MEC is rapidly increasing and rate of interest is sticky. Thus the cycles are inherently explosive but are contained by ceilings and floors of the economy. It serves especially to emphasise that in a capitalist economy characterised by substantial amounts of durable equipment, a period of contraction inevitably follows expansion. According to Dernburg and McDougall, the full employment level depends on the magnitude of the resources that are available to the country. According to him non-monetary factors like wars, strike, floods, drought may cause only temporary depression. Spiethoff has pointed out that over investment is the cause for trade cycle. Since investment in an innovation is risky, he must pay interest on it with his newly acquired funds, the innovator starts bidding away resources from other industries. Fall in income will lead to a decline in demand for goods and services produced by other sectors. And also, the more rapid the rate of growth, the shorter the depression.” Another factor which governs the duration of depression is the “carrying costs of surplus stocks.”. (5) The working of the accelerator in the downswing provides an indirect restraint on the downward movement of the economy. When there is crop failure, that will result in depression. The Hicksian theory of the business cycle has been severely criticised by Duesenberry, Smithies and others on the following grounds: Hicks’s model assumes that the value of the multiplier remains constant during the different phases of the trade cycle. This is unrealistic because financial crisis in a slump may reduce autonomous investment below its normal level. Over-optimism and speculation add further to the boom. On the contrary, when the market interest rate is more than the natural rate, the economy is in depression. In order to repay the loans, the borrowers sell their stocks. Through international trade, booms and depressions in one country are passed to other countries. The consumption function takes the form Ct= aYt-1 . Thus the competitive impact of an innovation would not increase costs and prices. Banks reduce their loans and advances. The result will be a damped cycle. Thus Schumpeter’s theory is not a correct explanation of trade cycles. The product life cycle theory is used to comprehend and analyze various maturity stages of products and industries. According to this theory, the spot that appears on the sun influences the climatic conditions. The usual cycle consists of a contraction phase in which economic activity declines to trough of the cycle, followed by expansion and reaching the peak of the cycle. To conclude with Dernburg and McDougall, “The Hicks’s model serves as a useful framework of analysis which, with modification, yields a fairly good picture of cyclical fluctuation within a framework of growth. Article shared by. The accelerator is defined by Hicks as the ratio of induced investment to the increase in income. Thus optimism encourages borrowing borrowing increases sales, and sales raise optimism. Generally, a trade cycle is composed of four phases – depression, recovery, prosperity and recession. This leads to a cumulative decline in employment and income via the reverse operation of the multiplier. 4. This will tend to raise service prices. Phases 4. As the innovators start repaying bank loans out of profits, the quantity of money is decreased and prices tend to fall. may at best cause a partial depression, but not a general depression. 1. It is the introduction of a new product and the continual improvements in the existing ones that are the principal causes of business cycles. Introduction If general acceptance by the economics profession were the criterion for success or failure of a theory, the theory of the trade cycle attributed to F. A. Hayek would have to be declared a failure. Further, it is also possible, as pointed out by Schumpeter, that autonomous investment may itself be subject to fluctuations due to a technological innovation. Similarly, the main cause of the downturn is reduction in investment. The amplitude of economic fluctuations depends: First, on the amplitude, time pattern, number and independence of the disturbances affecting the economic system. There is less investment in capital goods. With economic growth, banks are more willing to lend, increasing investment. Hicksian Theory of Trade Cycle Definition: Hicksian Theory of Trade Cycle was proposed by Hicks, who considered Samuelson’s multiplier-accelerator interaction theory and Harrod-Domar growth model in combination to explain his theory of the trade cycle. (5) Full Employment Assumption Unrealistic: Schumpeter’s analysis is based on the unrealistic assumption of full employment of resources to begin with. According to this theory, depression is due to over-saving. Before publishing your Articles on this site, please read the following pages: 1. Plagiarism Prevention 5. These theories can be classified into non-monetary and monetary theories. Since the supply price of capital assets is stable in the short-run, the MEC is determined by the prospective yield of capital assets, which, in turn, depends on business expectations. Thus the entire process becomes cumulative and the economy is forced into depression. Unable to repay bank loans, some firms go into liquidation, thus forcing banks to contract credit further. The second approximation of Schumpeter follows through the reaction of the impact of original innovation. Consequently, money incomes and prices rise and help to create a cumulative expansion throughout the economy. (2) The saving and investment coefficients are disturbed overtime in such a way that an upward displacement from equilibrium path leads to a lagged movement away from equilibrium. It is also possible that part of a particular investment may be autonomous