KEYNES THEORY AND UNDERDEVELOPED

COUNTRIES

R P Pradhan
BITS Goa

BITS Pilani, K K Birla Goa Campus

Objective

To understand Keynes analysis of economic stagnation (including

his prescription) and to examine its relevance for developing
economies.

1) Keynes analysis of economic stagnation

2) Background/ Context
3) Keynes prescription
4) Relevance of Keynes theory for developing countries

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 Classical Economics
The Market is Market
automatically
Perfect & Self adjusts itself to
Sustaining booms & busts

Govt.
Intervention
can only be
detrimental to
Supply = Demand
Economy

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 Keynesian Economics
The Market is Consumer Income
stimulates
imperfect Demand
& not which causes
Self Sustaining Economic Growth

Equilibrium may When Economic

therefore include Growth is lacking,
Unemployment & Supply Demand Govt. should
Negative Growth stimulate Demand

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 Keynes analysis of economic stagnation

[Context]
Keynes wrote his General Theory of Employment,
Investment and Money (1936) in the context of the Great
Depression of the 1930s. Which was a period marked by a global
economic downturn and mass unemployment.

Florence Owens

Dorothea Lange's Migrant Mother

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During the Great Depression, unemployment was high. Workers were
upset with the speedup of assembly lines, working conditions and the
lack of job security. Seeking strength in unity, they formed unions.

Many
employers
tried to get as
much work as
possible from
their
employees for
the lowest
possible wage.
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Migrant pea pickers camp in the rain. California, February, Part of the daily lineup outside the State Employment
1936. Photographer: Dorothea Lange. Service Office. Memphis, Tennessee. June 1938.
Photographer: Dorothea Lange.

Wage &
Unemployment is
the Keynesian
motivation

Men wait in line for Free coffee and

donuts for the unemployed BITS Pilani, K K Birla Goa Campus
Keynes analysis of economic stagnation

[Prevailing wisdom: Analysis of Classical

Economics]

Held the opinion that markets when left to themselves

automatically correct themselves (achieve equilibrium
or full employment) after experiencing some shocks. 'Jean-Baptiste Say's Law
Of Markets'

Classical economists saw the Great Depression as a Production is the

result of a decline in the incentive to produce which source of demand.
was caused by a rise in wages these ate into profits According to Say's
and therefore resulted in disincentives to produce. Law, when an
individual produces a
They therefore advocated reducing wages and also product or service, he
argued that if workers were willing to work for lower gets paid for that
wages then automatically opportunities for work work, & is then able to
would be created (Says law). use that pay to
demand other goods
& services.
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 Keynes analysis of economic stagnation

Argued that the existence of mass unemployment

could not be explained by the classical analysis of
workers not being willing to work for lower wages.
Keynes
Instead he argued that the economic downturn and counter
mass unemployment was not caused by rising wages analysis
but as a result of a decline in aggregate demand in
the economy. (Fall in Aggregate Demand)
That unemployment and
under-investment was
Reducing wages, he argued, was not only hard- actually the norm in
hearted but would further aggravate the problem, natural markets .
because lower wages would mean lesser spending
capacity and only reduce aggregate demand Unless active measures
further. were taken to correct this,
economic downturns
From this he made the overall assessment of free would result.
markets:
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Keynes analysis of economic
stagnation
Aggregate Demand - ?

When people earn wages, they use some of it to buy goods and
services Aggregate Expenditure or AE

When businesses expect to sell goods and services (Aggregate

Demand i.e.AD) they hire people (Employment). In this way
employment depends on people spending in the economy.

Therefore Keynes argued that unemployment was a problem of

spending in the economy and not a problem caused by the
wage rate.
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 ? Aggregate Demand = (1) consumption expenditure +
(2) investment expenditure.
Now Consumption Expenditure = (1) size of income &
(2) propensity to spend.

Consumption expenditure is fairly stable in the economy.

Investment Expenditure = Expected profitability of capital which is

determined by the difference between the marginal efficiency of capital
vis--vis the prevailing rate of interest in the economy.

