Economics - Keynesian Theory Of Employment - Notes - Economics, Study notes of Economics

Download Economics - Keynesian Theory Of Employment - Notes - Economics and more Study notes Economics in PDF only on Docsity! Keynesian theory of employment During the “Great Depression” in the late 1920s, the validity of classical economic theories completely collapsed as they failed to correct the disequilibrium in the economic activities. Although the classical economists advocated that demand created its own supply, savings were equal to investment, full employment prevailed, business cycles were temporary in nature and unemployment was a short term phenomenon, and that these disturbances could be easily corrected by varying the interest rates or by reducing the wage rate, nothing of the sort happened in 1919. Therefore, the then American President Hoover introduced various policy measures to correct the prevailing economic situations, all of which ended up being too little and too late. As a result, he was forced to resign and President Roosevelt took over on 04-03-1933. In 1936, the Keynesian ‘General Theory of Employment, Interest and Money’ completely changed the classical economic thought. This led to the emergence of the Keynesian revolution, which completely transformed the old economic thought based on the monetarist’s approach to an entirely new approach that was based more on fiscal economics. The latter came to be popularly known as the ‘welfare oriented economic policy’ (Dewett 2005). 1.1.6 Principles of effective demand The Keynesian approach was directed to redeem the capitalists’ economy from the conditions of great depression. Hence, it is also better known as a solution to the “depression economics”. According to Keynes, depression occurred as a consequence of lack of ‘effective demand’, which is the point at which aggregate demand equals the aggregate supply. Therefore, the level of ‘effective demand’ was to be increased, which in turn would raise the level of other economic variables. This may be expressed as:- ∆Q= ∆N = ∆Y ↓ ← Effective Demand where, ∆Q = aggregate output, ∆N = aggregate employment in an economy, and ∆Y = aggregate income in an economy. Effective demand comprises two important elements, viz., aggregate demand function (ADF) and aggregate supply function (ASF). ∆Q= ∆ N = ∆ Y ↓ Effective Demand Aggregate supply function: Adam smith, ‘the father of economics’ laid emphasis on human behaviour, especially the concept of self-love. Human beings are rational 0 N1 N N2 X Diagram 4: Level of Employment At the equilibrium level E, ADF = ASF. At this point, the level of employment is ON, where the equilibrium output and income also occur, reflecting the level of effective demand. When ADF > ASF, economic activities will rise and lead to higher levels of employment, output and income. The Keynesian multiplier and acceleration effects lead to acceleration in economic activities. As a consequence, production will increase, leading to a rise in employment from ON1 to ON. Thus, the economy would move to the equilibrium point E. Multiplier refers to the change in income caused by a change in investment, i.e., ∆Y/∆I. Meanwhile, accelerator refers to the change in investment caused by a change in income and consumption, i.e., ∆I/∆Y. On the other hand, when ASF > ADF and the economy move away from E to E2, production would fall and unemployment would emerge to the extent of ON2. As a result, the economy would revert back to the equilibrium point E and unemployment would fall from ON2 to employment level ON. When employment is ON, which is less than the full employment point, the government can raise ADF through autonomous investment, assuming ASF to be constant. 1.1.7 Keynesian theory The Keynesian theory states that employment is a function of income. Since both income and employment are determined by the level of effective demand, greater the national income, the greater would be the volume of employment. The Keynesian theory may be summarized in the form of the following flow chart. Effective Demand, Employment, Income Consumption Investment Income Prope nsity to cons ume Money Supply Rate of Interest Liquidity Preference Marginal OM, the rate of interest is determined at Or. Given the marginal efficiency of capital (MEC) curve and Or rate of interest, OI is the volume of investment determined. Given OI level of investment and the marginal propensity to consume, reflected by curve C in diagram (ii), the national income is determined at OY. In other words, the economy will be at equilibrium at OY level of income. Diagram (i) shows that OY level of national income creates ON volume of employment. Assuming ONF to be the level of full employment, the OE equilibrium represents less than full employment level. 1.2 Inflationary and Deflationary Gaps Inflation is the rise in price without a corresponding increase in the supply of goods and services at a given time. In the process, the values of commodities rise, while the value of money declines during inflation. By now it is understood that equilibrium need not necessarily occur at the full employment level and that it can also occur at less than full employment level. Therefore, the equilibrium level of national income or employment has no particular feature. For, an equilibrium level may involve both unemployment and waste of national resources, if the investment is insufficient to ensure full employment. Therefore, the desirable level of equilibrium is the one which is achieved at full employment or near full employment. This level may be achieved when investment opportunities equal full employment savings. As a result, there can be inflationary gap or deflationary gap. a) Inflationary gap: When