and a part induced, as in the case of machinery. This state of recession ends in depression. Further, the fall in the MEC may shift the consumption function downward thereby hastening the depression. A trade cycle is international in character. To date regionalization has not generated significant reverse exports to Japan, as the product cycle theory predicts; rather, it has led to trade triangles in which technology and components are sourced from Japan while the finished products are exported to third-country markets, principally to the United States and Western Europe. Hence this distinction between autonomous and induced investment is of doubtful validity in practice. These factors force the banks to raise interest rates and refuse to lend. The product life-cycle theory was developed by Raymond Vernon in the mid-1960s. Thus the introduction of an innovation may not lead to the withdrawal of labour and other resources from old industries. Dillard also points toward this defect when he writes that Keynes “does not examine closely the empirical data of cyclical fluctuations.”, One of the serious omissions of Keynes’s theory of the trade cycle is the acceleration principle. According to Schumpeter, there is nothing that can explain that inventions occur in a cyclical manner. There being competition between the two sectors, prices of factors and prices in the economy continue to rise. Second, on the reaction mechanism of the economic system to the disturbances. Innovation is financed by bank loans. It has been defined differently by different economists. In spite of its various merits, the Hicksian theory of trade cycle suffers from the following weaknesses its fundamental shortcoming is that Hicks assumes a fixed value of the multiplier during the fixed phases of the cycles. This cumulative process of rising investment, income and employment continues till the boom is reached. Hawtrey’s Monetary Theory 2. Higher prices induce traders to borrow more in order to hold still larger stocks of goods so as to earn more profits. Firstly, Schumpter’s theory is based on two assumptions viz., full employment and that innovation is being financed by banks. Mechanical Explanation of Trade Cycle: Another serious limitation of the theory is that it presents a mechanical explanation of the trade cycle. Merchants place more orders which induce the entrepreneurs to increase production by employing more labourers. Features of a Trade Cycle 3. Content Guidelines 2. As a result, production costs fall and profits increase. Therefore, changes in total expenditure i.e., consumption and investment expenditures, affect effective demand and this will bring about fluctuation in economic activity. Rendings Fels’s study of the American business cycles in the 19th century has revealed that the revival was not due to the exhaustion of excess capacity. (2) Unrealistic Assumption of Equilibrium: The assumption of this theory that in the beginning savings and investment are in equilibrium in the economy and the banking system destroys this equilibrium is unrealistic. Profits increase and old industries expand by borrowing from the banks. (Metzler). Forced savings increase with the fall in consumption which are invested for the production of capital goods. This leads to fall in the prices of factors and resources become unemployed. This new equilibrium will be at a higher level of income than the initial equilibrium because of the innovation which started the cycle. (6) Inventory Investments do not Produce True Cycles: Hamberg further points out that in Hawtrey’s theory cumulative movements in economic activity are the result of changes in stocks of goods. Though there is an element of truth in this theory, this theory is unable to explain the occurrence of boom and starting of revival. But this concept of neutrality of money is based on old quantity theory of money which has lost its validity. Pessimism gives way to optimism. Non-Monetary Theories of Trade Cycle: 1. 5.Distinction Between Autonomous and Induced Investment not Feasible: Critics like Duesenberry and Lundberg point out that Hicks’s distinction between autonomous and induced investment is not feasible in practice. A trade cycle is cumulative and self-reinforcing. The adjective ‘business’ restricts the concept of fluctuations in activities which are systematically conducted on commercial basis. Uploader Agreement. This leads to further increase in productive activity, income, outlay, and demand, and a further depletion of stocks of merchants. Hence trade cycle is a wave like movement. Next, Friedman and Schwartz explain the mechanism which brings about monetary changes leading to the business cycles. Hicks assumes in his model that the average capital-output ratio (v) is greater than unity for a time lag of one year or less. This has led Hicks to formulate his theory of the trade cycle in a growing economy. 11. In such a situation, there is no need of transferring resources from one sector to the other. A reduction of rate of interest by the banking institutions would enthuse the businessmen to borrow more and more and ex… Prof. Hawtrey considers trade cycle to be a purely monetary phenomenon. It induces a secondary wave of credit inflation which is superimposed on the primary wave of innovation. This is not correct because besides changes in the rate of interest, the expectations of profit, innovation, invention, etc. But Keynes gives more importance to fluctuations in the MEC as the principal cause of cyclical fluctuations. This is because the equilibrium may deviate due to both internal and external reasons. Thus the phase of expansion starts. (1) Innovator not Necessary for Innovations: Schumpeter’s analysis is based on the innovator. Another factor is the export of gold to other countries when imports exceed exports as a result of high prices of domestic goods. As pointed out by Lundberg, every investment is autonomous in the short run and a major amount of autonomous investment becomes induced in the long run. Induced by high profits, they try to produce more. If the accelerator worked continuously, output would plunge downward below the equilibrium level EE, and because of explosive tendencies, to a greater extent than it rose above it.” The fall in output in this case might be a steep one, as shown by P2 P3 Q. The non-bank sellers and commercial banks will try to readjust their portfolios. 