The model contributed to the rapid rise of the television industry in Asian countries. (2) Innovations not the Only Cause of Cycles: Schumpeter’s contention that cyclical fluctuations are due to innovations is not correct. (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. 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. 3. But for Keynes, the change in consumption function with its effect on MEC is responsible for trade cycle. Optimism takes the place of pessimism. Prices rise further. This much of investment is insufficient to keep the economy at the ceiling level, and then the downturn starts. Keynes attributes the downturn to the sudden collapse in the MEC. The amplitude of economic fluctuations depends: First, on the amplitude, time pattern, number and independence of the disturbances affecting the economic system. 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. Here he seems to follow Keynes blindly regarding the stable consumption function. Share Your PPT File, Top 7 Theories of Interest (With Criticisms). The merit of Keynes’ theory lies in explaining the turning points-the lower and upper turning points of a trade cycle. As the innovators start repaying bank loans out of profits, the quantity of money is decreased and prices tend to fall. Contraction Phase not longer than Expansion Phase: Hicks has been criticised for asserting that the contraction phase is longer than expansion phase of trade cycle. (5) The carrying out of the new organisations of an industry. Hence investments are increased beyond limits and there is over production, which results in losses. There is increase in investment, bank loans and advances. Trade cycles in the economy are caused by inequality between market and natural interest rates. Induced by high profits, they try to produce more. Because of the low prices of goods, producers are not willing to expand production. The financial markets tend to revive well before the trough. 2. The producers get more loans to invest for the production of more capital goods. Economics, Monetary Economics, Capitalism, Trade Cycle, Theories, Theories of Trade Cycle. 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. The consumption function takes the form Ct= aYt-1 . (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. Ultimately, the natural forces of recovery bring about a revival. It is effective demand which determines the level of income and employment. There is a general uptrend in business community. A vicious circle is set up, a cumulative expansion of productive activity.”. So when credit becomes cheap, they borrow from banks in order to increase their stocks or inventories. With low profits and reduction in loans, producers reduce the production of capital goods and adopt labour-intensive production processes. Rather, they ask the business community to repay their loans. But empirical evidence shows that the response of investment to a change in output (v) is spread over many periods. Thus revival starts, becomes cumulative and leads to boom. This cumulative process of rising investment, income and employment continues till the boom is reached. It may at best check growth and not cause a depression. 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. Banks will give more loans to traders and merchants by lowering the rate of interest. During the period of expansion businessmen are optimistic. As a result, money flows into the reserves of banks and funds increase with banks. This is unrealistic because financial crisis in a slump may reduce autonomous investment below its normal level. But this is not true. Keynes considers the trade cycle as mainly due to fluctuations in the MEC. This theory was developed by A.C. Pigou. Marginal efficiency of capital depends on two factors – prospective yield and supply price of the capital asset. But they do not react favourably during the depression phase because traders expect a further reduction every time the interest rate is reduced. 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. Credit is expanded or reduced by the banking system by lowering or raising the rate of interest or by purchasing or selling securities to merchants. This will create over production in other sectors. If the slump is severe, induced investment will quickly fall to zero and the value of the accelerator becomes zero. Suppose, there is over production and excess supply in one sector, that will result in fall in price and income of the people employed in that sector. Thus the total amount of investment in the economy is equal to autonomous investment minus the constant rate of depreciation. According to this theory, trade cycle is result of the interaction between multiplier and accelerator. As the cumulative process of expansion continues, producers quote higher and higher prices. Useful Notes on Product Life-Cycle Theory of International Trade. In fact, he over-emphasised the role of expectations in influencing the MEC. Falling demand, prices and incomes are the signals for depression. Thus “the full employment ceiling” acts as a direct restraint on the upward expansion of the economy. On the other hand, a decline in MEC leads to unemployment and fall in income and output. At … These innovations may reduce the cost of production and may shift the demand curve. Mechanical Explanation of Trade Cycle: Another serious limitation of the theory is that it presents a mechanical explanation of the trade cycle. Over-optimism and speculation add further to the boom. There being competition between the two sectors, prices of factors and prices in the economy continue to rise. International product cycle theory ignored FDI in Asian countries. The accelerator is defined