consumption and investment expenditures are greater than the full employment GNP level, it gives rise to inflationary gap. Under this circumstance, consumer demand for goods and services are greater than its supply. Thus, when inflationary gap occurs, national income, output and employment cannot increase any further. The rise in demand for goods and services results in increased price level. In other words, inflationary gap would occur when the scheduled investment exceeds the full employment saving. Under such a situation, the demand for goods would be more than what the economic system can produce. This would lead to a rise in the prices, which would result in an inflationary situation. Thus, when the full employment savings is lower than the scheduled investment at full employment, inflationary gap would emerge. This situation illustrated in diagram - 6. Y C ,I, Deflationary Gap A E C+ I+ GB (C+ I +G)’ C + I C 0 Q’ Q X Output Diagram 7: Real Output or National Income The diagram shows Q to be the total output at full employment level. The point at which the demand curve C+I+G cuts the 45° line at E, the real output is Q. If the real output is Q’, it would create a deflationary gap of AB. 1.3 Economic Development The economic development of a country is a complex process. It is influenced by both economic and non-economic factors, which determine the pace and direction of development. The most prominent among the economic factors are the economic system, availability of capital stock and the rate of capital accumulation, capital-output ratio in various sectors, agricultural marketable surplus, and the foreign trade situations. Meanwhile, the non- economic factors include quantity and quality of human resources, social organisation, general education and technical know-how, political freedom, corruption free environment and the people’s will to develop. Natural resources also govern the level of development, as they determine its limits. a) Economic factors: Economic factors play a decisive role in a country’s economic development. For instance, the growth of a country is generally determined by the stock of capital and the rate of capital accumulation. The other economic factors which influence development are the nature of economic system, the availability of surplus food grains or food security for the people, foreign trade situations, etc. It is important to examine the role of some of these factors in economic development. i) Economic system: The historical background and economic system of a country also influences its developmental prospects. It decides the institutional structure of a country. Laissez faire economic system was one of its earliest forms, wherein the market forces determined the economic progress. In today’s world, no country can claim to be having a pure economic system, whether capitalist or socialist. With the onset of liberalization policy, it is even more difficult to categorize countries under clear-cut economic system. The history of economic development of any country is inter-woven with the complex process of development, which has helped each of them to evolve their own path of development. Thus, economic system of a country plays a crucial role in determining the process, pace and level of development. ii) Capital formation: The strategic role played by capital in increasing the level of production is widely recognized, more so since the development of growth economics in the post-World War II period. Capital was treated as the crucial factor of economic growth in the Harrod- Domar growth model. At present, it is widely acknowledged that capital accelerates the pace of growth of a country. It is emphasized that the principal obstacle to growth is the lack of adequate capital for investment, without which no developmental plan can be implemented successfully. Therefore, in order to increase the level of investment, a country has to make increased savings. This is important, as this also avoids heavy reliance on foreign aid/capital, which can be risky. iii) Marketable surplus of agriculture: The excess of agricultural output produced by the sector, over and above what is needed for the subsistence of the rural population, is known as marketable surplus. Enhanced productivity and production in agriculture is vital for the development of a country. These in turn should result in increased marketable surplus of agricultural produces. Marketable surplus is particularly important in the context of a developing country, as the rise in urban population leads to an increase in the demand for agricultural products, mainly the food grains. These increase in demand need to be met by adequate supplies, as scarcity of food in urban areas would affect the process of economic growth. This is because food shortage would force a country to import food grains, which in turn would affect the balance of payments. India suffered a similar problem till 1976-77. Due to inadequate marketable surplus during the period, the government of India was compelled to import huge quantities of food grains to support the urban population and to avert a food crisis in the country. Although this solved the then food problem, it resulted in high foreign exchange drainage, which could have been used for furthering the economic development of the country. To overcome such a problem, there are countries which have embarked upon the strategy of accelerating the pace of industrialization, so as to prevent agriculture from lagging behind. It is for this reason that Maurice Dobb observed, “There is reason to suppose that it will be the marketed surplus of agriculture which plays the crucial role in the underdeveloped country in setting the limits to the possible rate of