41 Downloads; Abstract. The process of contraction becomes cumulative leading to depression. At this time, the banks call off loans from the borrowers. Secondly, innovation is not the only cause of business cycle. When the new product becomes successful, other entrepreneurs will also produce similar products. Many theories have been put forward from time to time to explain the phenomenon of trade cycles. It results in depression. Prof. Culbertson regards this evidence as faulty for two reasons: First, it relates turning points in one series in the money stock to turning points in economic activity. Howtrey’s Monetary Theory Of Trade Cycle: Prof. Hawtrey regards business cycle as purely a monetary phenomenon. Prohibited Content 3. They further observe that a secular change in the growth rate of the money stock leading to longer period changes in money income are reflected mainly in different price behaviour rather than in different growth rates of output. Theories. On the other hand, in deep depression cycles, there has been a greater fall in money stock. Second, it implies that monetary change has been an exogenous variable and that causation runs only from monetary change to economic change. He opines that non-monetary factors like strikes, floods, earthquakes, droughts, wars, etc. The old firms contract output and some are even forced to run into liquidation. According to Schumpeter, innovations in the structure of an economy are the source of economic fluctuations. One cannot therefore separate the long-run full employment trend from what happens during a cycle.”. It has neglected other factors determining investment. Money supply changes due to changes in rates of interest. MEC depends on the expectations of the entrepreneur about future. This is because the theory is based on the multiplier-accelerator interaction in rigid form, according to Kaldor and Duesenberry. 2. (2) Monetary Changes not the Main Cause of Business Cycles: According to this theory, monetary changes are the main cause of business cycles. Rather in certain cases, revival started even when there was excess capacity. For this, they place larger orders with producers who, in turn, employ more factors of production to meet the increasing demand. It pays too much attention on saving and too little on others. EE is the equilibrium level of output which depends on AA and is deduced from it by the application of the multiplier accelerator interaction to it. A trade cycle is asymmetrical. Optimism gives way to pessimism. 3. 10. During this period of recession, credit, prices and interest rate decline but total output is likely to average larger than in the preceding prosperity. As the cumulative process of expansion continues, producers quote higher and higher prices. Economics, Monetary Economics, Capitalism, Trade Cycle, Theories, Theories of Trade Cycle. Trade cycle is a complex phenomenon and it cannot be associated with climatic conditions. All these will bid up the prices of assets and of both producer and consumer goods. This equilibrium is characterised by Schumpeter as the “circular flow” which continues to repeat itself in the same manner year after year, similar to the circulation of the blood in an animal organism. To perform his economic function, the entrepreneur requires two things: first, the existence of technical knowledge in order to produce new products, and second, the power of disposal over the factors of production in the form of bank credit. There will be competition for factors of production between capital goods and consumption good industries. Further, Hicks’s contention that revival would start with the exhaustion of excess capacity has not been proved by empirical evidence. The merit of Keynes’ theory lies in explaining the turning points-the lower and upper turning points of a trade cycle. But in reality, business cycles are the result of the other exogenous factors like innovations. The impulse for innovation is reduced and eventually comes to an end. In the Hicksian theory, the accelerator is based on induced investment which along with the multiplier brings about an upturn. This is because they are very sensitive to changes in the rate of interest. Banks will give more loans to traders and merchants by lowering the rate of interest. Because of the low prices of goods, producers are not willing to expand production. On the other hand, with increase in the prices of consumer goods, their producers earn more profits. 