Keynes's theory of employment: effective demand, consumption and the multiplier

1. Setting

John Maynard Keynes published The General Theory of Employment, Interest and Money in 1936, in the middle of the Great Depression. He rejected Say’s Law and the classical belief that full employment is automatic (see Say’s Law of Markets). His theory is a short-run theory: technique, the stock of capital, the labour force and tastes are taken as given, so employment varies with output and output with demand.

2. Effective demand

Aggregate supply function (ASF). For each level of employment, the minimum total sales proceeds that entrepreneurs must expect to receive to make it worth offering that employment. It rises with employment and becomes vertical at full employment, because output cannot rise further.

Aggregate demand function (ADF). For each level of employment, the total sales proceeds entrepreneurs actually expect to receive from what the community will spend. It too rises with employment, but less steeply, because consumption rises by less than income.

Effective demand is the value of aggregate demand at the point where the ADF intersects the ASF. At that point entrepreneurs’ expected receipts just equal the receipts they need, profits are maximised, and there is no tendency to change employment. The level of employment so fixed is the equilibrium level.

Diagram in words. Employment (N) on the horizontal axis, sales proceeds on the vertical. The ASF (Z) rises from the origin and turns vertical at full employment N_F. The ADF (D) starts above zero and rises less steeply. They cross at E, above employment N_E. If N_E lies to the left of N_F, the gap N_EN_F is involuntary unemployment. To the left of E, D lies above Z, so expected receipts exceed costs and firms expand; to the right, Z lies above D and they contract.

3. Components of effective demand

In a closed economy without government, effective demand = consumption expenditure + investment expenditure. Since Y = C + I and Y = C + S, equilibrium is also where planned saving equals planned investment.

The consumption function and the psychological law of consumption

Consumption depends mainly on income: C = f(Y). Keynes’s psychological law states that “men are disposed, as a rule and on the average, to increase their consumption as their income increases, but not by as much as the increase in their income.” Three propositions follow:

1. When income rises, consumption rises, but by less: the marginal propensity to consume (MPC = ΔC/ΔY) is between 0 and 1.
2. The rest of the increase is saved; saving rises with income.
3. A rise in income leads to a rise in both consumption and saving, never a fall in either.

The average propensity to consume (APC = C/Y) falls as income rises. The law rests on assumptions: normal conditions (no war or hyperinflation), a free capitalist economy, and stable psychological and institutional factors (income distribution, habits, fashion) in the short run. Its importance: it explains why a gap opens between income and consumption as an economy grows richer, why investment must fill that gap, and why the multiplier is finite.

Investment

Investment depends on the marginal efficiency of capital (MEC, the expected rate of return on new capital assets) compared with the rate of interest. Firms invest as long as MEC exceeds the rate of interest. MEC depends on expectations, which are volatile (“animal spirits”); this is why investment, and so employment, fluctuates. The rate of interest is fixed by liquidity preference (the demand for money for transactions, precaution and speculation) and the supply of money.

4. The multiplier

An increase in investment raises income by a multiple of itself, because the first round of spending becomes someone’s income, part of which is spent again. R.F. Kahn developed the employment multiplier in 1931; Keynes adapted it to investment.

k = ΔY / ΔI = 1 / (1 − MPC) = 1 / MPS

With MPC 0.8, Rs. 100 crore of new investment generates income rounds of 100, 80, 64, 51.2 and so on, summing to 500. Leakages reduce the multiplier: saving, taxes, imports, debt repayment and purchase of old securities.

5. Policy conclusions

• Full employment is not automatic; the State must act.
• In a depression, raise effective demand by public investment (public works), deficit spending, lower taxes and cheap money.
• Redistribute income towards the poor, whose MPC is higher, to raise consumption.
• Wage cuts are not a remedy; they reduce demand.

6. Criticism

1. Short-run theory. It takes capital, technology and population as given and says little about long-run growth.
2. Closed economy. Foreign trade is largely ignored in the basic model.
3. Neglect of the supply side and inflation. Stagflation in the 1970s showed demand management alone could not handle supply shocks.
4. Limited relevance to developing countries. V.K.R.V. Rao (“Investment, Income and the Multiplier in an Underdeveloped Economy”, 1952) argued that in India unemployment is structural and disguised, due to lack of capital, not lack of demand. Extra demand raises prices more than output, because supply of goods (especially food) is inelastic, so the multiplier works in money terms but not in real terms.
5. Aggregation. Treating the economy in aggregates hides sector-level bottlenecks.

How this is examined

“Explain J.M. Keynes theory of employment” (January 2026, 100-mark, Q.2), “Critically explain J.M. Keynes theory of employment” (June 2025), and “Explain the Keynesian concept of effective demand with suitable diagram” (January 2026, 80-mark). Short notes: “Psychological law of consumption” (January 2026, August 2024) and “Effective demand” (June 2025). Draw the ADF–ASF diagram for every version. For “critically”, add section 6, with Rao’s point on developing countries.