Theories of Business Cycles

Theories of Business Cycles by different economist.

1. Theories of Business Cycle

2. Purely Monetary Theory of Trade Cycle: by R.G. Hawtrey R.G. Hawtrey describes the trade cycle as a purely monetary phenomenon, in this sense that all changes in the level of economic activity are nothing but reflections of changes in the flow of money . Thus, he holds firmly to the view that the causes of cyclical fluctuations were to be found only in those factors that produce expansions and contractions in the flow of money — money supply. Hence, the ultimate cause of economic fluctuations lies in the monetary system.

3. Continue According to Hawtrey , the main factor affecting the flow of money — money supply is the credit creation by the banking system. To him, changes in income and spending are caused by changes in the volume of bank credit. The real causes of the trade cycle can be traced to variations in effective demand which occur due to changes in bank credit. Therefore, “the trade cycle is a monetary phenomenon, because general demand is itself a monetary phenomenon.”

4. Continue He points out that it is the rate of progress of credit development that determines the extent and duration of the cycle, thus, “when credit movements are accelerated, the period of the cycle is shortened.” This implies that if credit facilities do not exist, fluctuation does not occur. So, by controlling credit, one can control fluctuations in the economic activity.

5. Continue He further maintains that although the rate of progress of cycles may be influenced by non-monetary causes, these factors operate indirectly and through the medium of the credit movement. For example, a non-monetary factor such as optimism in a particular industry can affect activity directly, but it cannot exert a general influence on industry unless optimism is allowed to reflect itself through monetary changes, i.e., through increased borrowing. On these grounds, Hawtrey regarded trade cycle as a purely monetary phenomenon.

6. Continue The gist of Hawtrey’s theory is that the inherent instability in bank credit causes changes in the flow of money which in effect leads to cyclical variations. An economic expansion is caused by the expansion of bank credit and the economic crisis occurs no sooner the credit creation is stopped by the banking system; thus, a contraction of credit leads to a depression.

7. The Monetary Sequence of a Trade Cycle: Basically, Hawtrey’s theory dwells upon the following postulates : 1. The consumers’ income is the aggregate of money income=national income or community’s income in general . 2. The consumers’ outlay is the aggregate of money spending on consumption and investment. 3 . The consumers’ total outlay constitutes community’s aggregate effective demand for real goods and services. Thus, general demand is a monetary demand. 4. The wholesalers or traders have strategic position in the economy. They are extremely sensitive in their stock hoarding business to the changes in the rate of interest .

8. Continue 5. The changes in the flow of money are usually caused by the unstable nature of bank credit. Hence, bank credit has a unique significance in Hawtrey’s cyclical model. According to Hawtrey , changes in business activity are due primarily to variations in effective demand or consumers’ outlay. It is the total money income that determines consumers’ outlay. The stability of the whole economic system follows from the establishment of monetary equilibrium.

9. Under monetary equilibrium: ( i ) Consumers’ outlay = consumers’ income; (ii) Consumption = production; (iii) Cash balances of consumers and traders remain unchanged; ( iv) Bank credit flow is steady; (v) Market rate of interest = the profit rate; (vi) Wages (as money costs) and prices on the whole are equal (this means normal profit margin and the normal rate of productive activity); and (vii) There is no net export or import of gold.

10. Continue Hawtrey contends that such a monetary equilibrium situation is one of extremely delicate balance, which can be easily dislocated by any number of causes and when disturbed, tends to move into a transitional period of cumulative disequilibrium. He emphasized that primarily it is the unstable nature of the credit system in the economy that causes changes in the flow of money and disturbs the monetary equilibrium. In this connection he feels that the discount rate or interest rate exerts a great influence.

11. The Expansion Phase: A typical expansion phase, according to Hawtrey , might proceed along the following lines. The expansion phase of the trade cycle is brought about by an increase of credit and lasts so long as the credit expansion goes on. A credit expansion is brought about by banks through the easing of lending conditions along with a reduction in the discount rate, thereby reducing the costs of credit.