industrialization” (Dobb 1955). India’s development experiences during the plan periods reflect such a situation, which has led to the growth of monopolies in industries and concentration of economic power in the hands of a few in the modern sector. Further, the new agricultural strategy has also been more favourable to the rich peasantry class, which has resulted in the emergence of widespread disparities in the rural sector. This indicates that the government policies of India have also resulted in development, which is far from being fair and just. This proves that India’s social organisation has failed to improve along the developmental process of the country. Therefore, although the government has been emphasizing upon participatory development since the early plan periods, not much success has been achieved by the country in this direction. Hence, there has been widespread apathy towards development planning in the country, which needs to be rectified. iii) General education and technical know-how: During 1909 and 1949, Robert M. Solow found the contribution of education to be greater than that of any other factor in increasing the output per man hour in the United States (Solow 1957). In recent times, some of the economists like T.W. Schultz, A.K. Sen and others have stressed upon the contribution of investment in man for economic development (Schultz 1977 and Sen 1972). They call for development of human capabilities through human capital investments. Although it is difficult to subject its contributions to quantitative measurement, the results of its verifications undertaken using proxy variables provide a tentative approximation of it. Further, the direct impact of the level of technical know-how on the developmental pace of a country is widely recognized today. Advancements in the scientific and technological knowledge help man to discover more sophisticated techniques of production that would contribute to enhanced levels of productivity. In fact, Schumpeter attributed most of the capitalist development to the role played by the entrepreneurial class in contributing to technological innovations (Schumacher 1978). This recognition has led to the consciousness towards increased investments on Research and Development for the development of highly sophisticated technology and its further advancement. Any country that neglects it in modern times, tends to suffer industrial underdevelopment, low productivity and poor competitiveness in the international market. iv) Political freedom: World history of modern times bears witness to the fact that the processes of development and underdevelopment are interlinked, rather than being isolated. It is a well known fact that the underdevelopment of past British colonies, like Sri Lanka, India, Bangladesh, Pakistan, Kenya, Malaysia and other countries, are all directly linked with the development of England, which indiscriminately stripped these countries of their development and appropriated huge shares of their economic surplus. Although these countries made a significant contribution to Britain’s economic development, they were pushed back into remaining backward. Another such example is that of the U.S.A.’s development being linked with the underdevelopment of Latin American countries, Netherlands’ development being linked with the underdevelopment of Indonesia, France’s development being linked with the underdevelopment of Algeria and Indo-China, and the like (Misra and Puri 2002). Hence, this indicates that a country’s level of development cannot be clearly understood by viewing it in isolation from that of the others with which it was historically linked in the past. v) Corruption: Corruption is rampant and ailing the development process of most of the world’s developing countries at various levels of their operations. This tends to negatively affect their growth process and acts as a retarding factor, which slows the pace of their development. In the process, the scarce resources allocated for development purposes thus tend to be misappropriated, which in turn affects the achievement of planned targets. Hence, unless corruption is rooted out of the administrative system of these countries, it is difficult for them to grow at the desired pace, no matter how well-formulated plan/policies they have. As a consequence of corruption, the vested interest groups like capitalists, traders and other powerful economic classes would continue to exploit the nation’s resources to their personal gains. A huge chunk of the plan outlay on development projects end up being misappropriated by the government officials and the associated functionaries through the adoption of corrupt methods. The regulatory system also tends to be misused quite often to obtain favours like grant of licenses, which may not be done on the basis of merit. Tax evasion is another major problem perfected by certain sections of the society in connivance with some of the corrupt government officials in most of the less developed countries, which further tends to hamper the pace of development for want of the required revenues. However, this fact has hardly received any attention in the literature on development and underdevelopment as a growth arresting factor in recent years. Economist Gunnar Myrdal has been very critical about this approach, who feels that rather unfortunately economists have deliberately ignored the role of corruption as a retarding factor in their analysis of development problems in the backward economies since the post-World War II period. He identified two main reasons responsible for this: first, the presence of diplomacy in economic research; and second, the application of Western models which do not reflect the actual realities