3. Thus the total amount of investment in the economy is equal to autonomous investment minus the constant rate of depreciation. Banks refuse to lend further because their cash funds are depleted and the money in circulation is absorbed in the form of cash holdings by consumers. Joseph A. Schumpeter has developed innovation theory of trade cycles. Thus innovations may bring about changes in economic conditions. This will lead to rise in market rate of interest above the equilibrium rate of interest. Low interest rate induces producers to get more loans from banks. Hicks writes in this connection: “I shall follow Keynes in assuming that there is some point at which output becomes inelastic in response to an increase in effective demand.” Thus certain bottlenecks of supply emerge which prevent output from reaching the peak and instead encounter the ceiling at P1. Keynes, thus, has given a satisfactory explanation of the turning points of the trade cycle, “Keynes consumption function filled a serious gap and corrected a serious error in the previous theory of the business cycle”. Incomes fall. According to him the basic cause of business cycles is the expansion and contraction of money. In addition, there may be an endogenous cycle. The autonomous investment is independent of changes in the level of output. At Q2, the slump reaches the bottom or floor provided by the LL line. Finally, when all excess capacity is exhausted, autonomous investment will cause income to rise which will in turn lead to an increase in induced investment so that the accelerator is triggered off which along with the multiplier moves the economy toward the ceiling again. A rise in demand raises prices. Prof. Over-Saving or Under Consumption Theory: This theory is the oldest explanation of the cyclical fluctuations. Thus the value of the multiplier changes with different phases of the cycle. (3) Traders do not depend Only on Bank Credit: Hamberg has criticised Hawtrey for the role assigned to wholesalers in his analysis. Unlike the sudden collapse of the economic system, the revival takes time. This theory explains only the turning point from prosperity to depression. The financial markets tend to revive well before the trough. They place more orders with producers. This is not correct. The process of revival and recovery becomes cumulative and leads to prosperity. The theories are: 1. Schumpeter assigns the role of an innovator not to the capitalist but to an entrepreneur. These cycles are mostly monetary in origin. This theory does not explain all the phases of trade cycle. As a matter of fact, factors other than the rate of interest are more important in influencing such decisions. These cycles are superimposed over a long run secular growth path, GP, as shown in Figure 3. This theory was developed by A.C. Pigou. The economy will move along the ceiling from P1 to P2 depending upon the time period of the investment lag. According to Hawtrey, “Trade cycle is purely a monetary phenomenon” and he strongly advocated that changes in the flow of money are exclusively responsible for the ranges in economic activity which in turn create boom or depression. Businessmen are optimistic. Every increase in investment leads to a multiple increase in income via the multiplier effect. A vicious circle is set up, a cumulative expansion of productive activity.”. The Product Life Cycle Theory is an economic theory that was developed by Raymond Vernon in response to the failure of the Heckscher-Ohlin model to explain the observed pattern of international trade.The theory suggests that early in a product's life-cycle all the parts and labor associated with that product come from the area where it was invented. About the causal relation between the money stock and economic activity, they make the following generalisations: (i) Changes in economic activity have always been accompanied by changes in the money stock; (ii) There have not been major changes in the money stock that have not been accompanied by changes in economic activity; and. Terms of Service 7. On the other hand, if traders finance their stocks with their own funds, interest rate changes will have little effect on their purchases. The reliance on the conventional hypothesis makes Keynes’ concept of expectations superfluous and unrealistic. They are provided by reducing the lending rate of interest and by purchasing securities. Equilibrium rate of interest is one at which savings are equal to investment. The commercial banks will create more money with increase in their reserves, thereby transmitting the increase in high-powered stock of money. Authors; Authors and affiliations; R. G. D. Allen; Chapter. It is the oldest theory of trade cycle. The first stage deals with the initial impact of innovation and the second stage follows through reactions to the original impact of innovation. According to Hawtrey, the process of recovery is very slow and halting. 1. There is optimism everywhere. John Maynard Keynes, one of the most influential economists of the 20th century, never worked out a pure theory of trade cycles, though he made significant contributions to the trade cycle theory.Keynes states, “The trade cycle can be described and analyzed in terms of the fluctuations of the marginal efficiency of capital relatively to the rate of interest.” 2. The prosperity phase is slow and gradual and the phase of depression is rapid. (2) The introduction of a new method of production; (4) The conquest of a new source of raw materials or semi-manufactured goods; and. According to Hayek, when the fall in prices comes to an end during depression, banks begin to raise the supply of money which reduces the market interest rate below the natural interest rate. Schumpeter believes in the existence of Kondratieff long wave of upswings and downswings in economic activity. Investment will fall; production declines leading to depression. The increased demand for assets will spread sooner or later affecting equities, houses, durable producer goods, durable consumer goods, etc. At best, it can create conditions for that. The expansion phase of the trade cycle starts when banks increase credit facilities. According to Keynes, the principal cause of depression and unemployment is the lack of aggregate demand. Therefore, it may be stated that banking system cannot originate a trade cycle. 