12. Continue By lowering their lending rates, banks stimulate borrowing. Such a reduction in the interest rate is a great stimulus to wholesalers (or traders). According to Hawtrey , traders are in a strategic position as they tend to carry their large stocks primarily with borrowed money. Moreover, traders usually mark their profits as fraction of the value of a large turnover of goods. Hence, a small change in the interest rate affects their profits to a disproportionately large extent. Thus, they are very sensitive to change in the rate of interest.

13. Continue Traders are induced to increase their stocks — inventories— when the interest rate falls. Hence, they give large order to the producers; the increased orders of traders cause the producers to raise their level of production and employment. This in turn leads to an increase in income and monetary demand. “Thus the whole amount of the funds created by the bank is received as income, whether profits, wages, rents, salaries, or interest, by those engaged in producing the commodities.” Evidently, the increased production leads to an expansion of consumers’ income and outlay.

14. Continue This means increased demand for goods in general, and traders find their stocks diminishing. These result in further orders to producers, a further increase in productive activity, in consumers’ income and outlay, and in demand, and a further depletion of stocks. Increased activity means increased demand, and increased demand means increased activity.” This leads to a cumulative expansion, set up, fed and propelled by the continuous expansion of bank credit.

15. Continue Hawtrey further states: “Productive activity cannot grow without limit. As the cumulative process carries one industry after another to the limit of productive capacity, producers begin to quote higher and higher prices.” Thus , when prices rise, traders have a further incentive to borrow and hold more stocks in view of the rising profits.

16. Continue The rising prices operate in the same way as falling interest rates and the spiral of cumulative expansion is accelerated further. This means that there are three important factors which influence credit expansion by banks. These are: ( i ) the rate of interest charged by the banks (ii) traders’ expectations about the price behaviour (iii) the actual magnitude of their sales

17. Continue The rate of interest is determined by the banks. Traders’ expectations depend on general business conditions and their psychology. Actual magnitude of sales depends on the net effect of the first two upon the consumers’ outlay. In short, “Optimism encourages borrowing, borrowing accelerates sales, and sales accelerate optimism.”

18. Financial Crisis (Recession ) According to Hawtrey , prosperity comes to an end when credit expansion ends. As banks go on increasing credit, their cash funds deplete and they are forced to curtail credit and raise interest rates in order to discourage the demand for new loans. Due to the shortage of gold reserves, the central bank — as lender of the last resort — has to set a limit on the accommodation to commercial banks.

19. Continue Eventually, the central bank will start contracting credit by raising the bank rate. Thus, the drain of cash from the banking system ultimately results in an acute shortage of bank ‘reserve’, so that the banks not only refuse to lend any more, but actually are compelled to contract. It is interesting to note that in Hawtrey’s view a drain upon the cash reserves of the banking system is caused by the public. For a rise in consumers’ income generally would lead to an increase in the cash holding (unspent margins) by the public.

20. Continue This happens when the wages rise and consequently wage-earners’ demand for cash rises. Thus, what ultimately limits the expansion of credit is the absorption of money in circulation, mainly by wage earning classes. Moreover, under the international gold standard, if expansion is taking place rapidly in a country, it will lose gold to other countries due to excessive imports. Eventually, the central bank will have to adopt a restrictive policy.

21. Contraction Phase (Depression) The recessionary phase merges with depression due to the growing shortages of credit. The contraction of credit exerts a deflationary pressure on prices and profits and on consumers’ income and outlay. High rate of interest charged by banks discourages traders to hold large stocks and their demand for credit decreases. Prices start falling, profits also drop.

22. Continue Accordingly, traders further reduce stocks and stop ordering goods. Producers in turn will curtail output and employment. The income of the factors of production will decline. When consumers’ income and outlay decrease, effective demand decreases, stocks and output decrease, prices fall, profits fall and so on — a cumulative downswing develops. In a nutshell, it is the contraction of effective demand reflected in reduced outlay by consumers and increased holding of cash balances in view of a large credit curb that causes a vicious circle of deflation leading to severe depression.