of the developing countries, and have thus blurred the perspective (Myrdal 1968). vi) Desire of the people to develop: According to Richard T. Gill, “The point is the economic development is not a mechanical process; it is not a simple adding up of assorted factors. Ultimately, prescribed for all underdeveloped countries. This is due to the fact that a technology which may be suitable to one country may not be equally suitable for all the others. Therefore, the question of choice of techniques is complex and must be analysed carefully. For this, clarity on the model of the underdeveloped country is necessary, for which the appropriate technique is being considered. For instance, for a country like India, which has labour as abundant factor of production, the choice of technique should take into account the development model of the Indian economy? Obviously, due to the huge population in the country, labour-intensive technology is considered the most appropriate one. This leads to the problem of making a choice between labour-intensive and capital-intensive technology for the country. Considering the abundant labour endowment, it is obvious that the choice should be in favour of labour intensive technology and against the capital intensive technology, because otherwise a large number of people would remain unemployed. The choice of technique would then be based on the argument that this would keep the social cost low. Hence, in countries like India, labour-intensive technology is more preferred to the capital-intensive technology. However, A.K. Sen is of the opinion that the problem of adopting labour- intensive technology could be much more complex than what it appears, because increase in labour employment would increase the wage bill, which in turn would raise the consumption expenditure. He argued that, It is, thus, possible that while the choice of a more labour-intensive technique will add to output, it will add more to consumption, reducing the volume of investible surplus. If the policy objective is the maximization of the growth rate, we may choose more capital-intensive techniques than when it is the maximization of immediate output per unit of investment. If our objective is something intermediate between the maximization of immediate output and the maximization of growth rate, we might choose techniques which are in between these (A.K. Sen 1972). 1.4.2 Quality of labour supply: Considering the conditions of labour supply in underdeveloped countries, it is obvious that India and other highly populated countries should adopt production technologies that absorb the abundant labour available in these countries rather than capital. This implies that under the adoption of such a production technology, a small quantity of capital per unit of labour would be employed, which need not necessarily be true. This is because in a production process, both fixed and variable capitals are used. If the technique involves a greater ratio of variable capital to fixed capital, the possibility is that the technology would be capital-intensive in nature, even though the country does not depend much on heavy machines. However, such a situation may arise rarely in practice. Therefore, it is quite logical to assume in the absence of abundant capital supply, that a country would adopt labour-intensive technology rather than a capital-intensive one. The basic argument that a labour-intensive technology should be adopted by highly populated underdeveloped countries is justified on two important grounds: a) labour supply is high, and b) the real wage rates are very low in these countries. Therefore, the implications of excess labour supply is that as the unemployed labour in such countries have no opportunity cost from the social point of view, a technology that absorbs the abundant labour in a large quantity should be adopted. Thus, the prevailing factor abundance in India warrants that the country goes in for the adoption of labour-intensive technology. However, situations are different in the African and Latin American countries, which are thinly populated. Further, in some of the underdeveloped countries where best suited for the countries with the objective of maximization of immediate employment and output levels. Further, it is difficult to solve the problem of unemployment in a labour abundant developing country without the adoption of labour-intensive technologies to absorb the surplus labour supply in it. Another important objective of the developing countries is the immediate maximisation of output levels, which are in extremely short supply in them. These shortages can best be taken care of by adopting labour-intensive technology, because the gestation lag in its case is also shorter when compared to that of the capital-intensive technologies. As a result, the former add to the volume of output faster than the latter. Moreover, another favourable aspect of the labour intensive technologies is that they involve no foreign exchange requirements, whereas the capital-intensive technologies require imports of substantial capital equipments from foreign countries and substantial maintenance of the imports later as well. Hence, the developing countries which lack foreign exchange resources should therefore choose labour- intensive technologies. 