(a) Explain the concept of underemployment equilibrium with graphical illustration. Why full employment cannot be reached…

(a) Underemployment equilibrium

Classical theory relies on Say's Law (supply creates its own demand) and on flexible wages, prices and interest rates, so the economy always returns to full employment. Keynes rejected this. Output and employment are set by effective demand, the point where the aggregate demand function (the receipts entrepreneurs expect) meets the aggregate supply function (the receipts they need to justify each level of employment). Nothing guarantees that this point lies at full employment.

In the Keynesian cross, the 45° line shows all points where planned expenditure equals output (AE = Y). The aggregate expenditure line AE = C + I + G has a positive intercept and a slope (the marginal propensity to spend) below one. Equilibrium is at E, where AE cuts the 45° line, giving income Y*. If Y* is below full-employment output Yf, the economy is in underemployment equilibrium. At Y* planned spending equals output, so firms have no reason to change production; at Yf, AE < Y, unsold stocks pile up and output falls back to Y*. The vertical distance between the 45° line and AE at Yf is the deflationary gap: the extra spending needed to reach full employment. In the second panel, effective demand fixes employment at Nₑ, below full employment N_f; the difference is involuntary unemployment, because workers willing to work at the going wage cannot find jobs.

Why full employment is not reached automatically in Keynes' approach:

• Money wages are rigid downwards because of contracts, unions, minimum wages and money illusion, so the labour market does not clear through wage cuts.
• Even if money wages fall, they also cut workers' incomes and hence consumption; aggregate demand may fall along with costs, leaving employment unchanged. Keynes argued that wage cuts help only indirectly, by lowering prices, raising real money balances and reducing interest rates (the Keynes effect).
• That route can fail. In a liquidity trap, extra money is simply held and the interest rate does not fall; and investment is interest-inelastic when business expectations (animal spirits) are pessimistic.
• Saving and investment are made by different people for different reasons. An increase in the desire to save lowers consumption and income, not interest rates (the paradox of thrift), so a fall in demand is not offset automatically.
• Hence the economy can rest at an equilibrium with unemployment, and government action, through fiscal expansion or monetary easing, is needed to raise effective demand.

(b) Equilibrium income and interest rate (IS–LM model)

The model has taxes but no stated government spending. The standard reading is a balanced budget (G = T), so the goods market clears when private saving equals investment. (Taking G = 0 instead gives negative interest rates, r = −8% and −32%, which have no economic meaning, so that reading is not used.)

Goods market (IS curve):

• Disposable income: Y − T = Y − 20 − 0.2Y = 0.8Y − 20
• Saving: S = −40 + 0.5(0.8Y − 20) + 0.25r = 0.4Y + 0.25r − 50
• S = I: 0.4Y + 0.25r − 50 = 20 − 0.25r, so 0.4Y + 0.5r = 70
• IS: Y = 175 − 1.25r (downward sloping: a lower r raises investment and income)

Money market (LM curve), with M = 40:

• M = L: 40 = 0.4Y − 0.5r
• LM₀: Y = 100 + 1.25r (upward sloping: higher income raises transactions demand for money, which needs a higher r to keep the money market in balance)

Equilibrium:

• 175 − 1.25r = 100 + 1.25r, so 2.5r = 75 and r = 30%
• Y = 100 + 1.25 × 30 = ₹137.5 crore
• Check: T = 20 + 0.2 × 137.5 = 47.5; S = 55 + 7.5 − 50 = 12.5; I = 20 − 7.5 = 12.5, so S = I

Money supply increased by ₹20 crore (M = 60):

• LM₁: 60 = 0.4Y − 0.5r, so Y = 150 + 1.25r
• 175 − 1.25r = 150 + 1.25r, so r = 10% and Y = ₹162.5 crore
• Check: S = 65 + 2.5 − 50 = 17.5; I = 20 − 2.5 = 17.5

The rightward shift of LM lowers the interest rate by 20 percentage points, which raises investment by 5 and, through the multiplier, raises income by ₹25 crore. The income gain (25) is smaller than the horizontal shift of LM (50) because the lower interest rate also raises the speculative demand for money, which absorbs part of the new money.

(c) Classical theory of interest: a critical analysis

The classical theory, associated with Marshall, Pigou, Taussig and Böhm-Bawerk, treats interest as the price that brings saving and investment into equality. The supply of capital (saving) rises with the rate of interest, which rewards abstinence or waiting; the demand for capital (investment) falls with the rate of interest, because the marginal productivity of capital declines as more is invested. The equilibrium rate is where the saving and investment schedules intersect. The theory assumes full employment, a given income level, interest-elastic saving and neutral money.

Merits: it rightly stresses the real forces behind interest, namely the productivity of capital and people's time preference (thrift), which still matter for long-run interest rates; and it was later absorbed into the loanable funds theory and the IS curve of the Hicks–Hansen synthesis.

Criticisms:

• Indeterminacy: Keynes showed that saving depends mainly on income. The saving schedule cannot be drawn until income is known, but income itself depends on investment and hence on the rate of interest. The theory is therefore circular and cannot fix the rate of interest on its own.
• Full employment assumed: with unemployment, saving and investment are brought into equality by changes in income, not by changes in the rate of interest.
• Neglect of monetary factors: it ignores bank credit, hoarding and dishoarding, and the demand for money as an asset, so it cannot explain why the interest rate changes when the money supply changes.
• Saving is not very sensitive to interest: people save for old age, precaution and target amounts, and a higher rate can even reduce the saving needed to reach a target.
• Interest is a reward for parting with liquidity, not only for waiting: a person can save and still hoard cash, earning no interest.
• It is a long-period theory that says little about short-run movements, which depend on liquidity preference and central bank policy. Recent experience supports this: RBI rate changes move short-term rates almost at once, while saving and investment adjust slowly.

On balance, the classical theory identifies important long-run determinants but is incomplete. A full explanation needs both real factors (the IS curve) and monetary factors (the LM curve).