23. Recovery During a depression, as traders experience slackening in the demand for their goods, they will try to dispose of goods at whatever low price they get and repay bank’s loans. When loans are liquidated, money gradually flows from circulation into the reserves of bank. As depression continues, banks will have more and more idle funds.

24. Continue The credit creating capacity of banks increases and in order to stimulate borrowing, banks lower the interest rate. Traders will now be stimulated to increase their inventories and the whole process of expansion will be once again set in motion.

25. Continue The central bank now helps by lowering the bank rate and adopts open market purchases of securities so that cash is pumped into banks improving their lendable resources. And when the purchase of securities is carried far enough, the new money will find an outlet. Hawtrey believes that the ordinary measures of monetary instruments such as bank rate policy and open market operations may help in bringing about a revival.

26. Continue In Hawtrey’s view, this cyclical behaviour is fundamentally a monetary phenomenon. He does not deny that non-monetary causes (such as invention, discovery, bumper crops, etc.) may affect productive activity but he feels that their effects will be synchronized only with monetary effects. Non-monetary causes have no periodicity; the periodicity that appears in trade cycles is due to monetary effects, and it can be surmounted by an appropriate banking policy.

27. Continue According to Hawtrey , it is only the inherent instability of bank credit that causes fluctuations in business and turn them into rhythmic changes. Abolish the instability of bank credit by an appropriate bank policy and the trade cycles will disappear.

28. A Critical Appraisal No doubt, Hawtrey’s theory is perfectly logical in its basic concept of a self-generating cycle of cumulative process of expansion and contraction. One of the most striking features of Hawtrey’s theory is his explanation of the period of a cycle, i.e., his explanation of the turning points of expansion and contraction. Hawtrey , in his analysis, however, exaggerates the significance of wholesalers, ignoring the capital goods industries and all other sectors of the economy.

29. Continue Some critics have pointed out that monetary inflation and deflation are not causes, as Hawtrey expounds, but the result of trade cycles. In fact, credit expansion follows business expansion, and once it takes place, it would accelerate business activity. So monetary deflation is preceded by business contraction. The role of bank credit in the economic system is over- emphasised by Hawtrey . It is true that finance is the backbone of business and bank credit plays an important role in it, but it does not mean that banks are always the leaders of economic activity.

30. Continue Hawtrey asserts that changes in the flow of money are the sole and adequate cause of economic fluctuations. But, a trade cycle, being a complex phenomenon, cannot be attributed to a single cause. There are various non­monetary indigenous and exogenous factors, besides monetary factors which influence economic activity. Thus, it is incorrect to say that trade cycles are a purely monetary phenomenon.

31. Schumpeter’s Theory of Innovation Definition:   Schumpeter’s Theory of Innovation  is in line with the other investment theories of the business cycle, which asserts that the change in investment accompanied by monetary expansion are the major factors behind the business fluctuations, but however, Schumpeter’s Theory posits that innovation in business is the major reason for increased investments and business fluctuations.

32. Continue According to Schumpeter, the cyclical process is almost exclusively the result of innovation in the organization, both industrial and commercial. By innovation he means, the changes in the methods of production and transportation, production of a new product, change in the industrial organization, opening up of a new market, etc. The innovation does not mean invention rather it refers to the commercial applications of new technology, new material, new methods and new sources of energy.

33. Continue Schumpeter has developed a model in two stages, i.e. first approximation, and second approximation, in order to further explain his business cycle theory of innovation. The first approximation lays emphasis on the primary impact of innovatory ideas while the secondary approximation deals with the subsequent responses obtained from the application of the innovations. Let’s study these stages in detail:

34. Continue First Approximation:  This stage begins with the economic system in equilibrium in which there is no involuntary unemployment, firm’s  mc = mr  (marginal cost is equal to marginal revenue) and price = Average Cost (AC). In the situation of complete equilibrium in the economy, if the firm decides to undertake a new technique of production, then the same needs to be financed through bank credit. Since the economy is in equilibrium, there are no surplus funds to finance the new venture.

