Theories of Business Cycles (Part - 1) - Macroeconomics | Macro Economics - B Com PDF Download

Some of the most important theories of business cycles are as follows:

1. Pure Monetary Theory
2. Monetary Over-Investment Theory
3. Schumpeter’s Theory of Innovation
4. Keynes Theory
5. Samuelson’s Model of Multiplier Accelerator Interaction
6. Hicks’s Theory.

A number of theories have been developed by different economists from time to time to understand the concept of business cycles. In the first half of twentieth century, various new and important concepts related to business cycles come into existence.

However, in nineteenth century, many of the classical economists, such as Adam Smith, Miller, and Ricardo, have conducted a study on business cycles. They linked economic activities with the Say’s law, which states that supply creates its own demand. They believed that stability of an economy depends on market forces. After that, many other economists, such as Keynes and Hick, had provided a framework to understand business cycles.

The different theories of business cycle are shown in Figure-3:

The different theories of business cycles (as shown in Figure-3) are explained in detail.

1. Pure Monetary Theory:

The traditional business cycle theorists take into consideration the monetary and credit system of an economy to analyze business cycles. Therefore, theories developed by these traditional theorists are called monetary theory of business cycle. The monetary theory states that the business cycle is a result of changes in monetary and credit market conditions. Hawtrey, the main supporter of this theory, advocated that business cycles are the continuous phases of inflation and deflation. According to him, changes in an economy take place due to changes in the flow of money.

For example, when there is increase in money supply, there would be increase in prices, profits, and total output. This results in the growth of an economy. On the other hand, a fall in money supply would result in decrease in prices, profit, and total output, which would lead to decline of an economy. Apart from this, Hawtrey also advocated that the main factor that influences the flow of money is credit mechanism. In economy, the banking system plays an important role in increasing money flow by providing credit.

An economy shows growth when the volume of bank credit increases. This increase in the growth continues till the volume of bank credit increases. Banks offer credit facilities to individuals or organizations due to the fact that banks find it profitable to provide credit on easy terms.

The easy availability of funds from banks helps organizations to perform various business activities. This leads to increase in various investment opportunities, which further results in deepening and widening of capital. Apart from this, credit provided by banks on easy terms helps organizations to expand their production.

When an organization increases its production, the supply of its products also increases to a certain limit. After that, the rate of increase in demand of products in market is higher than the rate of increase in supply. Consequently, the prices of products increases. Therefore, credit expansion helps in expansion of economy. On the contrary, the economic condition is reversed when the bank starts withdrawing credit from market or stop lending money.

This is because of the reason that the cash reserves of bank are washed-out due to the following reasons:

a. Increase in loans and advance provided by banks

b. Reduction in inflow of deposits

c. Withdrawal of deposits for better investment opportunities

When banks stop providing credit, it reduces investment by businessmen. This leads to the decrease in the demand for consumer and capital goods, prices, and consumption. This marks the symptoms of recession.

Some of the points on which the pure monetary theory is criticized are as follows:

a. Regards business cycle as monetary phenomenon that is not true. Apart from monetary factors, several non-monetary factors, such as new investment demands, cost structure, and expectations of businessmen, can also produce changes in economic activities.

b. Describes only expansion and recession phases and fails to explain the intermediary phases of business cycles.

c. Assumes that businessmen are more sensitive to the interest rates that is not true rather they are more concerned about the future opportunities.

2. Monetary Over-Investment Theory:

Monetary over-investment theory focuses mainly on the imbalance between actual and desired investments. According to this theory, the actual investment is much higher than the desired investment. This theory was given by Hayek.

According to him, the investment and consumption patterns of an economy should match with each other to bring the economy in equilibrium. For stabilizing this equilibrium, the voluntary savings should be equal to actual investment in an economy.

In an economy, generally, the total investment is distributed among industries in such a way that each industry produces products to a limit, so that its demand and supply are equal. This implies that the investment at every level and for every product in the whole economy is equal. As a result, there would be no expansion and contraction and the economy would always be in equilibrium.

According to this theory, changes in economic conditions would occur only when the money supply and investment-saving relations show fluctuations. The investment-saving relations are affected when there is an increase in investment opportunities and voluntary savings are constant.

Investment opportunities increase due to several reasons, such as low interest rates, increased marginal efficiency of capital, and increase in expectations of businessmen. Apart from this, when banks start supporting industries for investment by lending money at lower rates, it results in an increase in investment.

This may result in the condition of over­investment mainly in capital good industries. In such a case, investment and savings increase, but the consumption remains unaffected as there is no change in consumer goods industries.

Consequently, profit increases with increase in investment opportunities, which further results in an increase in the demand for various products and services. The demand for products and services exceeds the supply of products and services.

This leads to inflation in the economy, which reduces the purchasing power of individuals. Therefore, with decrease in the purchasing power of individuals, the real demand for products does not increase at the same rate at which the investment increases. The real investment is done at the cost of real consumption.

The balance between the investment and consumer demand is disturbed. As a result, it is difficult to maintain the current rate of investment. The demand of consumer goods would be dependent on the income of individuals.

An increase in the income level would result in the increase of consumer goods. However, the increase in consumer goods is more than the increase in capital goods. Therefore, people would invest in consumer goods rather than in capital goods. Consequently, the demand for bank credit also increases.

However, the bankers are not ready to lend money because of the demand for funds from consumer and capital goods industry both. This leads to recession in the economy. As a result, economic activities, such as employment, investment, savings, consumption, and prices of goods and services, start declining.