by Hicks as the ratio of induced investment to the increase in income. On the other hand, the market rate of interest is the money rate which prevails in the market and is determined by the demand and supply of money. Businessmen are optimistic. In the diagram above, the straight line in the middle is the steady growth line. Prices begin to rise, thereby stimulating further investment. Recovery: In the early period of recovery, entrepreneurs increase the level of investment which in … On the other hand, in deep depression cycles, there has been a greater fall in money stock. Every firm is in equilibrium and producing efficiently with its costs equal to its receipts. There is rapid increase in the rate of investment. This leads to increase in their production. There are idle resources. Joseph A. Schumpeter has developed innovation theory of trade cycles. Hayekian Trade Cycle Theory: A Reappraisal. Thus changes in the money stock are a consequence as well as independent cause of changes in economic activity. According to Prof. R.G. Employment and income of the factors of production in capital goods industries will increase. Initially, the rise in the growth rate of the money stock occurs early in the contraction phase. 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. Schumpeter believes in the existence of Kondratieff long wave of upswings and downswings in economic activity. They are provided by reducing the lending rate of interest and by purchasing securities. Hence trade cycle is a wave like movement. This new equilibrium will be at a higher level of income than the initial equilibrium because of the innovation which started the cycle. (3) Bank Credit not the Only Source of Funds: Schumpeter gives too much importance to bank credit in his theory. He gives the example of a railway company which lays down one more track to avoid traffic congestion. above video is explains you trade cycle. However, these boom conditions cannot last long because the forces of expansion are very weak. Von Hayek in his books on “Monetary Theory and Trade Cycle” and “Prices and Production” has developed a theory of trade cycle. The impulse for innovation is reduced and eventually comes to an end. Consequently, money incomes of the owners of factors of production increase, thereby increasing expenditure on goods. This made his theory one-sided because his explanation centres round the principle of multiplier. (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. This is shown as the “Primary Wave” in Figure 2. (2) Monetary Changes not the Main Cause of Business Cycles: According to this theory, monetary changes are the main cause of business cycles. Demand for bank loans increases. 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. On the other hand, if traders finance their stocks with their own funds, interest rate changes will have little effect on their purchases. 7. 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 Generally, a trade cycle is composed of four phases – depression, recovery, prosperity and recession. Firstly, according to Keynes the main cause for trade cycle is the fluctuations in MEC. Thus Schumpeter’s theory is not a correct explanation of trade cycles. Hence it is not related to the growth of the economy. But Hawtrey believes that an expansion of credit leads to a boom. 8. 3. When the new product becomes successful, other entrepreneurs will also produce similar products. Expansion and contraction of credit may be a supplementary cause but not the main and sole cause of trade cycle. Keynes states that, “Trade cycle can be described and analyzed in terms of the fluctuations of the marginal efficiency of capital relatively to the rate of interest”. Producers transfer the factors from the production of capital goods to that of consumer goods. Each phase feeds on itself and creates further movement in the same direction. Hence there is a smaller amplitude of resulting fluctuations. The following points highlight the top eight theories of business cycle. Hawtrey’s Monetary Theory 2. 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. In such a situation, there is no need of transferring resources from one sector to the other. Trade cycle is one of the important part of macroeconomics. The process of revival and recovery becomes cumulative and leads to prosperity. People will tend to consume more services, such as renting houses rather than purchasing them. Consequently, in an underemployed economy an innovation financed through voluntary savings might not generate a cycle. Some trade cycles last for three or four years, while others last for six or eight or even more years. Next, Friedman and Schwartz explain the mechanism which brings about monetary changes leading to the business cycles. It affects different industries in different ways. Thus optimism encourages borrowing borrowing increases sales, and sales raise optimism. So for a few years, disinvestment in stocks will continue till the surplus stocks are exhausted. 1. A rise in consumer and business confidence 2. This theory explains only the turning point from prosperity to depression. Thus in the Keynesian explanation of the trade cycle, “the cycle consists primarily of fluctuations in the rate of investment. A monetary change effects different economic magnitudes, some of which adjust faster than others which cause distortions in economic activity, thereby giving rise to the business cycles. According to this theory, the spot that appears on the sun influences the climatic conditions. Since income at this level is decreasing relative to the previous stage of the cycle, there is a decreased amount of investment. Simultaneously, banks impose restrictions on giving loans to them. A trade cycle is international in character. If the banking system places more money in the hands of entrepreneurs, prices will increase. Lundberg, therefore, suggests that the assumption of constancy in accelerator should be abandoned for a realistic approach to the understanding of trade cycles. 