35. Continue With the additional funds from the banking system, the firm keeps on bidding higher prices for the inputs with a view to withdrawing them from the other less important uses. With an increased expenditure in the economy, the price begins to rise. This process further expands, when other firms try to imitate the innovation and raise additional funds from the banking system. As the innovation gets widely adapted the output begins to flow in the market. This marks the beginning of prosperity and expansion.

36. Continue But after a certain level, with an increase in the level of output the price and profitability decreases. This is because the further innovation does not come by quickly and thus, there will be no additional demand for the funds. Instead, the firms which borrowed the funds from the bank start paying it back. This results in the contraction in money supply and hence the prices fall further. The process of recession begins and remains until the equilibrium in the economy is restored.

37. Continue Second Approximation:  The second approximation deals with the waves generated by the first approximation. The  speculation  is the main element of second approximation. As the primary wave of expansion begins, the investor, particularly in capital goods industries, expects this upswing to remain permanent and hence borrows heavily.

38. Continue Even the consumers expecting the prices to increase in future go into debt to acquire durable consumer goods. This heavy indebtedness turns out to be havoc when prices begin to fall. Both the investors and consumers find it difficult to meet their obligations, and this situation leads to a panic and then depression.

39. The Schumpeter’s theory of innovation suffers from the following criticisms It is not only difficult but also unavailing to perform the objective evaluation of Schumpeter’s theory of the business cycle because its arguments are more based on the sociological factors rather than the economic factors. Schumpeter’s theory is not basically different from the over-investment theory; it differs only in the respect of the cause of variation in investment when the economy is in stable equilibrium.

40. Continue Like other theories of the business cycle, this theory also leaves out other factors that cause fluctuations in the economic activities. Innovation is not the sole factor, rather is only one of the factors that cause fluctuations in the economy. In spite of these shortcomings Schumpeter’s theory of innovation is widely acceptable in the modern economy and is used to determine the economic fluctuations.

41. The Keynes’ Theory of Business Cycles  J.M. Keynes in his seminal work ‘General Theory of Employment, Interest and Money’ made an important contribution to the analysis of the causes of business cycles. According to Keynes theory, in the short run, the level of income, output or employment is determined by the level of aggregate effective demand. In a free private enterprise, the entrepreneurs will produce that much of goods as can be sold profitably. Now, if the aggregate demand is large, that is, if the expenditure on goods and services is large, the entrepreneurs will be able to sell profitably a large quantity of goods and therefore they will produce more.

42. Continue In order to produce more they will employ a larger amount of resources, both men and materials. In short, a higher level of aggregate demand will result in greater output, income and employment. On the other hand, if the level of aggregate demand is low, smaller amount of goods and services can be sold profitably. This means that the total quantity of national output produced will be small. And a small output can be produced with a small amount of resources. As a result, there will be unemployment of resources, both labour and capital. Hence, the changes in the level of aggregate effective demand will bring about fluctuations in the level of income, output and employment.

43. Continue Thus, according to Keynes, the fluctuations in economic activity are due to the fluctuations in aggregate effective demand. Fall in aggregate effective demand will create the conditions of recession or depression. If the aggregate demand is increasing, economic expansion will take place.

44. What causes fluctuations in aggregate demand?   The aggregate demand is composed of demand for consumption goods and demand for investment goods. Thus aggregate demand depends on the total expenditure of the consumers on consumption goods and entrepreneurs on investment goods . Propensity to consume being more or less stable in the short run, fluctuations in aggregate demand depend primarily upon the fluctuations in investment demand. Keynes shows that the fundamental cause of fluctuations in aggregate demand and hence in fluctuations in economic activity is the fluctuations in investment demand. Investment demand is very unstable and volatile and brings about business cycles in the economy.

