In underdeveloped countries, multiplier fails to operate effectively. It is so because conditions necessary for its operation do not exist in such countries. To make matters worse, several types of leakages from the multiplier process also persist.
Apart from these, underdeveloped countries have a peculiar socio-economic character that obstructs the multiplier process. In context to UDCs, we can outline the following reasons for the failure of the multiplier process or Keynesian economics.
1. Low Marginal Propensity to Consume:
It has been shown that the higher the marginal propensity to consume, the higher the investment multiplier and the faster the process of income propagation. In underdeveloped countries (UDCs), MPC for subsistence goods is very high, no doubt, but it is usually very low for industrial output.
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For the multiplier process to take off, MPC for industrial output should be very high. Industries produce goods mostly for trade. Division of labour and the degree of specialization help them to produce better products that sell faster. In UDCs, MPC is very low for industrial output due to low standard of living in these countries.
A vast majority of people in these countries depend on subsistence cultivation. Food grains they grow are mostly for self consumption. The rural population lives in primitive conditions with little civic amenities available to them.
Most of the rural regions have no electricity and hence no demand for consumer durables. MPC in such countries is very high but only for food grains. The overall MPC in UDCs is thus very low and so is the value of the multiplier. It is due to this reason that the process of income generation is extremely slow in these countries.
2. Lack of Investment:
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Investment, so crucial for income generation, is scarce in the less developed countries (LDCs). The reasons for this are the following:
(i) Low level of savings:
Savings finance investment. In LDCs per capita savings are very low due to low per capita income.
(ii) Low level of demand:
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Due to low per capita income, demand for consumption goods is low. This serves as a disincentive to invest.
(iii) Inadequate mobilization of savings:
Savings cannot be appropriately mobilized unless banking sector has a widespread and efficient network for the purpose. In most of the underdeveloped countries, banking sector has yet to reach the rural sector. Moreover, deposit attracting schemes in the LDCs are either inadequate or ineffective. Rate of interest offered to the depositors on the saving deposits is too low and it has been so for ages.
(iv) Existence of parallel economy:
Due to high rates of taxation, evasion of tax is a common practice in the LDCs. This leads to accumulation of black money, running a parallel economy of its own. Such stocks of money do not reach the banking sector due to the fear of detection by the income tax authorities. If invested, black money could provide a potential source of investment.
(v) Lack of capital goods and technology to utilize the available resource endowment:
Most of the underdeveloped countries have remained so due to their inability to tap the resources they possess. For instance, India, for long, has not been able to utilize its abundant soil resource due to its inability to provide machines, tools, fertilizers, irrigation facilities and improved seeds. Non-availability of capital goods discourages investment.
3. Leakages from Circular Flow of Income and Expenditure:
As stated earlier in the section, leakages from the multiplier process render the Keynesian tools of income generation and propagation totally ineffective in the underdeveloped countries. Savings, debt cancellation, taxes, inflation, accumulation of idle cash, purchase of old shares and imports are the common leakages in the underdeveloped countries.
4. Non-existence of conditions essential for operation of multiplier process:
Among the conditions necessary for the multiplier, the second and the fourth conditions, namely, non-existence of industrialized economy and elastic supply of capital goods are more relevant in context of the underdeveloped countries.
From the discussions above, it is evident why Keynesian economics fails in the underdeveloped or less developed countries.