Relevance of Various Keynesian Tools

The following points highlight the relevance of various Keynesian tool in context of underdeveloped economies. Some of the various tools are: 1. Effective Demand and Underdeveloped Economy 2. Consumption Function and Underdeveloped Economy 3. Investment Function (MEC) and Underdeveloped Economy and Others.

Keynesian Tool # 1. Effective Demand and Underdeveloped Economy:

According to Keynes, employment depends upon effective demand, which manifests itself in the spending of income.

No doubt, in underdeveloped economies, effective demand is low, but it is on account of low level of income and not on account of excess savings, as is the case in advanced economies.

A depressed developed economy has not only idle manpower but also excess industrial capacity and raw materials, while in underdeveloped countries the complementary resources like capital stock are lacking.

Thus, it is said that the theory of effective demand, as enunciated by Keynes, does not hold good in underdeveloped countries ; here the problem is more of increasing supplies and raising the surplus for capital formation rather than of generating demand which is already there in an unsatisfied form.

Keynesian Tool # 2. Consumption Function and Underdeveloped Economy:

Consumption function in underdeveloped economies presents interesting features. People have unusually high (near unity) average and marginal propensities to consume. Therefore, the marginal propensity to save is low, partly on account of low income levels and partly on account of high marginal propensity to consume.

In LDC’s the percentage of income saved decreases with the increase in income, while the tendency is just the opposite in advanced economics.

In advanced economics additional expenditure on consumption is primarily on industrial consumer goods and the percentage of expenditure on food is very low. In an underdeveloped economy; on account of low level of income, increases in income tend to be mostly spent on food grains and other protective food or in substituting superior quality of food for inferior types. In India, the income elasticity of demand for food has been found to be mostly near unity.

In an underdeveloped economy household enterprises predominate and production is more for self-consumption than for the market. Thus when income increases, the marginal propensity to consume leads to an increase in the demand for self-consumption rather than for purchases in the market.

The increased demand for self- consumption of food is met by a diversion of output from the market causing a reduction in the marketable surplus.

Thus, in an underdeveloped economy, an increase in income and hence in the propensity to consume would lead to a fall in the marketable surplus and rise in the level of prices. Keynesian’ remedy to remove unemployment in underdeveloped economy may actually plunge the economy into an inflationary spiral.

Hence one of the most important constituents of effective demand, namely, consumption function, has severe limitations for application in an under­developed economy.

Keynesian Tool # 3. Investment Function (MEC) and Underdeveloped Economy:

One of the most important factors-hindering investments in an underdeveloped economy is the low marginal efficiency of capital. This is due to factors like all types of market uncertainties; shortages, high cost, inflation; limited extent of the market (especially for capital goods) and low purchasing power of the masses.

A major part of the national income comes from the primary sector which shows great dependence on nature, and has variations of output from year to year.

This instability is further accentuated by fluctuations in the terms of trade and the value of exports. Domestic market for industrial consumer goods and that for the capital equipment to produce them is extremely limited.

It is said that even if heavy industrial plants with modern equipment are set up in backward economies, they may not be able to operate efficiently and to bring down the cost of production. It is stated that a modern steel mill, if set up in a poor economy like Chile, will be able to meet the entire demand for steel by working only a week and for the rest of the year it may remain idle.

Therefore, on account of the risky nature of investment, it tends to be extremely interest- inelastic. The MEC schedule will be more interest-elastic if the expectations of profits are easily realised. There is a conspicuous lack of initiative in starting new enterprises not familiar to the entrepreneurial class.

The abnormally low rate of returns is more the result of institutional and psychological factors than of economic forces.

Here it is necessary to point out that the overwhelming importance of investment emphasised by Keynes remains so; rather is more, in developing economics. This idea has been expressed by Hirschman where he gives investment an active role of a pace-setter for economic development and accords to saving a passive role.

Keynesian Tool # 4. Rate of Interest and Underdeveloped Economy:

Rates of interest and their structure in an underdeveloped economy are not very helpful in stimulating investments. No doubt, there is high liquidity preference but it mainly arises from market uncertainties and speculation in commodities.

There is no desire to earn from the rise and fall in prices of bonds because bonds and securities market is not well developed. Moreover, savings are quite inelastic to the changes in the rates of interest.

In the Keynesian case, an increase in the supply of money, other things being given, would lead to a fall in the rate of interest and increase investment. But in an underdeveloped economy (in which the wage-goods gap is not covered), an increase in the supply of money would lead to a rise in prices and not to a fall in the rate of interest. The interest rates are institutionally determined.

Keynesian Tool # 5. Liquidity Function and Underdeveloped Economy:

Keynes was of the opinion that the stagnation in an underdeveloped economy is due to the presence of high liquidity preference.

He says, “The history of India at all times has provided an example of a country impoverished by a preference for liquidity amounting to so strong a passion that even an enormous and chronic influx of the precious metals has been insufficient to bring down the rate of interest to a level which was compatible with the growth of real wealth.”

The money and capital markets being underdeveloped the speculative demand for money arises especially at the harvest time for storage of essential commodities, thereby causing a seasonal stringency in the credit market.

