4 Most Important Theories of Business Cycle – Explained!

Among the non-monetary theories are-(1) Meteorological or Sunspot Theory; (2) Psychological Theory; (3) Over-production Theory, (4) Over Saving Theory; (5) Innovation Theory; and (6) Cobweb Theorem.

Among the monetary theories of Business cycle the important ones are the following:

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(i) Howtrey’s Theory; (ii) Dr. Hayek’s over-investment Theory; (iii) Keynes’ Theory; (iv) Prof. Hicks Theory of Business cycle.

A full treatise is required to discuss in fuller details all these theories. A few of the old theories are no longer accepted now. We shall discuss here only the most important theories of business cycle.

Important Theories

1. Over-investment theory:

According to this theory trade cycle occurs because of the over investment in investment industries.

The investment industries are building and construction, iron and steel, engineering etc. During every boom investment increases.

This statement is supported by the fact that during boom, investment goods industries expand faster than consumption goods industries and during depression investment goods industries suffer more than consumption goods industries.

However, opinion among the writers differs on the question as to why in the boom phase investment goods industries expand faster than consumption goods industries.

Hayeis Machlup, Ropke and Ribbons hold banks responsible for it. Banks give credit at unduly low rates of investment and in this way they encourage investment.

Credits being cheap, all sorts of inefficient and even uneconomical units are set up. The entrepreneurs adopt more and more rounds about methods of production.

Resources are withdrawn from consumer’s goods industries and invested in production goods industries through the process of forced saving.

This brings about the disparity in the growth rates of consumption goods industries and investment goods industries.

At some points the banks feel that too much credit has been created. They raise the rate of interest.

Borrowing becomes a costly affair and the rate of investment falls this will bring about the contraction of credit and hence contraction of economic activity leading to depression.

But economists like Cassel consider the process of production rather than the expansion of bank credit to be more important cause of a trade cycle.

According to them a revival in economic activity leading to boom takes place because of real forces like new inventions. However, here also the assumption of ‘elastic money supply’ remains.

2. Under consumption theory:

The chief exponent of this theory is I.S. Hobson. According to him, trade cycles appear due to mal-distribution of national income.

This mal-distribution of national income takes place because during boom the entrepreneurs and businessmen gather income with business activities and banks and become richer. Since they cannot consume the whole income they save.

There is too much saving during the boom period. Reduction in the level of consumption means a fall in the demand for consumers’ goods because the amount saved is not spent on consumption.

The supply of consumer’s goods will be far greater than the demand for them. Prices of these goods begin to fall. The general outlook becomes pessimist. If this downward movement continues depression will set in.

3. Keynes’ saving and investment theory:

In this ‘General’ Theory Keynes has given an explanation of business or trade cycle. Keynes never attempted an elaborate theory of business cycle as such.

In fact business cycles show rhythmic fluctuations in the aggregate income, output and employment which is the main subject matter of Keynes’ ‘General Theory’.

In Dillard’s words, “Keynes’ General Theory is not a theory of business cycle as such. It is much more and also much less than that, it is more than a theory of business cycle in the sense that it offers a general explanation for the level of employment quite independently by the cyclical nature of changes in employment.

It is less than a complete theory of business cycle because it makes no attempt to give a detailed account of the various phases of the cycle and does not examine closely the empirical data of cyclic fluctuations, something which any complete study of the business cycle would presumably do.”

According to Keynes’ business cycles appear as a result of the fluctuations in the rate of investment and the fluctuations in the rate of investment are due to the marginal efficiency of capital (MEC) Keynes’ has defined marginal efficiency of capital as the relation between the prospective yield of that type of capital and the cost of producing the units.”

In simple words, we define marginal efficiency of capital as the expected rate of profit on new investment or capital goods.

Thus, the fluctuations in economic activity are due to the marginal efficiency of capital or the expected rate of interest on new investment.

The rate of interest which is the second determinant of investment is stable in short period and in the long period it cannot go beyond a maximum and minimum limit.

It is, therefore, the marginal efficiency of capital which is always fluctuating due to complex variables viz.; expected trends of prices, element of risks in enterprise, the existing stock of capital goods.

Therefore, fluctuations in investment are largely due to fluctuations in the marginal efficiency of capital. When the marginal efficiency of capital rises there will be burst in investment leading to a boom.

The burning point from the boom to contraction is explained by saying that there is a decline in the prospective yields on capital (i.e. marginal efficiency of capital) due to growing increase of the capital goods.

A wave of boom will set in and this will cause a further fall in marginal efficiency of capital. The result will be deciding production and consequent depression.

Just as Keynes’ explains the turning point from boom to contraction, similarly, he explains that a change from depression to recovery is due to the revival of the marginal efficiency of capital.

Along with the revival of marginal efficiency of capital, there will be the revival of business confidence which is more important.

Because without the revival of business confidence even if the rate of Interest is reduced, investment will remain the same because in the absence of business confidence marginal efficiency of capital remains low.

As the investment increases income increases more due to the multiplier effect so the overall business activity starts upwards.

4. Hicks’ theory of trade cycle:

Prof Hicks explains the phenomenon of trade cycles by combining the principle of multiplier and acceleration. According to Hicks, investment is of two types. (i) Autonomous investment and (ii) Induced investment.

Autonomous investment is independent of the variations in income, output and consumption, while induced investment is determined by the fluctuations in income, output and consumption.

The force of autonomous investment is expressed in multiplier while the force of induced investment is expressed in acceleration.

Thus, according to Hicks, autonomous investment and induced investment cause cyclical fluctuations in economic activity via multiplier and accelerator respectively.

Let us assume that the initial equilibrium position of the economy is disturbed by a change in autonomous investment.

This will lead to increase in income and output to the extent indicated by the multiplier. Now this expansion of income and output will affect the induced investment via the accelerator.

This gives rise to further expansion of income (multiplier) and investment (accelerator) of the economy and so on.

In this way during this period of upswing, output increases faster than the equilibrium rate. Investment also increases faster than the normal rate.

The expansion of income and output will continue till the economy reaches the upper limit or ceiling determined by full employment.

After this ceiling, it starts declining. The rate of expansion in output and income is slowed down to the natural rate.

This leads to decrease in the amount of induced investment. The multiplier and accelerator forces will work in the reverse order.

A fall in investment reduces income at a faster rate and the reduced income again reduce the level of investment and so on.

Now the level of output and income will not only reduce to the equilibrium level but rather below it.

The reason is obvious as the multiplier and the accelerator work just in the opposite directions. This will go on declining till it reaches the minimum (lower) turning point.

Thus, the cycle is complete the main limitation of this theory lies in the use of acceleration principle which the modern economists consider as a crude tool.

This principle assumes that investment generated by a change in output is independent of the absolute size of the change.

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