CHAPTER

16
Ke Theory The Keynesian Theory
The Keynesian theory does not analyse the problems of underdeveloped economies. It has relevance to advanced capitalist countries. But in order to find out how far the Keynesian theory is applicable to underdeveloped economies, it is better to summarise Keynes theory.

SUMMARY OF KEYNES1 THEORY

Total income is a function of total employment in a country. The greater the national income, the greater the volume of employment resulting therefrom and vice versa. The volume of employment depends on effective demand. Effective demand determines the equilibrium level of employment and income. The effective demand is determined at the point where aggregate demand price equals aggregate supply price. Effective demand consists of consumption demand and investment demand. Consumption demand depends on the propensity to consume. The latter does not increase to the same extent as the increase in income. The gap between income and consumption can be made up by investment. If the requisite volume of investment is not forthcoming, the aggregate demand price will fall short of aggregate supply price. As a result, income and employment will fall till the gap is bridged up. Thus, variations in employment
1. J.M. Keynes, The General Theory of Employment, Interest and Money, pp. 113-15.

and income largely depend on investment. The volume of investment depends on the marginal efficiency of capital and the rate of interest. The marginal efficiency of capital is the expected rate of return from new capital assets. When profit expectations are high, businessmen invest more. The rate of interest, other determinant of investment, depends on the quantity of money and liquidity preference. Now investment can be raised either by raising the marginal efficiency of capital or by lowering the rate of interest. Though a rise in investment usually leads to an increase in employment. This may not happen if the propensity to consume falls at the same time. On the contrary, a rise in the propensity to consume can lead to rise in employment without increase in investment. Rise in investment leads to increase in income, and out of the increased income, there is more demand for consumption goods which leads to further increase in income and employment. This process tends to become cumulative. As a result, a given rise in investment causes a multiple increase in income via the propensity to consume. This relationship between increment of investment and of income is called by Keynes, the multiplier K. The multiplier establishes a precise relationship, given the propensity to consume, between aggregate employment and income and the rate of investment.... It tells us that, when there is an increment of aggregate investment, income will increase by an amount which is K times the increment of investment. The formula is Y=KI, and 1l/K represents the marginal propensity to consume. Thus the multiplier K=1/1MFC. Since the marginal propensity to consume falls with increase in income, it becomes necessary to inject large doses of investment for securing higher levels of income and employment within the economy. This, in brief, is Keynes Theory of Employment. Kenyes did not develop any systematic model of economic development in his General Theory. This was left to his predecessors like Harrod, Domar, Joan Robinson and others who made full use of the Keynesian tools to construct models of economic growth. It is only in an essay entitled Economic Possibilities for Our Grand Children that Keynes suggested an outline of the fundamental conditions of economic progress. They are: (i) our power to control population; (ii) our determination to avoid civil war and dissension; (iii) our willingness to entrust to science, the direction of those matters which are properly the concern of science; and (iv) the rate of accumulation as fixed by the margin between our production and our consumption.2 So far as the future of capitalism is concerned, Keynes was optimistic. He may be said to be a prophet of boom. Keynes regarded capitalism as a mechanism possessing great resilience and adaptability to mould itself according to circumstances. Keynes developed his theory of capitalist breakdown (secular stagnation) based on general over-production, chronic underconsumption, and the declining marginal efficiency of capital in future. The remedy he proposed was deliberate state action. APPLICABILITY OF KEYNES THEORY TO UNDERDEVELOPED COUNTRIES The Keynesian theory is not applicable to every socio-economic set-up. It only applies to advanced democratic capitalist economies. As Schumpeter wrote, Practical Keynesianism is a seedling which cannot be transplanted into foreign soil; it dies there and becomes poisonous before it dies. But left in English soil, this seedling is a healthy thing and promises both fruit and shade. All this applies to every bit of advice that Keynes ever offered. 3
2. J.M. Keynes, Essays in Persuasion, p. 373. 3. J.A. Schumpeter, Ten Great Economists, op. cit., p. 275.

