In figure 19, SS and II are the initial savings
and investment curves respectively. The point of intersection of
these curves is E which represents the initial equilibrium position.
At point E the rate of interest is r and amount of savings equal
to investment is L. When consumers decide to spend less their unspent
portion of the income results in an increased level of savings. This has
been shown by a shift in the supply curve of savings from SS to S1S1.
With increased amount of savings, the rate of interest starts reducing.
It falls from r to r1. With reduction in the
rate of interest, the price paid for borrowed loanable funds reduces.
This induces producers to invest more to reach a new point of equilibrium
E1. This is a point at which S1S1,
the saving supply curve intersects the investment demand curve. Once again
savings are equal to investment at higher level of loanable funds L1.
Therefore in the new equilibrium position a fall in the rate of interest
causes a rise in the amount of investment of the size L1.
This compensates for the fall in the consumption demand for goods and
services. As a result of such an increase in the investment demand, the
level of aggregate demand is restored. Any danger of large-scale unemployment
has thus been avoided. The classical economists have also depended on
similar adjustments in the level of prices and wage rates. Hence flexible
rates of interest, prices and wage rates together ensure full employment
in the loanable funds, commodity and labor markets. Such a self-equilibrating
process prevents any dangers of prolonged and general unemployment conditions.
The total equilibrium has been shown below in figure 20.
(E) Full Equilibrium: The classical flexible interest,
price, wage rate solution automatically leads the economy back to the
full employment level. Therefore the effect of a fall in consumer demand
on the levels of output and employment is only temporary. In figure 20,
AD1 and SAS1 are original aggregate demand and aggregate
supply curves respectively. The two curves have intersected at point E.
In this equilibrium position original price level is
P and real output or national income level is Y. This is full employment
equilibrium since the long run supply curve LAS passes through this point.
When the consumers reduce their demand for consumption goods the aggregate
demand curve then shifts as AD2. The new
AD2 curve and original SAS1
curve have intersected at point E1 which is a short
run partial equilibrium condition. At E1
the price level falls to P1 and real output
level reduces to Y1. Thus a fall in the
real output causes some unemployment of labor and other resources. But
due to equilibrating forces at work, such as a fall in the rate of interest
and a cut in the wage rates, a fresh demand for investment goods is generated.
A fall in the wage rates reduces cost of production which induces producers
to employ more workers. As a result of these adjustments the economy moves
from E1 to a new equilibrium point E2.
At this point AD2 intersects the new supply
curve SAS2 which has shifted downwards.
Such a shift in the supply curve shows a fall in the cost of production
due to a cut in the wage rates. At point E2
the original equilibrium level of output Y can be produced which is the
full employment level of output. The price level has now fallen to P2.
Thus with a fall in the rate of interest, price level and wage rate, the
restoration of full employment equilibrium level becomes possible.
2 Keynes' Employment Theory