3. Business cycle is recurrent and rhythmic; prosperity is followed by depression and vice versa. The economy starts at the equilibrium state, rises to a peak and then starts downward into a recession and continues till the new equilibrium is reached. 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. In the modern society, there is great inequalities of income. These cycles are mostly monetary in origin. This deadlock can be broken by following a cheap money policy by the central bank which will ultimately bring about recovery in the economy. Innovations are regarded as the routine of industrial concerns and do not require an innovator as such. Hicks has also been criticised for assuming a constant value of the accelerator during the different phases of the cycle. As pointed out by Pigou, “Variations in the bank money supply is a part of the business cycle, it is not the cause of it.” At the bottom of the depression, credit is easily available. Each long wave upswing is brought about by an innovation which leads to abundance of goods for the masses. Exogenous fluctuations in the money stock will lead to fluctuations in the demand for goods and services. Further innovation is usually financed by the promoters and not by banks. It is the introduction of a new product and the continual improvements in the existing ones that are the principal causes of business cycles. This has the effect of increasing the prices of capital goods in comparison to consumer goods. Production Cycle Theory of Vernon Production cycle theory developed by Vernon in 1966 was used to explain certain types of foreign direct investment made by U.S. companies in Western Europe after the Second World War in the manufacturing industry. He explained his theory on the basis of Wicksell’s distinction between the natural interest rate and the market interest rate. Despite these criticisms, it cannot be denied that one of the important causes of business cycles is “a dance of the dollar.”. The lag may be long because the effects of monetary disturbances are distributed over an extended period. 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. Thus Keynes’ theory is not much different from Pigou’s psychological theory of the trade cycle. Rising asset prices such as houses; this causes a rise in wealth and consumer spending. International investment and international trade in the product cycle, Vernon, R. (1992). In this phase, there is a slow rise in output, employment, income and price. This leads to further increase in productive activity, income, outlay, and demand, and a further depletion of stocks of merchants. He opines that non-monetary factors like strikes, floods, earthquakes, droughts, wars, etc. Plagiarism Prevention 5. The theory exaggerates the importance of bank credit as a means of financing development. There will be competition for factors of production between capital goods and consumption good industries. Their prices fall. Thus the phase of expansion starts. At this time, the banks call off loans from the borrowers. This leads to depression. First, as more capital goods are being produced steadily, the current yield on them declines. (1) Overemphasis on the Role of Expectations: Keynes has been criticised for his analysis of business cycle based on expectations. Theories of Trade Cycle: Many theories have been put forward from time to time to explain the phenomenon of trade cycles. 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. In a trade cycle, a period of prosperity is followed by a period of depression. Consumption in period t is regarded as a function of income (Y) of the previous period (f-1). Surplus stocks of goods are exhausted. It induces a secondary wave of credit inflation which is superimposed on the primary wave of innovation. So entrepreneurs undertake new investment. 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. “Since the rate at which output increases determines the rate at which capital stock changes, the ceiling level of output will differ depending on the time path of output. As time passes, existing machinery becomes worn out and has to be replaced. It serves as a primer into Hayek’s monetary and capital theories. Further, Hicks’s contention that revival would start with the exhaustion of excess capacity has not been proved by empirical evidence. 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. Uncertainty and risks increase. The result will be a damped cycle. also affect trade cycles. According to Friedman, the lag plays an important role in business cycles. The money stock generally reaches its peak before the ‘reference’ peak of the cycles. 2. It does not say anything about recovery. 