Deficit Financing and Employment:
Keyness was of the view that the total production of a country depends upon the level of employment at a given time. And the level of employment depends upon the effective demand. It implies that conditions of unemployment may be removed by increasing the effective demand, i.e., by increasing the demand for consumption goods and investment goods. The effective demand depends upon the marginal propensity to consume.
Thus, for increasing the effective demand and removing the conditions of unemployment in developed economies during the period of recession or depression, Keynes advocated deficit financing to finance public works projects. This will increase the purchasing power in the hands of the public. Hence, the effective demand will be increased. This will further increase employment which again will increase effective demand and, hence employment and so on. Keynes called it the multiplier effect. Thus, through deficit financing during the period of depression, the tendency of decreasing effective demand is not only checked but the cycle of increasing effective demand is placed in motion. This leads to an increase in employment and level of income.
In mathematical terms, it can be stated as:
|K = 1/(1 – MPC) = 1/MPS|
Where i.e., = multiplier
MPC = marginal propensity to consume
MPS = marginal propensity to save
K is directly proportional to the marginal propensity to consume and inversely proportional to the marginal propensity to save.
It means, supposes an investment of $ 100 crores is made on public works through deficit financing, if K is equal to 4, then due to the effect of the multiplier, income will increase to $ 400 crores i.e., the level of income will ultimately increase four-fold of the basic additional investment (100 x 4 = 400).
But this does not hold well in underdeveloped countries, as the assumption, on which Keynes’s analysis is based is not found true in underdeveloped countries. They are as follows:
(1) Existence of idle and unutilized capacity in the industrial and agricultural sectors.
(2) Supply of working capital is relatively elastic.
Thus, deficit financing is helpless in removing the conditions of unemployment in underdeveloped countries because of the absence of idle and unutilized capacity in industrial and agricultural sectors, and, the lack of capital formation and existing capital equipment. Moreover, the multiplier concept does not hold well in underdeveloped countries because of the lack of entrepreneurship, lack of technical knowledge, lack of infrastructure of economic and social over-heads and lack of market imperfections, etc.
In fact, the multiplier principle, as steady by Keynes, tends to raise the effective demand rather than the effective supply. But, the problem of underdeveloped countries is of increasing the effective supply rather than effective demand. Hence, the multiplier principle is not applicable to underdeveloped countries.