Question

Account for the various elements of Keynes’ rejection of the Classical proposition that full employment is the “natural” state of the economy.

Answer 1

Based on awkward and unrealistic assumptions, classical economist argues that fullemployment is a normal situation of a capitalist economy. If unemployment exists, it is temporary and the economic forces themselves change in such a manner to remove unemployment. In a situation of unemployment the demand for labour is less than its supply. The law demand lowers the wage rate and fall in wage rate stimulate more demand for labour and unemployment disappears. But the classical agree with frictional and voluntary unemployment. But involuntary unemployment is absent in their notion. The foundation of classical economics is Say’s Law of market. Says Law states that every purchase is a sale and every sale is a purchase. Every product which enters into the market leaves sufficient income to generate its demand. The people never hold money as an idle balance since holding money gives disutility to human. In any case if the people hold money or save it, the saving will be automatically channeled into investment through the flexibility of interest rate. In any circumstances, there are unsold goods in the market and resulting unemployment, the price level falls so as to generate sufficient demand and the unsold goods will be sold out and the unemployed people will get employment. Thus in classical view, fullemployment is a normal situation of an economy with wage price and interest rate flexibility.

But Keynes rejected all the classical notions and proved their theories are inadequate and inappropriate in his book General Theory of Employment Interest and Money which was published in 1930. Keynes rejected the classical theories on the following grounds.

1. Say’s Law is invalid.

People do not spend all of their income, they save a part of income and thus aggregate demand falls short of aggregate supply. The unsaved income cannot be channeled into investment because of the existence of liquidity trap. After a certain low level of interest the demand for money is perfectly elastic. Thus a further fall in rate of interest cannot stimulate investment and the deficiency in aggregate demand cannot be filled by increased investment. Thus over production and unemployment persist in the economy.

2. Saving and investment are not interest elastic.

Another dubious assumption of classical theory is that saving and investment are equalized through the rate of interest. According to Keynes saving depends upon the level of income and investment depends upon the rate of interest and marginal efficiency of capital. Even at low rate of interest people will not invest if the marginal efficiency of capital is lower than the rate of interest. In short saving investment equality is not brought about not by rate of interest rather it depends upon the MEC. In such a situation fullemployment cannot be maintained.

3. Wage is not flexible in downward direction.

In modern economies the existence of strong trade unions will not let the wages to be reduced. Again the modern government passes minimum wage laws which do not allow the wage to fall below a minimum level. If wage cut is not a practical solution fullemployment cannot be restored. On the other hand if the wage rate is not flexible in downward direction, it is not possible to give employment to those who are unemployed.

4. Absence of self adjustment.

The economic forces are not self generating and self adjusting to restore fullemployment. Thus external force like government intervention is necessary.

Thus in the context of deficiency in aggregate demand, inability of interest to bring sufficient investment, inapplicability of wage cut and absence of self adjustment Keynes points out that the normal situation of an economy is underemployment.