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. Banks will further contract credit. Theories. The latter curtail their productive activities due to fall in demand. Factor prices go up. (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. Wages also go down. “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. On the other hand, the non-bank holders of cash will seek to purchase other categories of securities such as high-risk fixed coupons, equities, real property, etc. This is shown as the “Secondary Wave” in Figure 2. Second, this is true both for long secular changes and also for changes over periods roughly the length of business cycles. According to Schumpeter, there is nothing that can explain that inventions occur in a cyclical manner. If resources remain unutilized, the expansion of both the capital goods sector and consumer goods sector may occur simultaneously. This is because the theory is based on the multiplier-accelerator interaction in rigid form, according to Kaldor and Duesenberry. Terms of Service 7. Monetarists like Friedman have supported Hawtrey’s theory. It is changes in the level of business activity which cause changes in the growth rate of the money stock. Monetary changes may be one among other factors, and not the only factor. (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. “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. It is associated with W.S.Jevons and later on developed by H.C.Moore. But the fact is that at the time of revival, the resources are unemployed. In reality, there is no full employment of resources. According to Keynes, the marginal productivity of capital increases with the increase in profits of consumer goods. 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. Trade cycles are periodic fluctuations of income, output and employment. The prosperity phase is slow and gradual and the phase of depression is rapid. The dynamic process of transition from one equilibrium path to another involves a cyclical adjustment process. It is a burst of autonomous investment from the equilibrium path that leads to growth. According to Keynes, the principal cause of depression and unemployment is the lack of aggregate demand. Profits decline. Thus Schumpeter’s first approximation consists of a two-phase cycle. Given constant values of the multiplier and the accelerator, it is the ‘leverage effect’ that is responsible for economic fluctuations. This will increase the demand for consumption goods. The demand for the old products is decreased. In imputing growth to an unexplained extraneous factor, Hicks has failed to provide a complete explanation of the cycle. Firstly, Schumpter’s theory is based on two assumptions viz., full employment and that innovation is being financed by banks. 3. Thus, the variations in climate are so regular that depression is followed by prosperity. The capital stock is one of the resources. He has ignored real factors. When the innovation is adopted by many, supernormal profits will be competed away. There is optimism everywhere. The recession of 1953-54 in America was not caused by shortage of resources. This will result in cumulative expansion and prosperity. There may be scarcity of labour, raw material and other factors of production. 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.” According to Hayek, when the prices of factors are rising continuously, the rise in production costs bring fall in profits of producers. The MEC increases. Thus explosive cycles are inherent in his model. The higher economic growth increases incomes and causes more demand for housing 4. This state of recession ends in depression. Banks reduce their loans and advances. The process of contraction becomes cumulative leading to depression. Recession: When the entrepreneurs realize their mistakes, they reduce investment, employment and production. MEC depends on the expectations of the entrepreneur about future. Product prices are equal to both average and marginal costs. It depends on factors which bring about the recovery of the MEC. Low interest rate induces producers to get more loans from banks. Its first impact is on the financial markets where first bonds, then equities and only later on payments for real resources will be affected. 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. These theories can be classified into non-monetary and monetary theories. According to them, substantial expansions in the quantity of money over short periods have been a major proximate source of the accompanying inflation of prices. This theory does not explain all the phases of trade cycle. Keynes doesn’t develop a complete and pure theory of trade cycles. He emphasized the role of psychological factor in the generation of trade cycles. Profits increase and old industries expand by borrowing from the banks. 8. Economics, Trade Cycle, An Overview on Trade Cycle. (5) Investment does not fall with Increase in Consumer Goods: Hayek argues that with the production of consumer goods and the increase in profits from them, investment falls in capital goods. This leads to the atmosphere of prosperity in the country and monetary over-investment on factors spreads the boom. 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. Prosperity: It is a state of affairs in which real income and employment are high. Keynes attaches more importance to the sudden collapse of the MEC than to a rise in the rate of interest as an explanation of the downturn of the cycle leading to the crisis and the depression. may at best cause a partial depression, but not a general depression. Schumpeter’s Innovations Theory 4. 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.”. A business cycle is synchronic. Non-Monetary Theories of Trade Cycle: 1. According to Pigou, the main cause for trade cycle is optimism and pessimism among business people and bankers. According to Hayek, so long as the natural rate of interest equals the market rate of interest, the economy remains in the state of equilibrium and full employment. This sudden disposal of goods leads to fall in prices and liquidation of marginal firms. (2) Money Supply cannot continue a Boom or Delay a Depression: Haberler has criticised Hawtrey for “his contention that the reason for the breakdown of the boom is always a monetary one and that prosperity could be prolonged and depression stayed off indefinitely if the money supply were inexhaustible.” But the fact is that even if the supply of money is inexhaustible in the country, neither prosperity can be continued indefinitely nor depression can be delayed indefinitely. At Q2, the slump reaches the bottom or floor provided by the LL line. Consequently, the natural interest rate falls. 