3. Business cycle is recurrent and rhythmic; prosperity is followed by depression and vice versa. Keynes believes that consumption expenditure is stable and it is the fluctuation in investment expenditure which is responsible for changes in output, income and employment. Even though the bank rate is very low, there is “credit deadlock” which prevents businessmen to borrow from banks due to pessimism in economic activity. So for a few years, disinvestment in stocks will continue till the surplus stocks are exhausted. Hicks’s model also pinpoints the fact that in the absence of technical progress and other powerful growth factors, the economy will tend to languish in depression for long periods of time.” The model is at best suggestive. To him, “the theory of the acceleration and the theory of the multiplier are the two sides of the theory of fluctuations.” Unlike Samuelson’s model, it is concerned with the problem of growth and of a moving equilibrium. Hayek formulated his monetary over-investment theory of trade cycle. During the period of expansion businessmen are optimistic. Monetary changes may be one among other factors, and not the only factor. Banks may stop their loans. As a result, money flows into the reserves of banks and funds increase with banks. One of their estimates of the lag between turning points in the growth of the money stock and in the level of economic activity reveals that during the seven cycles between 1927 and 1970, peaks in the rate of change in the money stock precede reference cycle peaks (in economic activity series) before downturns by 20 months on an average, and troughs in the rate of change of the money stock precede reference troughs by about 11 months on an average before upturns. Raymond Vernon, a Harvard Business School professor, developed the product life cycle theory A modern, firm-based international trade theory that states that a product life cycle has three distinct stages: (1) new product, (2) maturing product, and (3) standardized product. The basic cause of boom or depression according to Hawtrey is the changes in the volume of money which are brought about by the changes in the rate of interest. It is effective demand which determines the level of income and employment. But rate of interest does play an important role in decision making process of entrepreneurs. If equilibrium rate of interest is higher than market rate of interest there will be prosperity and vice versa. This encourages investment and the process of revival begins in the economy. An innovation includes the discovery of a new product, opening of a new market, reorganization of an industry and development of a new method of production. Hicks explains his theory of the trade cycle in terms of Fig. These encourage borrowings on the part of merchants and producers. It is the money stock itself that shows a consistent cyclical behaviour which is closely related to the cyclical movements in economic activity at large. (iii) Changes in the stock of money have been attributed to a specific variety of exogenous factors rather than to changes in economic activity. In the words of Dillard, “It is less than a complete theory of the business cycle because it makes no attempt to give a detailed account of the various phases of the cycle.”, Saulnier criticises Keynes’s for lacking in factual proof. Hawtrey’s theory is considered to be an incomplete theory as it does not take into account the non-monetary factors which cause trade cycles. As defined by Hicks, it is independent of the path of output. This extension of cycle is followed by a period of revival which continues till the equilibrium level is reached. The Hicksian theory of trade cycle is based on the following assumptions: (1) Hicks assumes a progressive economy in which autonomous investment increases at a constant rate so that the system remains in a moving equilibrium. To explain the course of the Keynesian cycle, we start with the expansion phase. First, as more capital goods are being produced steadily, the current yield on them declines. In actuality, cyclical fluctuations are caused by expansion and contraction of bank credit which, in turn, lead to variations in the flow of monetary demand on the part of producers and traders. It believes that over production in one sector leads to over production in other sectors. Thus Keynes’ theory is not much different from Pigou’s psychological theory of the trade cycle. Credit expansion and contraction do not lead to boom and depression. This is based on the Keynesian stable consumption function. Prices begin to rise, thereby stimulating further investment. Consequently, supply exceeds demand. Uncertainty and risks increase. But the actual behaviour of the postwar cycles has shown that the expansionary phase of the business cycle is much longer than the contractionary phase. Rich people have large income but their marginal propensity to consume is less. Expansion and contraction of credit may be a supplementary cause but not the main and sole cause of trade cycle. The MEC (marginal efficiency of capital) depends on the supply price of capital assets and their prospective yield. TOS4. If the banking system places more money in the hands of entrepreneurs, prices will increase. Every firm is in equilibrium and producing efficiently with its costs equal to its receipts. Cyclical variations in the quantity of money may well be an important element in the ordinary mild business cycle. 7. There is also much evidence that during business cycles the money stock plays largely an independent role. The shorter the length of life of durable assets, the shorter the depression. Entrepreneurs become pessimistic and reduce their investment and production. The lags in economic activity behind peaks and troughs in the rate of change of the money stock are not uniform. There has been strong secular changes in the money stock over these decades. Boom. But more factors cannot be used in the consumer goods sector as compared to the capital goods sector. Prof. Strigl has criticised this theory for giving undue importance to forced savings. Consumption in period t is regarded as a function of income (Y) of the previous period (f-1). But Hawtrey believes that an expansion of credit leads to a boom. Disclaimer 8. LL is the lower equilibrium path of output representing the floor or ‘slump equilibrium line’. Schumpeter’s theory starts with the breaking up of the circular flow by an innovation in the form of a new product by an entrepreneur for earning profit. Initially, the rise in the growth rate of the money stock occurs early in the contraction phase. 