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Before we study the applicability of Keynesian economics to underdeveloped countries, it is essential to analyse the assumptions of Keynesian economics vis-a-vis the conditions prevailing in underdeveloped economies. KEYNESIAN ASSUMPTIONS AND UNDERDEVELOPED COUNTRIES The Keynesian economics is based on the following assumptions which limit its applicability to underdeveloped countries: Cyclical Unemployment. The Keynesian theory is based on the existence of cyclical unemployment which occurs during a depression. It is caused by deficiency in effective demand. Unemployment can be removed by an increase in the level of effective demand. But the nature of unemployment in an underdeveloped country is quite different from that in a developed economy. In such economies unemployment is chronic rather than cyclical. It is not due to lack of effective demand but is the result of deficiency in capital resources. Apart from chronic unemployment, underdeveloped countries suffer from disguised unemployment. Keynes was concerned with the removal of involuntary unemployment and the problem of economic instability. So he did not refer to disguised unemployment and its solution. The remedy to the chronic and disguised unemployment is economic development to which Keynes paid no attention at all. Thus, the Keynesian assumptions of cyclical unemployment and economic instability are hardly tenable in an underdeveloped economy. Short Period Analysis. The Keynesian economics is a short period analysis in which Keynes takes as given the existing skill and quantity of available labour, the existing quantity and quality of available equipment, the existing technique, the degree of competition, the tastes and habits of the consumer, the disutility of different intensities of labour and of the activities of supervision and organisation as well as social structure.4 The development economics, however, is a long period analysis in which all the basic factors, assumed by Keynes as given, change over time. Closed Economy. The Keynesian theory is based on the assumption of a closed economy. But Underdeveloped countries are not closed economies. They are open economies in which foreign trade plays a dominant role in developing them. Such economies primarily depend on the exports of agricultural and industrial raw materials and the import of capital goods. Thus the Keynesian economics has little relevance to underdeveloped countries in this respect. Excess Supply of Labour and Complementary Factors. The Keynesian theory assumes an excess supply of labour and other complementary resources in the economy. The analysis refers to a depression economy where the industries, machines, managers and workers, as well as consumption habits, are all there, only wanting to resume their temporarily suspended functions and role.5 But in underdeveloped economies there is no temporary suspension of economic activity. Economic activity is static. Capital, skills, factor supplies and economic infrastructure are woefully lacking. Labour and Capital Simultaneously Unemployed. Moreover, it can be inferred from the above assumption that labour and capital are unemployed simultaneously, according to the Keynesian analysis. When labour is unemployed, capital and equipment are also not fully utilized or there is excess capacity in them. But this is not so in underdeveloped countries. When labour is
4. J.M. Keynes, op.cit., p. 245, note l. 5. A.O. Hirschman, The Strategy of Economic Development, p. 54.

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unemployed, there is no question of capital being unutilized because there is acute shortage of capital and equipment. TOOLS OF KEYNESIAN ECONOMICS AND UNDERDEVELOPED COUNTRIES Thus, the assumptions on which the Keynesian theory is based are not applicable to the conditions prevailing in underdeveloped countries. We now study the principal tools of the Keynesian theory to test their validity to underdeveloped countries. 1. Effective Demand. Unemployment is caused by deficiency of effective demand, and to get over it, Keynes suggested the stepping up of consumption and non-consumption expenditures. In an underdeveloped country, however, there is no involuntary unemployment but disguised unemployment. Unemployment is caused not by lack of effective demand but by lack of complementary resources. The concept of effective demand is applicable to those economies where unemployment is due to excess savings; and in such a situation the remedy lies in stepping up the levels of consumption and investment through various monetary and fiscal measures. But in an underdeveloped economy, income levels are extremely low, the propensity to consume is very high and savings are almost nil. All efforts to increase money income through monetary and fiscal measures will, in the absence of complementary resources, lead to price inflation. Here the problem is not one of raising the effective demand but one of raising the levels of employment and per capita income in the context of economy development. The economic progress consists of two distinct categories; one, where given the level of economic development, you move from low employment to full employment, and the other, where you move from full employment at a given level of economic development to full employment at the next higher level of economic development. The Keynesian thesis applies only to the first category.6 2. Propensity to Consume. One of the important tools of Keynesian economics is the propensity to consume which highlights the relationship between consumption and income. When income increases, consumption also increases but by less than the increment in income. This behaviour of consumption further explains the rise in saving as income increases. In underdeveloped countries the relationship between income, consumption and saving do not hold. People are very poor and when their income increases, they spend more on consumption goods because their tendency is to meet their unfulfilled wants. The marginal propensity to consume is very high in such countries, whereas the marginal propensity to save is very low. The Keynesian economics tells us that when the MPC is high, consumer demand, output and employment increase at a faster rate with the increase in income. But in an underdeveloped country it is not possible to increase the production of consumer goods due to the scarcity of co-operant factors, when consumption increases with the rise in income. As a result, prices rise instead of a rise in the level of employment. 3. Propensity to Save. On the saving side, Keynes regarded saving as a social vice for it is excess of saving that leads to a decline in aggregate demand. Again, this idea is not applicable to underdeveloped countries because saving is the panacea for their economic backwardness. Capital formation is the key to economic development, and capital formation is possible through increased saving on the part of people. Underdeveloped countries can progress by curtailing consumption and increasing saving, as opposed to the Keynesian view of raising consumption and reducing saving. To underdeveloped countries, saving is a virtue and not a vice. 4. Marginal Efficiency of Capital. According to Keynes, one of the important determinants of
6. V.K.R.V. Rao, Essays in Economic Development, op. cit., p. 61. Italics mine.

