Is Keynesian Theory of Employment Applicable in India?

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In recent years various attempts have been made to apply Keyne­sian economics to solve the problems of less developed countries (LDCs) like India. However, these efforts have met with limited success. In fact, Keynes himself has admitted this when he said that “the theory of econom­ics does not furnish a body of settled conclusions immediately applicable to policy”.

The fact remains that the distance between theory and policy is perhaps the greatest in the area of development economics (and development prob­lems). The object of this section is to show the irrelevance of Keynesian economics in today’s LDCs.

In short, in the Keynesian theory of income (output) determination the root cause of unemployment is deficiency of aggregate (effective) demand. Therefore the only solution to the problem lies in raising aggregate demand or purchasing power.

This can be achieved by adopting an expansionary fiscal policy (e.g., by raising government expenditures and/or reducing taxes). By making appropriate use of fiscal policy governments can accel­erate economic activity and thus ensure high levels of employment.

Con­versely, if there is inflation arising out of aggregate demand exceeding the productive capacity (aggregate supply) of the economy, the government has to adopt a contractionary fiscal policy. It has to cut its own expenditure and raise taxes so that people are left with less money to spend on already produced goods and services. This, in turn, reduces pressure on prices.

Keynesian economics reveals various inadequacies when applied to the realties of economic life in LDCs especially in those having fragmented product, resource, money and capital markets. Such market fragmentation goes by the name economic dualism.

This problem arises due to the co-exist­ence of modern and traditional ways of doing things in both traditional (mainly agricultural) and modern (mainly industrial) sectors. The problem is accentuated by the inadequate functioning of the saving-investment process and malfunctioning of credit systems as also by the influence of foreign economic powers including multinationals.

Keynesian theory developed in the context of the great depression of the 1930s has lost its relevance in present-day LDCs for the simple reason that economic problems, economic systems and institutions of LDCs are quite different from those of the Western capitalist countries.

Most of the countries were faced with the unemployment problem in 1930s and some of them adopted Keynesian remedy and succeeded in achieving full em­ployment. However, in LDCs the major economic problem of today is not simply unemployment or inflation but ‘stagflation’ (i.e., co- existence of demand-pull inflation and unemployment in a stagnant economy). So by making use of monetary and fiscal measures it is not possible to ensure full-employment growth in the absence of demand-pull inflation.

Moreover, the Keynesian income and employment theory also leaves the development economists perplexed about the causes of unemployment and what might be effective policies for full employment. The Keynesian invest­ment multiplier was first identified as an employment multiplier and it was predicted that increase in output would lead to an exactly proportional increase in employment.

However, history has amply demonstrated that in spite of the rise in their investment ratios and growth in GNP, LDCs in general have at the same time experienced growing unemployment and underemployment. The unemployment was the result of inappropriate set of factor prices and the very structure of the economy.

These factors have largely been ignored by Keynesian theory. In fact, the unemployment prob­lem in LDCs is not of the Keynesian variety arising out of deficient aggregate demand. Therefore the policy implications of the Keynesian income theory has to be suitability modified for LDCs.

As M. P. Todaro has rightly pointed out, “In fact, the traditional Keynesian policy for alleviating industrial unemployment—the creation of more urban jobs real-world conditions in poor countries actually increase the level of urban unemployment as a result of induced rural-urban migration. It may simultaneously exacerbate domes­tic inflationary pressures”.

Todaro has referred to two major deficiencies of the Keynesian model in the context of economic development.

First, the Keynesian prescription for reducing or eliminating unemploy­ment is to increase aggregate demand through an expansionary fiscal policy—a policy that encourages private business investment. This, in turn, will raise output and create jobs and incomes in the private sector.

So if supply conditions are favourable Keynesian remedy will work automat­ically to ensure full employment. It may be recalled that in the Keynesian model demand creates its own supply. However the Keynesian model is derived from the experience of industrially advances countries and it is implicity based on the institutional and structural assumption of well-func­tioning commodity, resources and money markets.

It is assumed that in such countries business firms and farmers can respond quickly and effec­tively to increases in the demand for their products by rapidly expanding output and employment. But LDCs are not characterised by these features.

In most LDCs like India the institutional-cum-organizational structure is quite different. In such countries the major bottleneck to higher output and employment levels seems to structural and institutions constraints on the supply side.

In fact, an increase in government expenditure or private investment spending is unlikely to raise output and create additional em­ployment opportunities because of shortages of capital, strategic raw ma­terials, intermediate goods, skilled human resources, managerial talent, poor functioning of money and capital markets, inadequate infrastructure (i.e., transport and communication facilities), paucity of foreign exchange, bias toward imported consumption goods among the rich and a host of other structural and institutional factors.

In fact, as V.K.R. V. Rao has pointed out, when the aggregate supply curve is price-inelastic as in most LDCs, an act of investment or government expenditure will have a multiplier effect through an increase in prices and not through an increase in production and employment.

This is exactly what has happened in India where agriculture is the most dominant sector of the economy. However, agriculture itself is characterized by several constrainers on the supply side like low productivity per acre, caused by various factors, absence of irrigation facilities in most areas and thus dependence on whether and so on.

Therefore planned investment in agriculture has the effect of raising prices of agricultural commodities and incomes of the already rich farmers. But the conditions of landless laborers and small and marginal farmers deteriorated over the years.

In several Latin American countries also expansion of aggregate demand through deficit-finance government expenditure has created chronic inflation and made the management of the economy really difficult.

The second major limitation of the Keynesian model for most LDCs relates to the nature of the labour supply curve in such countries, on the basis of his own empirical study on rural-urban migration in certain African countries Todaro has reached the conclusion that the creation of additional modern sector urban jobs through increased aggregate demand is likely to attract many more workers from rural areas, more so due to differences in wages in the two areas.

The net result may be that the creation of additional urban jobs through Keynesian demand-oriented policies de­signed to reduce unemployment may, in fact, aggravate the problem by inducing workers to move to urban areas.

It is also apprehended that since many rural migrants are productive farmers or low-paid farm workers, the overall level of national employment and output may fall due to the adoption of Keynesian policies designed to increase employment and out­put. The cure may be worse than the disease.

So the conclusion is that for various reasons such as structural and institutional, supply constraints and the phenomenon of induced rural-urban migration the simple Keynesian model of income and employment has little, if any, relevance to the planners and policy-makers of today’s LDCs.