6. There is unemployment. Lundberg, therefore, suggests that the assumption of constancy in accelerator should be abandoned for a realistic approach to the understanding of trade cycles. In actuality, traders do not depend exclusively on bank credit but they finance business through their own accumulated funds and borrowing from private sources. Hawtrey, “The trade cycle is a purely monetary phenomenon.” It is changes in the flow of monetary demand on the part of businessmen that lead to prosperity and depression in the economy. Hicks’s Theory. Real income production, employment, prices, profit etc. 4. As there is a fall in price of raw-materials and equipment, costs fall. If there is a lag in the adjustment of real money balances to the new price level, the initial portfolio adjustment will tend to overshoot. The Keynesian theory of the trade cycle is an integral part of his theory of income, output and employment. Demand for bank loans increases. It is a burst of autonomous investment from the equilibrium path that leads to growth. The new innovation starts producing goods and there is an increased flow of goods in the economy. Ceiling fails to explain adequately the onset of Depression: Hicks has been criticised for his explanation of the ceiling or the upper limit of the cycle. But now all innovations form part of the functions of joint stock companies. Profits decline. In reality, there is no full employment of resources. Hence it is not related to the growth of the economy. According to Keynes, the carrying cost of surplus stocks during the depression is seldom less than 10 per cent per annum. There is no wastage of materials. For instance, if the market rate of interest is lower than equilibrium rate of interest due to increase in money supply, investment will go up. Further this theory fails to explain the periodicity of trade cycle. Optimism takes the place of pessimism. During the period of good trade, entrepreneurs become optimistic which would lead to increase in production. In the circular flow, the same products are produced every year in the same manner. As a matter of fact, trade cycles may be due to psychological, natural or financial causes. According to him, when people with fixed incomes reduce their consumption with the increase in prices and the high income groups also reduce their consumption to the same extent, savings will not be forced but voluntary. Rather, they ask the business community to repay their loans. A business cycle is synchronic. He explained his theory on the basis of Wicksell’s distinction between the natural interest rate and the market interest rate. Consequently, output, employment and income increase. This increases or decreases the flow of money in the economy and thus brings about prosperity or depression. Such persons were to be found in the 18th and 19th centuries who made innovations. According to Duesenberry, the ceiling fails to explain adequately the onset of depression. If both equilibrium rate of interest and market rate of interest are equal, there will be stability in the economy. When there is positive economic growth, this tends to cause: 1. Investment depends on rate of interest and marginal efficiency of capital. Schumpeter’s Innovations Theory 4. They also cancel orders with producers. Bank credit may be important in the short run when industrial concerns get credit facilities from banks. Keynes’s theory of the trade cycle is superior to the earlier theories because “it is more than a theory of the business cycle in the sense that it offers a general explanation of the level of employment, quite independently of the cyclical nature of changes in employment.” However, critics are not lacking in pointing out its weakness. Ultimately, expenditures rise on all directions without any change in interest rates at all. Economists have criticised Friedman’s theory of money and business cycles on the following grounds: (1) Monetary Changes not the Only Cause of Changes in Economic Activity: Friedman argues that it is monetary changes that cause changes in economic activity. This made his theory one-sided because his explanation centres round the principle of multiplier. In a period of recession and depression, according to Keynes, rate of interest should be high due to strong liquidity preference. As the process of expansion continues, cost of production increases, due to scarcity of factors of production. are falling. This theory has been formulated by Malthus, Marx and Hobson. Keynes’s Theory 5. Banks will further contract credit. Shortage of resources cannot bring a sudden decline in investment and thus cause a depression. There are many other causes which have not been analysed by Schumpter. Similarly during boom, rate of interest should be low because of weak liquidity preference; but actually the rate of interest is high. An increase in money supply will lead to boom and vice versa, a decrease in money supply will result in depression. Privacy Policy 9. This starts the recessionary phase. Share Your Word File Schumpeter’s theory is weak in that it does not take these factors into consideration. The money stock generally reaches its peak before the ‘reference’ peak of the cycles. Mere contraction of bank credit will not lead to