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investment is the marginal efficiency of capital. There is an inverse relationship between investment and MEC. When investment increases, the MEC falls, and when investment declines, the MEC rises. This relationship is however not applicable to underdeveloped countries. In such economies, investment is at a low level and the MEC is also low. This paradox is due to lack of capital and other resources, small size of the market, low income, low demand, high costs, underdeveloped capital and money markets, uncertainties, etc. All these factors keep the MEC (profit expectations) and investment at a low level. 5. Rate of Interest. The rate of interest is the second determinant of investment in the Keynesian system. It is, in turn, determined by liquidity preference and the supply of money. Of the motives for liquidity preference, the transaction and precautionary motives are income elastic and they do not influence the rate of interest. It is only the demand for money for the speculative motive that affects the rate of interest. In underdeveloped countries, the liquidity preference for transaction and precautionary motives is high and for the speculative motive low. Therefore, liquidity preference fails to influence the rate of interest. The other determinant of the interest rate is the supply of money. According to Keynes, increase in the supply of money lowers the interest rate and encourages investment, income and the level of employment. But in underdeveloped countries, an increase in the supply of money leads to rise in prices rather than to the fall in interest rate. The rate of interest in such countries is not influenced so much by the demand for and supply of money as by traditions, customs and institutional factors. 6. The Multiplier. Prof. V.K.R.V. Rao has analysed the feasibility of applying the Keynesian multiplier theory and policy implications to an underdeveloped country like India.7 According to Rao, Keynes never formulated the economic problems of underdeveloped countries, nor did he discuss the relevance to these countries of either the objective or the policy that he proposed for the more developed countries. The result has been a rather unintelligent application of Keynesian economics to the problems of underdeveloped countries. The Keynesian concept of multiplier is based on the following four assumptions: (a) Involuntary unemployment. (b) An industrialized economy where the supply curve of output slopes upward towards the right but does not become vertical till after a substantial interval. (c) Excess capacity in the consumption goods industries. (d) Comparatively elastic supply of the working capital required for increased output. Given these assumptions, if we apply the multiplier theory on underdeveloped countries, the value of the multiplier will be apparently much higher than even in a developed country. We know that the multiplier depends on the size of the marginal propensity to consume. Since in an underdeveloped country the marginal propensity to consume is fairly high, small increments of investment are likely to induce full employment much earlier than in a rich country where the marginal propensity to consume is low. This is something paradoxical and contrary to facts. For the assumptions on which the multiplier theory is based do not hold valid in the case of an underdeveloped country. Let us test them in the light of conditions prevailing in an underdeveloped country like India. (a) Involuntary Unemployment. Involuntary unemployment in the Keynesian analysis is associated with a capitalist economy where the majority of workers work for wages and where production is more for exchange than for self-consumption. According to Prof. Dasgupta, the organised sector of an underdeveloped economy, with its large-scale industries and fairly well7. The analysis that follows is based on V.K.R.V. Rao, op. cit., Ch. 2.

