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)
2)
3)
4)

Keynes analysis of economic stagnation

Background/ Context
Keynes prescription
Relevance of Keynes theory for developing countries

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The Market is
Perfect & Self
Sustaining
Govt.
Intervention
can only be
detrimental to
Economy

Classical Economics

Market
automatically
adjusts itself to
booms & busts

Supply = Demand
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Keynesian Economics
The Market is
imperfect &
not Self
Sustaining

Consumer Income
stimulates
Demand
which causes
Economic Growth

Equilibrium may
therefore include
Unemployment &
Negative Growth

When Economic
Growth is lacking,
Govt. should
stimulate Demand

Supply

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,

1936. Photographer: Dorothea Lange.

Part of the daily lineup outside the State Employment

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

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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.
Classical economists saw the Great Depression as a
result of a decline in the incentive to produce which
was caused by a rise in wages these ate into profits
and therefore resulted in disincentives to produce.
They therefore advocated reducing wages and also
argued that if workers were willing to work for lower
wages then automatically opportunities for work
would be created (Says law).

'Jean-Baptiste Say's Law

Of Markets'

Production is the
source of demand.
According to Say's
Law, when an
individual produces a
product or service, he
gets paid for that
work, & is then able to
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.
Instead he argued that the economic downturn and mass
unemployment was not caused by rising wages but as a result
of a decline in aggregate demand in the economy.
Reducing wages, he argued, was not only hard-hearted but
would further aggravate the problem, because lower wages
would mean lesser spending capacity and only reduce
aggregate demand.
From this he made the overall assessment of free markets:
that unemployment and under-investment was actually the
norm in natural markets unless active measures were taken to
correct this, economic downturns would result.

Keynes
counter
analysis

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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.
When businesses expect to sell goods and services they hire people.
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

JBS Market Laws Disproved

Expenditure vs. GDP

AE= A+ mpcY
Y= A+ mpcY
Aggregate Consumption= C+ mpcY

Sticky Price Level vs. GDP

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 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.
According to his analysis, economic downturn
and unemployment was a problem of the lack
of aggregate demand.
And to counter the situation he advocated
increasing investments in the economy which
would have a multiplier effect and stimulate
economic growth and full employment

Economic
downturn &
unemployment
- A problem of
lack of
Aggregate
Demand.
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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 underdeveloped 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:
1. [Inelastic supply of agricultural goods]
Supposes, Investments made in the economy did result
in increased incomes and this in turn generated demand
for consumer goods

Keynes
Proposes Govt.
Investment

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 nonresponsiveness 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 pickup 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>

BITS Pilani, K K Birla Goa Campus

BITS Pilani, K K Birla Goa Campus

BITS Pilani, K K Birla Goa Campus