depression if marginal efficiency of capital is high. But in the long run when the need for capital funds is much greater, bank credit is insufficient. The impact of a trade cycle is differential. Line AA shows the path of autonomous investment growing at a constant rate. This will result in cumulative expansion and prosperity. When the net trade days are positive, the company needs to funds those days with net income or a line of credit.When the net trade cycle is negative, the firm is being paid for the service or product before the firm pays its vendor AP.While a negative net trade cycle can be very advantageous to a business, it only holds true when a business is increasing the revenues. (3) Time Lag of Peaks and Troughs not Long and Variable: According to Friedman, the time lag of peaks and troughs in the rate of change of the money stock relative to economic changes in business cycles is both long and variable. Marginal efficiency of capital depends on two factors – prospective yield and supply price of the capital asset. It is consistent with saving-investment equilibrium. Hence there is a smaller amplitude of resulting fluctuations. When the capital stock is increasing during any period, the ceiling is raised. Consequently, the production of consumer goods falls, their prices increase and their consumption decreases. The Austrian business cycle theory (ABCT) is an economic theory developed by the Austrian School of economics about how business cycles occur. This is not correct because the former is not the cause of the latter. On the other hand, a decline in MEC leads to unemployment and fall in income and output. Innovations are not inventions. Hence it is a function of the growth rate of the economy. This will increase the demand for consumption goods. There are idle resources. There is increase in investment, bank loans and advances. These, in turn, lead to reduction in the demand for factors of production. In this sense, it is similar to that of Pigou’s psychological theory. The induced investment, on the other hand, is dependent on changes in the level of output. “Interest rates and asset prices may simply be conduit through which monetary change is transmitted to expenditures without being altered at all, just as a greater inflow into a tank may, after an interval, simply increase the rate of outflow without altering the level of the tank itself.” All these forces operate simultaneously and there are cyclical fluctuations. In the diagram above, the straight line in the middle is the steady growth line. Thus, with the continuous reduction in the prices of goods and factors in the economy, a long period of depression and unemployment begins. This website includes study notes, research papers, essays, articles and other allied information submitted by visitors like YOU. The dynamic process of transition from one equilibrium path to another involves a cyclical adjustment process. Vernon believes that there are four stages of production cycle: innovation, growth, According to him, Keynes makes no attempt to test any of his deductions with facts. (4) Innovation financed through Voluntary Savings does not produce a Cycle: Critics point out that if an innovation is financed through voluntary savings or internal funds, there will not be an inflationary rise in prices. On the basis of the above analysis, Friedman and Schwartz point toward two propositions: First, appreciable changes in the growth rate of the money stock are necessary and sufficient conditions for appreciable changes in growth rate of economic activity or money income. Keynes attributes the downturn to the sudden collapse in the MEC. The model contributed to the rapid rise of the television industry in Asian countries. It depends on factors which bring about the recovery of the MEC. But for Keynes, the change in consumption function with its effect on MEC is responsible for trade cycle. Thus expansion or contraction of credit cannot originate either boom or depression in the economy. in the 1960s. On the other hand, an increase in the rate of interest will lead to reduction in borrowing, investment, prices and business activity and hence depression. According to Friedman and Schwartz, the empirical evidence justifies the generalisations noted above. (7) It is assumed that the average capital-output ratio (v) is greater than unity and that gross investment does not fall below zero. Their prices fall. Hayek has suggested that the volume of money supply should be kept neutral to solve the problem of cyclical fluctuations. Consequently, the natural interest rate falls. Market rate of interest is one at which demand for and supply of money are equal. According to Hart, Keynes relied on “convention” for forecasting changes in business expectations. This results in increase in employment and income leading to an increase in demand for goods. F.A. As pointed out by Sir John Hicks, “The theory of acceleration and the theory of multiplier are two sides of the theory of fluctuations, just as the theory of demand and the theory of supply are the two sides of the theory of value.”