Question

Narrate the equilibrium between ADF and ASF with a diagram.

Answer 1

• Under the Keynes theory of employment, a simple two-sector economy consisting of the household sector and the business sector is taken to understand the equilibrium between ADF and ASF.
• All the decisions concerning consumption expenditure are taken by the individual households, while the business firms take decisions concerning investment.
• It is also assumed that the consumption function is linear and planned investment is autonomous.
• There are two approaches to the determination of the equilibrium level of income in Keynesian theory. These are:
  1. Aggregate demand – Aggregate supply approach
  2. Saving – Investment approach –
• In this chapter, out of these two, the aggregate demand and aggregate supply approach is alone explained to understand the determination of equilibrium level of income and employment.
• The concept of effective demand is more clearly shown in the figure.
• In the figure, the aggregate demand and aggregate supply reach equilibrium at point E. The employment level is N0 at that point.
• At ON₁ employment, the aggregate supply is N, Rr But they are able to produce M₁ N₁ The expected level of profit is M₁, R₁
• To attain this level of profit, entrepreneurs will employ more labourers.
• The tendency to employ more labour will stop once they reach point E.
• At all levels of employment beyond, ON₀, the aggregate demand curve is below the aggregate supply curve indicating loss to the producers.
• Hence they will never employ more than ON₀ labour.
• Thus effective demand concept becomes a crucial point in determining the equilibrium level of output in the capitalist economy or a free market economy in the Keynesian system.
• It is important to note that the equilibrium level of employment need not be the full employment level (N₁) from the Figure, it is understood that the difference between N₀ – N₀ is the level of unemployment.
• Thus the concept of effective demand becomes significant in explaining the under employment equilibrium.