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developed banking system, comes under the scope of Keynesian economics, for it presents the features of a capitalistic economy. But involuntary unemployment in this sector is insignificant when considered in relation to the total working population of the country.8 In fact, in an overpopulated underdeveloped country there exists disguised unemployment. In such an economy, the existence of disguised unemployment instead of involuntary unemployment hinders the working of the multiplier theory. The secondary, tertiary and other effects of the initial increment of investment do not follow mainly because there is no labour force willing to accept employment at the current wage level. The disguised unemployed are not available at the current wage level because, firstly, they are not conscious of the fact that they are unemployed, and secondly, they are already receiving a real income which gives them atleast as much satisfaction as they would get from the current wage level. Thus, the absence of involuntary unemployment and the presence of disguised unemployment in underdeveloped countries retard the operation of the multiplier towards increasing output or employment. (b) Inelastic Supply Curve of Output. The supply curve of output in an underdeveloped country is inelastic which renders the working of the multiplier all the more difficult. The reason is that the nature of the consumption goods industries is such that they are unable to expand output and offer more employment. The main consumption goods industry in an underdeveloped country is agriculture which is almost stagnant. The supply curve of agricultural output is backward sloping so that an increase in the value of output does not necessarily lead to an increase in the volume of output. This is because in the short run necessary facilities are not available to the agricultural producers for increasing output. As a result, the secondary, tertiary and other increases in income, output and employment do not come about with an initial increment of investment. The primary increase in income is spent on food and its multiplier effect is lost. Since the marginal propensity to consume is high in underdeveloped countries, the increased income is spent on self-consumption, of food products by the farmers which leads to a reduction of the marketable surplus of foodgrains. This, in turn, leads to a rise in the prices of foodgrains in the non-agricultural sector without a rise in aggregate real income. The possibility of spending more by the agriculturists on non-agricultural goods is, however, limited because there is little excess capacity in industries. Output is difficult to increase due to non-availability of sufficient raw materials, capital equipment and skilled labour. Thus, concludes Dr. Rao, the primary increase in investment, and therefore, increase in income and employment leads to a secondary and a tertiary increase in income but not to any noticeable increase in output or employment, either in the agricultural or the non-agricultural sector. The multiplier principle, therefore, works with reference to money income but not with reference either to real income or employment. Similarly, the absence of conditions (c) and (d) in an underdeveloped country renders the operation of the multiplier difficult. Absence of excess capacity in consumption goods industries coupled with a comparative inelastic supply of working capital for increasing output prevent the required increase in the output of consumption goods industries and the resultant therein. Thus, the obvious conclusion is that the Keynesian principle of multiplier does not operate in an underdeveloped country like India mainly due to two reasons: firstly, involuntary unemployment of the Keynesian type is not to be found; and secondly, the supply of agricultural and non-agricultural output is inelastic due to the working of certain factors peculiar to such economies.
8. A.K. Dasgupta, Planning and Economic Growth, pp. 32-33.

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7. Policy Measures. Not only this, even the Keynesian policy prescriptions are hardly tenable under the conditions prevailing in underdeveloped countries. Rao maintains that an attempt to increase investment through deficit financing leads to an inflationary rise in prices rather than to an increase in output and employment. He is, therefore, of the view that the economic policy of deficit financing and disregard for thrift advocated by Keynes for securing full employment does not apply in the case of an underdeveloped country. But in another essay Financing for Capital Formation and Price Behaviour in an underdeveloped Economy, he contends that deficit financing for capital formation does not lead to inflation since it is used for increasing the capacity and thereby imparting elasticity to the supply curve of output. However, a certain measure of price rise is inevitable but it is of a self-liquidating character. He points out that the only question is the extent to which it is wise to resort to deficit financing; and the obvious answer is that deficit financing should not be resorted to beyond the point at which it becomes inflationary. Dasgupta advocates the use of the Keynesian policy of public investment to achieve a higher standard of living and to provide increasing employment opportunities in underdeveloped countries. But in the absence of adequate public savings and the flow of foreign capital, he advocates deficit financing which if not accompanied by a system of price and capital issue controls, in the transitional period, will lead to inflationary rise in prices. According to Rao, in underdeveloped countries the old-fashioned prescription of work harder and save more still seems to hold as the medicine for economic progress than the Keynesian hypothesis that consumption and investment should be increased simultaneously. But it cannot be denied that though the Keynesian policy prescriptions do not apply in toto to the problems of underdeveloped countries, yet the Keynesian tools of analysis are indispensable for understanding the problems of such economies. To conclude with Dasgupta: Whatever the generality of the General Theory may be in the sense in which the term general was used by Keynes, the applicability of the propositions to the General Theory to conditions of an Underdeveloped economy is at best limited.9

9. Ibid.,p.34.