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

Part (a): Underemployment equilibrium

Classical theory assumes Say’s Law: supply creates its own demand, so output adjusts to full employment through flexible wages and prices. Keynes rejects this. In a 45° diagram, the 45° line represents Y=AE; the aggregate demand line AE=C+I+G is drawn with positive intercept and slope less than one. Its intersection with the 45° line gives equilibrium Y*. If Y* lies to the left of full-employment output Yf, the economy is in underemployment equilibrium. At Y*, planned spending equals output, so firms have no incentive to expand; at Yf, AE<Y, inventories accumulate and output falls back to Y*. The gap between Y* and Yf is the unemployment gap. Because AE is determined by consumption, investment and government spending, a fall in any component shifts AE down and lowers Y*, not merely wages. Thus equilibrium need not be full employment.

Full employment is not automatic because effective demand can be deficient. Money wages are downward rigid due to contracts, unions, minimum wages and expectations, so labour cannot be cleared by wage cuts. Even if wages fall, the liquidity trap can make money demand highly interest-elastic, so rate cuts may not lower r enough. Investment may be insensitive to interest because expectations, capacity and credit conditions dominate. The paradox of thrift shows that higher saving can reduce income and aggregate demand, not increase investment. Hence Say’s Law breaks down and policy is needed.

Part (b): IS–LM equilibrium

With no G given, take G=0. Goods-market equilibrium requires S+T=I. Substituting T: S=-40+0.5(Y-20-0.2Y)+0.25r=0.4Y+0.25r-50. Hence S+T=0.6Y+0.25r-30. Equating to I=20-0.25r gives 0.6Y+0.5r=50, or 6Y+5r=500, i.e. Y=83.33-0.833r, the IS curve. The IS curve is downward sloping because a lower r raises I and hence Y. Money-market equilibrium gives M=L: 40=0.4Y-0.5r, or 4Y-5r=400, i.e. Y=100+1.25r, the LM curve. The LM curve is upward sloping because a higher Y raises transaction demand for money, requiring a higher r to keep the money market in equilibrium. Solving, 10Y=900, so Y=90 crore and r=-8%. The negative rate is a direct arithmetic result of the given functions; it does not affect the comparative-static result.

When M rises to 60, LM becomes 60=0.4Y-0.5r, or 4Y-5r=600. The LM curve shifts right. Solving with 6Y+5r=500 gives 10Y=1100, so Y=110 crore and r=-32%. Thus monetary expansion raises equilibrium income and lowers the interest rate, confirming the Keynesian view that money affects real output when the economy is below full employment.

Part (c): Classical interest theory

Classical theory treats interest as the price that equilibrates saving and investment in a full-employment loanable-funds market. Saving is a function of positive interest as reward for abstinence; investment is a function of negative interest as cost of capital. The critique is that this reasoning is circular: it assumes full employment and then derives interest from the intersection of saving and investment, but if effective demand is short, saving and investment need not determine a positive rate. The classical loanable-funds diagram also presumes a fixed full-employment output, so the saving and investment schedules are drawn at Yf; if output is below Yf, the schedules shift, making the original intersection irrelevant. It also ignores the speculative motive for holding money. Keynes shows that money demand depends on transactions, precautionary and speculative motives, and interest is the reward for parting with liquidity, not merely abstinence. Without a fixed money supply and speculative demand, the classical model can be indeterminate. Empirically, in India after the 2008 crisis, despite RBI easing, private investment remained weak, showing that lower rates do not automatically raise investment. Hence Keynes’s liquidity preference better explains interest and supports active monetary and fiscal policy. Together, underemployment equilibrium, IS–LM monetary transmission and liquidity preference show that macroeconomics must start from effective demand, not full-employment adjustment.