymentUnit Two What determines national income and employment in an economy? The classical theory of full employment Classical economists believed that if wages and prices were flexible, a competitive market economy would always operate at full employment. That is, economic forces would always be generated so as to ensure that the demand for labour was always equal to its supply. These notes are incomplete without having attended lectures

3. National Income and EmploymentUnit Two The classical theory of full employment In the classical model the equilibrium levels of income and employment were supposed to be determined largely in the labour market. At lower wage rate more workers will be employed. That is why the demand curve for labour is downward sloping. The supply curve of labour is upward sloping because the higher the wage rate, the greater the supply of labour. In the following figure the equilibrium wage rate (w) is determined by the demand for and the supply of labour. The level of employment is OL. These notes are incomplete without having attended lectures

4. National Income and EmploymentUnit Two The classical theory of full employment The lower panel of the diagram shows the relation between total output and the quantity of the variable factor (labour). It shows the short-run production function which is expressed as Q = f ( K, L ), where Q is output, K is the fixed quantity of capital and L is the variable factor labour. Total output Q is produced with the employment of L units of labour. According to classical economists this equilibrium level of employment is the ‘full employment’ level. So the existence of unemployed workers was a logical impossibility. The classical economists believed that aggregate demand would always be sufficient to absorb the full capacity output Q. In other words, they denied the possibility of under spending or overproduction. This belief has its root in Say’s Law. These notes are incomplete without having attended lectures

5. National Income and EmploymentUnit Two The classical theory of full employment Say’s Law: According to Say’s Law supply creates its own demand. The very act of producing goods and services generates an amount of income equal to the value of the goods produced. The circular flow of income model suggests this sort of relationship. Households receive income equal to the value of goods and services produced. Part of this income is spend and part they save. Consumption demand, then falls short of the total value of production by the amount of saving. This short fall is made up by investment demand and so long as investment and saving are equal, aggregate demand will necessarily equal the total value of production. These notes are incomplete without having attended lectures

6. National Income and EmploymentUnit Two The classical theory of full employment The classical economists argued that with flexible interest rate and a competitive market for loanable funds, saving and investment would always be made equal by changes in interest rates. How? These notes are incomplete without having attended lectures

7. National Income and EmploymentUnit Two The classical theory of full employment In conclusion: Classical system depends upon the following: • The dependence of investment and saving on the rate of interest • The upward and downward flexibility of wages, prices and interest rate and ; • The existence of competitive forces in the economy These notes are incomplete without having attended lectures

8. National Income and EmploymentUnit Two Keyne’s Criticism of Classical Theory: J.M. Keynes criticized the classical theory on the following grounds: 1. According to Keynes saving is a function of national income and is not affected by changes in the rate of interest. Thus, saving-investment equality through adjustment in interest rate is ruled out. So Say’s Law will no longer hold. 2. The labour market is far from perfect because of the existence of trade unions and government intervention in imposing minimum wages laws. Thus, wages are unlikely to be flexible. Wages are more inflexible downward than upward. So a fall in demand (when S exceeds I) will lead to a fall in production as well as a fall in employment. 3. Keynes also argued that even if wages and prices were flexible a free enterprise economy would not always be able to achieve automatic full employment. These notes are incomplete without having attended lectures

9. National Income and EmploymentUnit Two The Simple Keynesian Theory of employment According to this theory, real national income and employment is determined by aggregate demand. This different from the classical model which suggested that supply creates its own demand. In this model it is the demand that determines how much is supplied. The keynesian argues that if firms are producing more than it is demanded, this will results in increase in their inventory of unsold goods and they can only rectify this in the short run by cutting back on production and lying off workers which will cause national income to fall until the value of what is produced is equal to the value of aggregate demand These notes are incomplete without having attended lectures

10. National Income and EmploymentUnit Two The Simple Keynesian Theory of employment If firms are not producing enough to satisfy demand, they will experience fall in their inventories and this time will try to increase production in the short run by employing more workers. National income will increase until the value of what is produced is equal to the value of aggregate demand. According to Keynesian model, there is only one value of national income at which aggregate demand is equal to the total value of production. This is called equilibrium national income These notes are incomplete without having attended lectures

11. National Income and EmploymentUnit Two The Simple Keynesian Theory of employment Determination of equilibrium national income For us to be able to determine equilibrium national income, there are number of assumptions that have to be made. • Wages and prices are fixed • We ignore the money market • Planned consumption C and planned saving S are both directly related to income • Planned investment I and planned government spending G are autonomous . • Taxation T is in the form of lump-sum taxes only • Planned exports X are autonomous, but planned imports M depend directly on income • There is no economic growth These notes are incomplete without having attended lectures

12. National Income and EmploymentUnit Two The Simple Keynesian Theory of employment Determination of equilibrium national income Economy is in equilibrium when the aggregate demand for the economy’s goods and services is equal to the total value of goods and services produced. AD = Y Where AD = C+I+G+X-M and Y = C+S+T C+I+G+X-M = C+S+T I+G+X = Injections S+T+M = withdrawals I+G+X = S+T+M The condition for equilibrium can now be presented as follows: Withdrawals = Injections These notes are incomplete without having attended lectures

13. National Income and EmploymentUnit Two The Simple Keynesian Theory of employment Determination of equilibrium national income All the injections (I, G and X) are independent of income so that when plotted against income on the graph, the injections line will be a horizontal straight Line. Savings and imports are both directly related to income but taxes are lump-sum taxes therefore total withdrawals will be directly related to income with a slope equal to the sum of the marginal propensity to save and the marginal propensity to import These notes are incomplete without having attended lectures

14. National Income and EmploymentUnit Two These notes are incomplete without having attended lectures

15. National Income and EmploymentUnit Two AD, I, W (m) 60 45 50 AD=C+I+G+X-M 40 30 20 S+T+M= withdrawals 10 I+G+X= injection 0 10 20 30 40 50 60 National income These notes are incomplete without having attended lectures

16. National Income and EmploymentUnit Two From the graph, we can see that there two ways of identifying the equilibrium national income. • At the point where aggregate demand is equal to national income that is where AD line cuts the 45 line and, • At a point where total injections equal total withdrawals These notes are incomplete without having attended lectures

17. National Income and EmploymentUnit Two The Multiplier A measure of the relationship between the change in the equilibrium national income and the autonomous change that brings it about. What is likely to happened to national income if investment increases by N$2 million? Equilibrium condition, Y=C+I+G+X-M where I, G and X are autonomous. Consumption function, C=a+b(Y-T) Import function, M=c+d(Y-) These notes are incomplete without having attended lectures