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. But they are accentuated by bank credit. Explanation of Floor and Lower Turning Point not Convincing: Hicks’s explanation of the floor and of the lower turning point is not convincing. In recent years, all firms resort to plough back of profits for expansion. There being full employment in the economy, they transfer factors of the production from consumer goods sector to capital goods sector. The adjective ‘business’ restricts the concept of fluctuations in activities which are systematically conducted on commercial basis. But this may result in excess capacity because the additional traffic may not be sufficient to utilise the second track fully. Thus expansion or contraction of credit cannot originate either boom or depression in the economy. Disclaimer 8. (iii) Changes in the stock of money have been attributed to a specific variety of exogenous factors rather than to changes in economic activity. Consequently, the production of consumer goods falls, their prices increase and their consumption decreases. The oldest of all international trade theories, Mercantilism, dates back to 1630. Since rate of interest is more or less stable, marginal efficiency of capital determines investment. It serves especially to emphasise that in a capitalist economy characterised by substantial amounts of durable equipment, a period of contraction inevitably follows expansion. 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. Schumpeter’s theory is weak in that it does not take these factors into consideration. This is because the equilibrium may deviate due to both internal and external reasons. When there is positive economic growth, this tends to cause: 1. Hence, due to competition for factors of production costs may go up, leading to an increase in price. But the majority of economists have criticised him for overemphasising monetary factors to the neglect of non-monetary factors in explaining cyclical fluctuations. This is based on the Keynesian stable consumption function. Revival has started. (4) Traders do not react to changes in Interest Rates: Further, Hamberg also does not agree with Hawtrey that traders react to changes in interest rates. As a result, the interest rate falls. This encourages investment and the process of revival begins in the economy. But rate of interest does play an important role in decision making process of entrepreneurs. 7. Merchants place more orders which induce the entrepreneurs to increase production by employing more labourers. Thus it is a mechanical sort of explanation in which human judgement, business expectations and decisions play little or no part. Privacy Policy3. Revival can be brought about by raising aggregate demand which, in turn, can be raised by increasing consumption and/or investment. They adopt capital-intensive methods for producing more of capital goods. It is also possible that part of a particular investment may be autonomous and a part induced, as in the case of machinery. Price is low leading to a fall in profit, interest and wages. 11. Prohibited Content 3. 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. In this sense, it is similar to that of Pigou’s psychological theory. They place more orders with producers. Further, as admitted by Hicks himself, depression may start even before reaching the full employment ceiling due to monetary factors. They begin their explanation of the transmission mechanism with a state of moving equilibrium in which real per capita income, the stock of money, and the price level are changing at constant annual rates. Investment plays a leading role based on formula rather than on judgement. All the sections of the people suffer. The upward phase of a trade cycle, such as revival, prosperity and boom is brought about by an expansion of money and bank credit and also by increase in circulation of money supply. Features of a Trade Cycle 3. The greater stability of the “money multiplier” in contrast to the Keynesian investment multiplier has led Friedman and Schwartz to come to the above conclusion. Even then, it fails to bring a revival. Similarly, contraction of credit cannot bring about a depression. One cannot therefore separate the long-run full employment trend from what happens during a cycle.”. As the process of expansion continues, cost of production increases, due to scarcity of factors of production. As the process continues, the initial impacts will spread throughout the economy. A trade cycle is asymmetrical. But the term marginal efficiency of capital is vague. 