Thus, the nature of liquidity preference in underdeveloped countries is quite different from the nature of liquidity in advanced economies. In underdeveloped countries liquidity preference for funds is just to gain the capacity to store goods for speculative purposes rather than to earn the difference in the rates of interest as is the case in the advanced economies.

Keynesian Tool # 6. Multiplier in an Underdeveloped Economy:

Dr. V.K.R.V. Rao has pointed out the limitations of the operation of the Keynesian investment multiplier in an underdeveloped country. Keynes’s; multiplier concept is based on the magnitude of the marginal propensity to consume (MPC). The higher the A/PC, the greater is the multiplier and vice versa.

In a country such as India, the MPC is almost unity. Hence the magnitude of the multiplier in India should be very high but this is not so. The Keynesian Multiplier operation is hardly observable in underdeveloped countries. The reasons are quite obvious.

The theory of the investment multiplier is based on specific assumptions:

1. There is a sizable amount of involuntary unemployment and unutilized resources due to lack of effective demand.

2. The economy is industrialised and possesses adequate capital stock. As such, there is high elasticity of supply of the desired goods to meet the increase in demand.

3. There is excess capacity in consumption goods industries which would permit an increase in output.

4. The economy has relatively elastic supply of goods called Variable capital, such as power and raw materials.

These are the conditions prevailing in a depressed developed economy, and there the multiplier works. In the case of an underdeveloped country, such as India, these conditions are not likely to be found. Dr. V.K. R. V. Rao points out that involuntary unemployment of the Keynesian type are essentially a feature of a capitalist economy where the majority of workers work for money wages and where production is meant more for exchange than for self-consumption. Involuntary unemployment is this sense is rare in an underdeveloped economy.

The fact is that a large part of the economy of the underdeveloped countries comprises the subsistence non-monetized sector which remains totally isolated from money transactions and the workers in this sector work mostly for the purpose of self-consumption. Dr. Rao observes that agrarian economy, with little capital equipment and primitive techniques, disguised unemployment are a normal phenomenon. Workers cannot be easily withdrawn from occupations without decreasing the total output; the existence of disguised unemployment in an underdeveloped country hinders the working of the multiplier.

As regards the second assumption on which the multiplier is based, the supply curve of output in a poor economy is much more inelastic than it is in an industrially advanced economy. In a poor country, the policies of monetary expansion and deficit financing lead to an increase in money income but no corresponding increase in real income. This has an inflationary pressure on the economy. The inelasticity of the supply of goods in a poor economy is due mainly to the fact that the economy is dominated by household enterprises producing with traditional technology.

The prevalence of self-consumption in poor countries acts as a leakage in the working of the multiplier. Moreover, the operation of the demonstration effect induces efficient people of poor countries to increase their consumption of imported goods. This increase in imports (official or smuggled) means a leakage in the stream of expenditure.

As far as the last two assumptions of the multiplier principle are concerned, it may be said that there is insignificant capacity in consumption goods industries in underdeveloped countries. Since these countries are characterised by capital deficiency, the supply of other inputs is also relatively inelastic.

There is no increase in the supply of consumption goods to match increase in their demand arising out of the initial rise in money income. This rise in demand without any corresponding rise in output leads to inflation.

We are now in a position to conclude. We can say: Although the policy measures suggested by the Keynesian theory may not be relevant to the problems of underdeveloped countries, it does not mean that Keynesian economics has no significance.

Indeed, Keynesian way of thinking in macro-economic terms is very essential and appropriate for understanding the major problems of any economy, whether developed or developing.

However, in view of the changing institutional set-up of the developing economies during the process of planning ‘and socio­economic reforms, Keynesian tools have to be adopted with suitable modifications. The theory as a whole may be inapplicable, but its tools taken separately are of great use in analysing and solving the problems of underdeveloped economics.

As these economies are becoming more developed, they afford greater chances of application to Keynesian policies.

Some economists have again reviewed the ‘General Theory’s’ applicability to developing economies. It is now believed that “Discarding the Keynesian thesis as altogether inoperative in underdeveloped countries is really throwing the baby away with the bath-water.” This is so because some of the basic propositions and techniques of analysis developed by Keynes and his followers have applicability to LDCs.

The controversy has revolved largely round the Keynesian prescriptions of deficit financing, cheap money policy, etc., and the relevance of the various tools in economic development of the poor economies. This amounts to putting the cart before the horse.

Rather than first examining the basic premises of Keynes, the methodology he adopted, the kit of tools he used, we jumped at the policies based on his thesis. “Whether Keynesian economics is applicable to economies like ours is a wrong question, to pose, and that the relevance of Keynesian economics to our situation is to be sought in the basic methodology that Keynes used or he was using in arriving at the general theory.”

Keynes’s methodology was simple. He was faced with a particular situation (depression and underemployment equilibrium); he had also before him the logically consistent classical theory which did not fit with facts. He, therefore, concluded that the classical theory was based on wrong assumptions.

He built, up his thesis from his contemporary world: he used tools of some older economists that appealed to him and built up his system that could explain the facts of his time and country. There have been good deals of social and institutional changes in underdeveloped countries. Let the economists of these countries take the challenge. Let them build a relevant theory.