Some of the limitations of monetary over-investment theory are as follows:

a. Assumes that when the market rate of interest is lower than the natural market rate of interest, the bank credit flows to the capital goods industry. This is applicable only in the situation of full employment. However, business cycles are the part of an economy and can take place under improper utilization of resources.

b. Considers interest rate as the most important factor that affects investment. However, there are several factors, such as capital goods cost and businessmen expectations, which can influence investment.

c. Focuses on balance between consumer goods and investment, which is not much required.

3. Schumpeter’s Theory of Innovation:

The other theories of business cycles lay emphasis on investment and monetary expansion. The Schumpeter’s theory of innovation advocates that business innovations are responsible for rapid changes in investment and business fluctuations.

According to Schumpeter said, “Business cycles are almost exclusively the result of innovations in the industrial and commercial organization. Innovations are such changes of the combination of the factors of production as cannot be effected by infinitesimal steps or variations on the margin. [Innovation] consists primarily in changes in methods of production and transportation, or changes in industrial organization, or in the production of a new article, or opening of a new market or of new sources of material.”

According to Schumpeter, innovation refers to an application of a new technique of production or new machinery or a new concept to reduce cost and increase profit. In addition, he propounded that innovations are responsible for the occurrence of business cycles. He also designed a model having two stages, namely, first approximation and second approximation.

The two stages of the model are discussed as follows:

(a) First Approximation:

Deals with the effect of innovatory ideas on an economy in the beginning. First approximation is the startup stage of innovation in which the economy is in equilibrium. This implies when Marginal Cost (MC) is equal to Marginal Revenue (MR) and Average Cost (AC) is equal to price. In addition, at this stage, there is no involuntary unemployment.

In equilibrium, organizations lack idle funds or surplus funds to invest. In such a case, banks are the only source of funds for innovators. When the innovators get the desired fund from banks, they purchase inputs for production at a higher price to make these inputs available only for innovation purposes.

Increase in prices of inputs result in the rise of prices. Over time, competitors also start copying innovation and acquire funds from bank. As a result, the output and profit of organizations start increasing.

However, after a certain point of time, profit shows decline with a decrease in output prices. Simultaneously, debtors need to repay their debts to bank. This leads to decrease in the flow of money, which finally results in recession.

(b) Second Approximation:

Deals with the subsequent effects of first approximation. It is related to the speculation of future economic conditions. In first approximation, it is assumed by investors that the expansion phase would not be affected in future, especially in capital goods industries. On the basis of this belief, investors take large amounts of money from banks.

In addition, in this stage, customers perceive an increase in the durable goods in future and therefore, start purchasing goods at present by borrowing funds. When the prices start falling, debtors are in the worst situation because they are not able to repay loan and meet their basic needs. This leads to depression in the economy.

4. Keynes Theory:

Keynes theory was developed in 1930s, which was the period when whole world was going through great depression. This theory is the reply of Keynes to classical economists. According to classical economists, if there is high unemployment condition in an economy, then economic forces, such as demand and supply, would act in a manner to bring back full employment condition.

In his theory of business cycles, Keynes advocated that the total demand helps in the determination of various economic factors, such as income, employment, and output. The total demand refers to the demand of consumer and capital goods.

In such a case, total investment and expenditure on products and services is more, the level of production would increase. When the level of production increases, it results in the increase of employment opportunities and income level. However, if the total demand is low, the level of production would also be less.

Consequently, the income, output and investment would also be low. Therefore, changes in income and output level are produced by changes in total demand. The total demand is further affected by changes in the demand of investment, which depends on the rate of interest and expected rate of profit.

Keynes referred expected rate of profit as the marginal efficiency of capital. Expected rate of profit is the difference between the expected revenue generated by the capital employed and the cost incurred to employ that capital.

In case, the expected rate of profit is greater than the current rate of interest, then the investors would invest more. On the other hand, the marginal efficiency of capital is determined by expected return from capital goods and cost involved in the replacement of capital goods.

Marginal efficiency of a capital increases due to new inventions or innovations in economic factors, such as product, production technique, investment option, assuming that prices would rise in future. On the other hand, it decreases due to various reasons, such as decrease in prices, increase in costs, and inefficiency of the production process.

According to Keynes theory, in the expansion phase of business cycle, investors are positive about economic conditions, thus, they overestimate the rate of return from an investment. The rate of return increases until the full employment condition is not achieved.

When the economy is on the path of achieving full employment, this phase is termed as boom phase. In the boom phase, investors are not able to diagnose the fall in marginal efficiency of capital and even do not consider the rate of interest. As a result, the profit from investments starts Calling due to the increase in the cost of investment and production of goods and services. This situation results in the contraction or recession in economy.

This is because the rate of decrease in the marginal efficiency of capital is more than that of current rate of interest. In addition, in this situation, investment opportunities shrink. Banks are not also able to provide credit because of the lack of funds.

Current rate of interest is higher that encourages people to save rather than invest. As a result, the demand for consumer and capital goods decreases. Further, the income and employment level decreases and economy reaches to the phase of depression.

Keynes has proposed three types of propensities to understand business cycles. These are propensity to save, propensity to consume, and propensity of marginal efficiency of capital. He has also developed a concept of multiplier that represents changes in income level produced by the changes in investment.

Keynes also advocated that the expansion of business cycle occurs due to increase in marginal efficiency of capital. This encourages investors (including individuals and organizations) to invest. Organizations replace their capital goods and start production.

As a result, the income of individuals increases, which further increases the rate of consumption. This increases the profit of organizations, which finally lead to an increase in the total income and investment level of an economy. This marks the recovery phase of an economy.

Some points of criticism of Keynes theory are as follows:

a. Fails to explain the recurrence of business cycles.

b. Ignores the accelerator’s role to describe business cycles. However, a business cycle can be explained property with the help of multiplier acceleration interaction.

c. Offers only a systematic framework for business cycles, not the whole concept.