Marginal Efficiency of K = long term expectations of profit which

according to Keynes is often determined by animal spirits an
expression to suggest that it is not very rational.
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Keynes prescription for the problem of
economic stagnation
Keynes prescription
Since consumption expenditure is fairly stable and largely the
domain of private individuals and enterprises, Keynes advocated
tweaking with the investment expenditure to stimulate the
economy out of recession/depression and move towards full
employment.
Two ways of doing this:
1. lower the interest rates in the economy so that private
enterprises would be likely to borrow and invest in the
economy.

2. The government can itself borrow & directly invest in the

economy by setting up various enterprises and in doing so,
raise the level of investment in the economy.
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BITS Pilani, K K Birla Goa Campus
 Aggregate Expenditure (AE) = Sum of
JBS Market Laws Disproved consumption, investment, government
purchases, and net export.

Of these four sectors, the consumption

represents the largest share.

The consumption function:

C = Co + MPC (Yd)
C = total consumption

Co = autonomous consumption whose

amount is independent of disposable
income
MPC = marginal propensity to consume.

MPC = change in C / change in Yd )

Expenditure vs. GDP
AE= A+ mpcY Ad = Aggregate Demand = Y
Y= A+ mpcY Yd = disposable income.
Aggregate Consumption= C+ mpcY
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BITS Pilani, K K Birla Goa Campus
 Govt. Investments would stimulate the economy out of recession
by:

1. directly increasing (a) demand for employment and (b) raising

incomes in the sectors where the investment is initially made in.

1. indirectly increase (a) demand for employment and (b) raise

incomes in other sectors which provide inputs to the first sector.

Thus the initial investment would have a multiplier effect leading to

increases in employment and incomes beyond that which is
directly created through the initial investment.
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Relevance of Keynes theory to under-developed
countries
[Recap]
Keynes analysis was concerned with
understanding recession (economic stagnation)
and unemployment in developed capitalist
economies.

Economic
According to his analysis, economic downturn
and unemployment was a problem of the lack downturn &
of aggregate demand. unemployment
- A problem of
lack of
And to counter the situation he advocated
increasing investments in the economy which Aggregate
would have a multiplier effect and stimulate Demand.
economic growth and full employment
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Keynes & under-developed countries

[Application to under-developed
economies?]

Many wondered if Keynes prescriptions could

be used to stimulate the under-developed
economies which were stagnant to growth and
employment.

[Tentative possibility] It was felt that since under-

developed countries suffer from poor incomes,
investments would first lead to increases in
income which would subsequently result in
increasing demand for consumer goods, thus
activating the multiplier.
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Keynes & under-developed countries
[Application to under-developed countries was
found to be problematic]

A number of reasons are given why the outcome was

not as predicted in developing countries:
Keynes
1. [Inelastic supply of agricultural goods] Proposes Govt.
Investment
Supposes, Investments made in the economy did result
in increased incomes and this in turn generated demand
for consumer goods

BUT it was found that the agricultural sector (the primary

sector is the main source of consumer goods) did not
respond with increased production, for the following
reasons:
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 Keynes & under-developed countries

Seasonal agricultural production implies inability to respond quickly to

increases in demand.

Large portion of agricultural production is not carried out for

commercial purposes but for subsistence implying non-
responsiveness to market incentives.

Prevalence of large scale poverty among agricultural producers

implies that increases in production are consumed and do not end up
in markets.

Governments in under-developed countries often interfere with

agricultural prices in order to keep them artificially low.

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 2. [Unresponsiveness in secondary and tertiary sectors]
Even if we assume that agricultural production responds positively to the
increase in consumer demand and the multiplier comes into effect which raises
demand for goods and services from the secondary and tertiary sectors of the
economy. In under-developed economies these sectors are themselves unable
to respond to demand effectively because:

The absence of excess capacity in the industrial sector (c.f. idle capacity of
the sector in the Great Depression) prevents the sector from being able to
quickly respond to the increase in demand by raising production.

Even if there was excess capacity, under-developed countries also suffer

from shortages of raw materials and skilled labour which are necessary to
increase production.
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Keynes & under-developed countries

3. [Structural differences between the Developed economies

and Under-developed economies]

There are a number of serious differences between Developed

economies (and the nature of their economic stagnation and
unemployment) as compared to Under-developed economies
(and their nature of economic stagnation and employment)...
which imply limited applicability of Keynesian economics.

