In figure 21, units of employment have been shown on the horizontal axis and levels of real income have been shown on the vertical axis. AD1, AD2 and AD3 are the levels of aggregate demand. Note the demand curves in this case are seen as upward functions and not downward sloping as normal demand curves. This is because demand curves (AD1, AD2 and AD3) here are functions of the level of income and not of the price level. The relationship between level of income and demand is direct, suggesting that the richer a person gets, the more would be his demand for all goods and services. OZ curve is a continuous upward function representing ASP and producersí expectations. Since ASP is related to the cost of production it behaves in the same manner as a usual aggregate supply curve. The points of intersection between the two have been marked as E1, E2 and E1 which are all equilibrium points. At every equilibrium position the simultaneous values of real income and level of employment are determined. At points E1, E2 and E3 these are Y1, Y2, Y3 and N1, N2, N3 respectively. Moreover the points of equilibrium decide effective demand on different AD curves. Though every point on the individual AD is a point on the Schedule, only one point on it is effective, in the sense reflecting the willingness of consumers to actually spend a part of their income.
Letís distinguish between Classical and Keynesian approaches. As we notice in the figure with a given aggregate supply curve higher levels of effective demand help to generate more employment opportunities and lead towards the full employment level. Letís assume that the economy is initially at point E2 with employment level as N2 and level of national income as Y2. At this stage some amount of the workforce is unemployed. If the classical solution of wage cut is applied then the economy is likely to move downwards in the direction of point E1. This will cause a further reduction in the effective demand, level of employment and real income. Therefore wage cut solution is self-defeating and intensifies the unemployment condition. What is needed at point E2 is the organization of the public expenditure program and the boosting the level of effective demand so as to move from E2 to E1. Such a movement ensures a higher level of employment and leads the economy closer to the full employment point. This proves that the level of employment is not a function of the rate of wages but it is a function of effective demand and size of the total expenditure in the economy.
1 Classical Theory
5. 2 Keynes'