Keynes's View on Full Employment

• “Full employment is a situation in which everyone who want to work is working except for those who frictionally and structurally unemployed.”
  — Prof. Spencer

“The natural rate of unemployment is the rate of unemployment arising from normal labour market frictions that exist when the labour market is in equilibrium. Natural unemployment, refers to frictional unemployment and structural unemployment.” — Ruffin and Gregory

J.M. Keynes was a famous 20th-century economist. He explained his theory of employment in his book The General Theory of Employment, Interest and Money. His main arguments were:

• There is no automatic full employment in the economy. Instead, underemployment (less-than-full employment) exists.
• This happens because of a lack of Aggregate Demand — people and businesses are not spending enough.
• Government intervention (State action) is needed to remove unemployment by raising the level of investment.

Think of it this way: Imagine a school canteen that can serve 500 students, but only 300 students show up to buy food. The canteen has the supply (capacity to serve 500), but the demand is only 300. The canteen will use fewer cooks and less food — that's underemployment caused by low demand.

Effective demand is the core idea of Keynes' theory. It is the level of total demand in the economy where:

Aggregate Demand (AD) = Aggregate Supply (AS)

At this point, whatever goods and services producers are willing to supply are exactly matched by what consumers and businesses are willing to buy.

Why does it matter? Because the level of employment in the economy depends on effective demand. More effective demand → more production → more jobs. Less effective demand → less production → unemployment.

According to Keynes, in the short run, the total production and national income of the economy depend on the level of employment. Here is the chain of reasoning from the source material:

Step 1: National income depends on employment

Y = f(N)

National Income or Output (Y) is a function of the Level of Employment (N) — meaning, the more people who are employed, the more the economy produces.

Step 2: Employment depends on effective demand

N = f(ED)

The Level of Employment (N) is a function of Effective Demand (ED) — meaning, employment rises when effective demand rises, and falls when effective demand falls.

Step 3: Effective demand is where AD meets AS

ED → AD = AS

Effective Demand (ED) is the equilibrium point where Aggregate Demand (AD) equals Aggregate Supply (AS).

The source material includes a flow chart that shows what effective demand depends on. Here is a simplified breakdown of each branch:

Branch 1: Aggregate Supply (Left Side)

• Aggregate Supply is given (fixed) in the short run — it doesn't change quickly because technology, machinery, and resources stay the same in the short period.

Branch 2: Aggregate Demand (Right Side)

Aggregate demand depends on two things:

A. Consumption Expenditure

This is how much households spend on goods and services. It is stable in the short period and depends on:

B. Investment Expenditure

This is how much businesses spend on new machines, factories, and equipment. It depends on:

i) Marginal Efficiency of Capital (MEC) — the expected rate of return from a new investment. MEC itself depends on:​

If the expected earnings (prospective yeild) are high and the cost (supply price) is low, the MEC will be high → businesses will invest more.

ii) Rate of Interest — the cost of borrowing money. It depends on:

Demand for Money (Liquidity Preference) — how much people want to hold cash instead of investing it. Keynes identified three motives for holding money:

Supply of Money — the total money available in the economy, which is given (fixed) in the short period, as it is controlled by the central bank.

If the rate of interest is low, borrowing is cheap → businesses invest more → employment rises.
If the rate of interest is high, borrowing is expensive → businesses invest less → employment falls.

• Keynes argued that economies usually face underemployment, not full employment, due to deficiency of aggregate demand.
• Full employment does not mean zero unemployment; frictional and structural unemployment always exist (natural rate of unemployment).
• Employment is determined by effective demand, i.e., where aggregate demand equals aggregate supply (AD = AS).
• To achieve full employment, state intervention and increased investment are necessary.