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Keynes & under-developed countries

3. 1. [The nature of employment and unemployment]

The conditions of recession or depression in developed economies is

characterised by Keynesian unemployment (involuntary
unemployment) which Keynes attributed to the lack of effective
demand which led to lowering production and thereby laying people
off.

Under-developed countries do not suffer from Keynesian

unemployment but from disguised unemployment wherein sectors of the
economy (especially Agriculture) possess excessive labour meaning
that the same output could be possible with less number of persons.

In this respect persons who are disguisedly employed, consider

themselves to be employed and do not respond easily to incentives
to give up their jobs in agriculture and migrate to non-agricultural
jobs.
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Keynes & under-developed countries

3. 2. [Differences in capital stock]

The situation of Depression in the Developed economies meant
that production slowed down or stopped resulting in people getting
laid off from their jobs. In other words capital (factories,
machinery) was lying idle. This meant that the economy could pick-
up fairly easily - by applying the Keynesian principles to stimulate
aggregate demand which would usher a return to production by
using the old but idle resources.

Under-developed economies suffer from capital shortages (factories

and machinery are not lying idle, there are no, or very few factories
and machinery). In this respect applying Keynesian economics of
increasing investments would lead to increases in income and
demand BUT no increases in supply resulting instead in the
problem of inflation!
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 Keynes & under-developed countries

3. 3. [Differences in wage rates]

In developed countries wage rates are usually significantly higher

than the minimum standard of living. This gives policy makers
substantial leeway to adjust monetary and fiscal policies (apply
Keynesian principles) which result in increases in prices. These
will not hurt the consumers significantly as their wages are much
higher than subsistence levels.

In the first place Under-developed countries have smaller

portions of their labour force who earn wages. Further most of
the wage earners incomes are close to the subsistence level
which means that increase in prices (inflation) brought about
through policy adjustments can have serious implications for
survival.

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 Keynes & under-developed countries

3. 4. [Differences in the marginal efficiency of capital]

Keynes saw the problem of stagnation in under-developed countries

as a result of liquidity preference of people in countries like India.
This meant that the people preferred to hold onto capital and not part
with it, thus not making it available for investment.

Economists, like A.K. Das have argued that the liquidity preference
of people in India is because of a low marginal efficiency of capital
(as a result of various bottlenecks, returns on investment are low).

For the efficiency of capital to increase it is necessary for

simultaneous development of multiple industries.
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Relevance of Keynes theory to under-developed countries

[Insights from Keynes for Developing economies]

Keynes overall insights that the free play of market forces in a

capitalist economy can lead to:

(1) Sub optimal outcomes and

(2) in extreme cases lead to a crisis situation (like Great
Depression and recent Financial crisis).

This is a note of caution to developing countries, many of whom

have sought, or have been induced, to pursue free market
principles as a route to rapid economic growth.

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 Keynes advocacy of a mixed economy of complementary private and
public sectors is almost unanimously accepted as necessary for balanced
growth.

Keynes General Theory provides a good understanding of how the

economy works and for many seeking to pursue the path of western style
development, it can be useful for identifying possible bottlenecks to look
out for along the path to development.

Keynes has provided economists with a plethora of analytical tools which

are used by development economists.

For e.g. Investment-saving ratios used by Harrod-Domar, Capital

investments used by R. Nurkse and National Income analysis used in
development planning.

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REFERENCES

Misra, S. K. and Puri, V. K. (2010), Keynes Theory and Underdeveloped

Countries, in Development and Planning: Theory and Practices, 13th ed.
Himalaya Publishing House Pvt. Ltd. Mumbai, pp. 137-146.

Backhouse, R. (2006) The Keynesian Revolution in Economic Theory in

The Cambridge Companion to Keynes, R. Backhouse & B. W. Bateman
(eds.), Cambridge, Cambridge University Press, pp. 19 28.

Swartz, A (2009), A Summary Explanation of John Maynard Keynes

General Theory, Raw Though, viewed on 20th July 2012
<http://www.aaronsw.com/weblog/generaltheory>

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BITS Pilani, K K Birla Goa Campus
BITS Pilani, K K Birla Goa Campus