45. Expansion to contraction Phase- Keynes Theory During an economic expansion two factors eventually work to cause invest­ment to fall . First, During the expansion phase increase in demand for capital goods due to large-scale investment activity leads to the rise in prices of capital goods due to rising marginal cost of their production. Higher prices of capital goods raise the cost of investment projects and thereby reduce marginal efficiency of capital (that is, expected rate of return).

46. Continue Secondly, as income rises during expansion phase, the demand for money increases which raises interest rate. Higher interest rate makes some potential, projects unprofitable. Thus, fall in marginal efficiency of capital on the one hand and rise in interest rate on the other cause decline in investment demand . Declining trend of investment, according to Keynes, raises doubts about the prospective yield on capital goods which is more important factor determining marginal efficiency of capital than cost of investment projects and rate of interest. When among businessmen pessimism sets in about future profitability of investment projects stock prices tumble.

47. Continue The crash in stock prices worsens the situation and causes investment to fall even more. Besides, fall in prices of shares reduces wealth of households. Wealth, according to Keynes, is an important factor determining consumption. Thus, the decline in stock prices reduces autonomous consumption demand of households. With the fall in both investment and consumption demand aggregate demand de­clines which result in accumulation of unintended inventories with the firms. This induces the firms to cut production of goods.

48. Continue It follows from above that besides the rise in cost of capital goods and rise in rate of interest towards the end of the expansion phase, it is the fall in expected prospective yield that reduces the marginal efficiency of capital and causes investment demand to fall . The turning point from expansion to con­traction is thus caused by a sudden collapse in marginal efficiency of capital.

49. Criticisms of the Keynesian theory of trade cycle 1. Half the Explanation: A complete theory of the trade cycle must explain not only the turning points of the trade cycle but also the periodicity of the business cycle. Keynes could not explain the latter. Periodicity means the period from depression to boom of the various trade cycles.

50. 2. Psychological Theory in a New Form Keynes told us that the major cause of the burst of a boom is the over-optimism of the business community. It brings about the sudden collapse of the MEC. Likewise, Keynes asserted that recovery will start only after the confidence of the investors in investment profitability gets restored. This brings Keynes’s theory very near to the psychological theory of trade cycles given by some classical writers.

51. 3. Neglect of the Role of Accelerator Keynes explained the cumulative nature of the upswing and downswing through his concept of investment multiplier. But income does not increase or decrease through the multiplier process alone. ‘Accelerator’ which can be called the process of induced investment is also instrumental in bringing about rapid changes in income . Multiplier accelerator interaction is capable of generating different types of trade cycle under different values.

52. 4. No Explanation of the Trend of Growth with Business Cycles It has been noticed that all private-enterprise economies continue to grow while they suffer from cyclical fluctuations in economic activity. Keynes provided the concept of equilibrium level of income for the short period. He avoided discussing growth with business cycles. This deficiency in Keynes’ analysis was removed by Professor Roy Harrod who distinguished between three rates of growth of the economy the actual rate of growth, the warranted rate of growth and the natural rate of growth. This way he could explain simultaneously both growth and trade cycles.

53. 5. Asymmetry of the Expansion and the Contraction Phases It has been observed that the rate of rise in income during the expansion phase is much more than the rate of fall of income during the contraction phase. There is an asymmetry here which Keynes did not record or analyse . Prof. Hicks provided an explanation of the same in his theory of the trade cycles. This asymmetry is due to the inactivity of accelerator in the downturn.

54. 6. Neglects the Theory of Capital Keynes observed that the duration of contraction is related definitely to the life of capital assets and the carrying costs of inventories. But he did not care to introduce this aspect of the theory of capital in his theory of the business cycles.

55. 7. Doubtful Efficacy of the Anti-cyclical Policy Keynes advocated a cheap- money policy along with the policy of public works for fighting a depression. His policy was successful in many countries. But his policy did not prove to be successful against inflation. In fact, Keynes’ ‘General Theory’ was depression economies. It did not analyse well the nature of booms and as such could not provide a satisfactory anti-inflationary policy. Rather it was felt that the classical policy proved to be better during inflation.