. Bank credit plays an important role in business activity. This deadlock can be broken by following a cheap money policy by the central bank which will ultimately bring about recovery in the economy. It is associated with W.S.Jevons and later on developed by H.C.Moore. These effects will raise interest rates on the whole range of assets. Content Guidelines 2. The warranted rate of growth is the rate which will sustain itself. As a result, the interest rate falls. According to Hawtrey, “Increased activity means increased demand, and increased demand means increased activity. (4) The economy cannot expand beyond the full employment level of output. As time passes, existing machinery becomes worn out and has to be replaced. Since autonomous investment is taking place, the fall in output is much gradual and the slump much longer than the boom, as indicated by Q1Q2. According to Hamberg traders are likely to react favourably to a reduction in the interest rate only if they think that the reduction is permanent. Despite these apparent weaknesses of the Hicksian model, it is superior to all the earlier theories in satisfactorily explaining the turning points of the business cycle. This sets the process of falling prices. In the modern society, there is great inequalities of income. Trade cycles are the outcome of economic development in a capitalist society. Despite these criticisms, it cannot be denied that one of the important causes of business cycles is “a dance of the dollar.”. In this phase, there is a slow rise in output, employment, income and price. Falling demand, prices and incomes are the signals for depression. Then fall in employment leads to fall in income, expenditure, prices and profits. The rise in prices may induce the entrepreneurs to increase their investments leading to over-investment. This will bid up prices of such assets. The two models of investments can be looked at using the international product cycle of Vernon’s model. At this time, banks will decide to reduce credit expansion. Growth not Dependent only on changes in Autonomous Investment: Another weakness of the Hicksian model is that growth is made dependent upon changes in autonomous investment. Fresh investment starts taking place. Account Disable 12. Friedman and Schwartz have argued on the basis of US historical data that business cycles are mostly monetary in origin. Further, as admitted by Hicks himself, depression may start even before reaching the full employment ceiling due to monetary factors. A rise in consumer and business confidence 2. 2. Many economists do not know what the theory is, and many are sure that the theory is fundamentally wrong-headed. Trade cycles are periodic fluctuations of income, output and employment. Thus, fluctuations are due to optimism leading to prosperity and pessimism resulting depression. Hawtrey’s theory has been criticised on many grounds: 1. This will create over production in other sectors. When the economy hits the full employment ceiling at P1 it will creep along the ceiling for a period of time to P2 and the downward swing will not start immediately. Consequently, in an underemployed economy an innovation financed through voluntary savings might not generate a cycle. Hicks begins from a cycle less situation PQ on the equilibrium path EE when an increase in the rate of autonomous investment leads to an upward movement in income. If the slump is severe, induced investment will quickly fall to zero and the value of the accelerator becomes zero. Friedman concludes on the basis of empirical evidence that lags involving changes in the rate of the money stock that affect the level of economic activity are both long and variable. However, this theory is not accepted today. 8. Bank credit is the principal means of payment in the present times. The economy does not turn upward immediately from Q2 but will move along the slump equilibrium line to Q3 because of the existence of excess capacity in the economy. On the other hand, if the spot did not appear on the sun, rainfall is good leading to prosperity. Some of the characteristics of a boom include: A fast growth of consumption helped by rising real incomes, strong confidence and a surge in house prices and share prices; A pick up in demand for capital goods as businesses invest in extra capacity to meet strong demand and to make higher profits During depression, the level of economic activity is extremely low. The higher economic growth increases incomes and causes more demand for housing 4. They adopt capital-intensive methods for producing more of capital goods. 4. During the expansion phase, the MEC is high. This explanation of the transmission mechanism fits with the empirical observations of business cycles. Business expansion stops. Rising asset prices such as houses; this causes a rise in wealth and consumer spending. According to Hicks, it is autonomous investment that brings a gradual movement towards the floor and it is again increase in autonomous investment at the bottom that leads to the lower turning point. Suppose, at the full employment level, an innovation in the form of a new product has been introduced. International product cycle theory ignored FDI in Asian countries. It gives too much importance to rate of interest in determining investment. It does not say anything about recovery. This is shown as the “Secondary Wave” in Figure 2. He gives the example of a railway company which lays down one more track to avoid traffic congestion. “The time which must elapse before recovery begins, depends partly upon the magnitude of the normal rate of growth of the economy and partly upon the length of life of capital goods. Line FF is the full employment ceiling level above the equilibrium path EE and is growing at the constant rate of autonomous investment. In fact, causation also has run in other direction. With the increase in the purchasing power of consumers, the demand for the products of old industries increases in relation to supply. On the other hand, a short period change in the growth rate of money stock also exerts a substantial influence on the growth rate of output. Further innovation is usually financed by the promoters and not by banks. Hicks has also been criticised for assuming a constant value of the accelerator during the different phases of the cycle. Hawtrey believes that trade cycle is nothing but small scale replica of inflation and deflation. A high rate of interest will not prevent the people to borrow.
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