1.4.6 Appropriate technology: In recent years, the issue of appropriate technology for the developing countries has caught the attention of the policy makers, economists and planners. This is attributable to the fact that huge import of capital-intensive technology by the developing countries from the developed countries over the past few decades have also failed to yield the desired growth and development in them. Such import of technology by them have largely resulted in the development of certain towns and major cities, created a few employment opportunities, and left the smaller towns and rural areas lagging behind, such that large number of their residents continue to remain poor, unemployed and underemployed. Besides, the cost of every additional employment created through the adoption of the imported technology also becomes very high, which is more suited to the advanced countries with their high per capita income, a low population growth rate, and high saving to income ratio. However, for the developing countries which have acute shortage of investment resources for creating infrastructure and building industries, insufficient foreign exchange resources, and high construction and equipment cost, such a technology tends to be inappropriate. Given the high rate of population growth, a growth strategy based on industry- led development using the technologies suited to developed countries only creates poverty, unemployment and underemployment in the developing countries. Thus, it is the responsibility of the developing countries to work out and adopt an appropriate technology, most suited to the available natural resources, human capital, socio-economic features, etc., which would contribute to its growth and development. 1.4.7 Intermediate technology: Owing to the failure of intermediate technology to generate the desired effects in overcoming the problems of poverty and unemployment in the developing countries, some economists have recommended the use of intermediate technology by them. For, the gap between the technologies of developed and an underdeveloped country is so wide, that the latter can achieve little success by adopting the advanced technologies of the former. This is attributable to two major reasons: (i) Technology of the developed countries is too expensive for the underdeveloped countries, which lack the required resources; and (ii) The adoption of such advanced technologies would only aggravate the already existing problems of poverty and unemployment in these countries. According to E.F. Schumacher, it is a serious error to assume that whatever technology is appropriate to developed countries of the West is equally appropriate to developing countries of the Third World. Granted that the technological backwardness is the main cause of poverty of underdeveloped countries and their traditional techniques of production would not survive long, nonetheless, it cannot be concluded that the most sophisticated technology of the The government may also announce support prices for primary agricultural products in the interest of farmers, particularly during the periods of surplus production resulting from technological advancement. The purpose of support prices is to ensure that farmers do not incur any loss, when cost of production falls. Such prices, however, interfere with the automatic determination of market prices through the interaction of market demand and supply. India has placed 22 farm products under minimum support price or statutory price categories. Besides, cereal crops like rice and wheat are procured at previously announced prices in every crop season. (c) Direct intervention: Tax is one of the ways in which government makes direct intervention, which directly increases the price of a product by adding to the cost of production. Government may impose tax to reduce production, or reduce tax or provide tax subsidy to encourage it. Tax relief may also be given to encourage production in strategic industries. On the other hand, higher taxes may be imposed to discourage production of commodities which are injurious to health. In the process, the government may also influence the consumption level of such commodities. (d) Indirect intervention: The device of allocating quotas is another important method of government intervention in the context of business enterprises. This method is generally adopted by the developed countries, who find it more convenient to restrict production so as to restrain the rising burden of price support to producers. Under this method, the producers are restricted from producing output beyond a prescribed limit by the government. If the government directive is not followed, they would be debarred from any government policy, benefits, including that of the price support. Thus, production quotas tend to have an upward pressure on the price, due to restriction imposed on output supply. In sum, the expected change from price support should be acceptable to both the producers and consumers, such that they may be neutral towards price support and production quota policies. Besides, the government also controls inflation through the price regulation mechanisms. (e) Control of monopolies: Monopoly enterprises are harmful to the welfare of consumers. As only one producer controls the production under it, there is a tendency on its part to exploit consumers by charging high prices because the product has no close substitute. Besides, the price may also be artificially raised through under- production. Further, monopolies also result in the concentration of economic power in the hands of a few, which interferes with the objective of just and equitable distribution of income and wealth. To avoid such consequences, most governments have passed legislative acts to control their activities. The Indian government passed the Monopoly and Restrictive Trade Practice Act in 1976 to control them. Thus, the government may participate in the production activities along with the private sector in an economy, besides controlling, regulating and governing the activities of the latter in the general interest of maximizing the welfare of the people of the country.