Since bank credit forms comparatively a large proportion of total money supply in circulation, variation^ in the volume of bank credit are the principal cause of trade cycle.
The theory rests on the following propositions:
a) An elastic supply of money is essential for cyclical fluctuations; these cyclical fluctuations could not occur in the absence of an elastic supply of money.
b) The money supply of all countries equipped with modern banking system is capable of expansion and contraction.
c) The normal behaviour of the banking system is such as to cause expansions and contractions of the total money supply.
d) Such expansions and contractions in the money supply are sufficient to account for business cycles.
e) Therefore the business cycle is essentially the result of variations in the money supply produced by the banking system.
Variations in effective demand which are the real substance of the trade cycle must be traced to changes in bank credit.
The upward movement of the trade cycle is brought about by an expansion of credit by reducing interest rate. Inspired by this the businessmen start sending orders for goods to producers on a very large scale.
The producers start increasing means of production to meet these orders. This results in the rise of demand for production. Due to the rise in the demand the price rises and there is rise in employment also.
Thus, with the rise of purchasing power of the people, effective demand also rises. As a result of all these phenomena an upward cycle comes into existence.
The whole process is fed by continuous expansion of bank credit. There are three factors which influence the credit expansion by banks. These are (1) rate of interest on traders’ borrowing; (2) traders’ expectations as to the course of prices; and (3) actual extent of their sales.
The first is within the control of banks, the second is purely psychological and the third depends on the net effect of the two. Optimism encourages borrowings, borrowing accelerates sales and sales accelerate optimism.
As long as the banks provide facilities to businessmen to grant loans on low interest rate the economy proceeds smoothly.
But there is a definite limit of the loan being granted by banks. Banks have to keep minimum cash reserve in proportion to their liabilities.
Hence, when they experience difficulty in maintaining this ratio, they suddenly stop granting loans to businessmen and ask them to pay back their old loans early.
Due to this sudden change in the policy of banks, traders holding stocks with borrowed money are forced to sell them quickly and as a result prices tumble down, manufacturers get fewer orders, curtail productive activities and begin to discharge labourers.
Unemployment ensues, money incomes are reduced and depression begins. Thus the cycle is complete. Thus the uncertainty of bank credit is responsible for business cycle.
1) Statistical studies do not support the view that the low rates of interest encourage businessmen to keep large stocks. But stocks are actually made after judging the extent or the possibility of selling them at profitable prices.
If the businessmen are convinced that the prices of goods would rise in future, then they will increase their stocks despite the high rate of interest. On the contrary if there is an apprehension of fall in prices in future, then businessmen would not keep stocks even at low rate of interest.
2) According to this theory, only a rise in the rate of interest at the peak of boom can give a new turn to the situation and initiates crisis. But the common experience indicates that rise in bank rate occurs after the crisis and not before the crisis.
3) Hawtrey considers business cycle as a purely monetary phenomenon. But business cycle is a complex phenomenon in the making of which many non-monetary factors are also important.