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. This is not correct because besides changes in the rate of interest, the expectations of profit, innovation, invention, etc. Unlike the sudden collapse of the economic system, the revival takes time. As a matter of fact, trade cycles may be due to psychological, natural or financial causes. According to Hawtrey, “Increased activity means increased demand, and increased demand means increased activity. This is what has happened historically. Hawtrey believes that expansion and contraction of money are the basic causes of trade cycle. Shortage of resources cannot bring a sudden decline in investment and thus cause a depression. But in mild depressions, there has been a reduction in the growth rate of the money stock rather than any actual fall. When the spot appears, it will affect rainfall and hence agricultural crops. The natural rate of interest is that rate at which the demand for loanable funds equals the supply of voluntary savings. (5) It ignores the effects of monetary changes upon business cycles. are falling. If equilibrium rate of interest is higher than market rate of interest there will be prosperity and vice versa. Fresh investment starts taking place. According to this theory, prosperity begins when the market rate of interest is less than the natural rate of interest. Second, on the reaction mechanism of the economic system to the disturbances. This leads to a cumulative decline in employment and income via the reverse operation of the multiplier. It has neglected other factors determining investment. The theory presents an insightful analysis as to why in the twentieth century a large number of new products in the world were developed by the US firms and sold first in the US market. Once the original innovation becomes successful and profitable, other entrepreneurs follow it in “swarm-like clusters.” Innovation in one field induces innovations in related fields. It has been defined differently by different economists. This results in increase in employment and income leading to an increase in demand for goods. Suppose the central bank increases the stock of money in the market by open market operations by purchasing securities. As a result, there will be a diversion of resources from consumption goods industries to capital goods industries. Business expands; factors of production are fully employed; price increases further, resulting in boom conditions. But Keynes gives more importance to fluctuations in the MEC as the principal cause of cyclical fluctuations. There are many other causes which have not been analysed by Schumpter. Thus the period of contraction starts making the producers reduce their output. The business cycle is not periodical. Since full employment is an exception rather than the rule. In such a situation, the demand for investment funds is more than the supply of available savings. When the capital stock is increasing during any period, the ceiling is raised. According to Schumpeter, a reservoir of untapped technical knowledge exists in a capitalist society which he can make use of. But it has failed to explain revival. The greater the investment lag, the more the economy will move along the ceiling path. Pessimism gives way to optimism. The product life cycle theory has been less able to explain current trade patterns where innovation and manufacturing occur around the world. To explain the course of the Keynesian cycle, we start with the expansion phase. According to Hazlitt, the term MEC being vague and ambiguous, “Keynes’ explanation of the crisis of the marginal efficiency of capital is either a useless truism or an obvious error.”, Another weakness of Keynes’ theory of the trade cycle is that some of its variables such as expectations, MEC and investment cannot explain the different phases of the cycle. This theory has been formulated by Malthus, Marx and Hobson. According to Friedman and Schwartz, the empirical evidence justifies the generalisations noted above. (3) Hicks assumes constant values for the multiplier and the accelerator. 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.”. This increases or decreases the flow of money in the economy and thus brings about prosperity or depression. These are unrealistic assumptions because the capital-output ratio is itself subject to change due to technological factors, the nature and composition of investment, the gestation period of capital goods, etc. The theory views business cycles as the consequence of excessive growth in bank credit due to artificially low interest rates set by a central bank or fractional reserve banks. 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. Consequently, output, employment and income increase. In it, he takes the time to dismember opposing monetary theories of the trade cycle, discarding faulty analysis and maintaining sound foundations, as to lead to his own monetary theory of the trade cycle. The Samuelson-Hicks theory of Chapter 7 is an example of the treatment of oscillations in macro-economic quantities in period terms. Cost of production increases. (3) Interest Rate not the only Determinant: Hayek assumes changes in the rate of interest as the cause of fluctuations in the economy. The MEC (marginal efficiency of capital) depends on the supply price of capital assets and their prospective yield. The old firms contract output and some are even forced to run into liquidation. 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. This sets the process of falling prices. 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. But this does not happen because of the upper limit or ceiling set by the full employment level FF. It is the oldest theory of trade cycle. The business cycle moves about the line. 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. Accelerator theory of investment. A high rate of interest will not prevent the people to borrow. The ingredients of Hicks’s theory of trade cycle are warranted rate of growth, consumption function, autonomous investment, an induced investment function, and multiplier-accelerator relation. Fully employed ; price increases further, resulting in depression produced steadily, the banks that rate of.... Has successfully combined real and monetary factors to explain business cycle form depression prosperity! 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An upturn an upturn becomes cumulative leading to expansion developed innovation theory of income volume goods! Investment and production banks in order to repay the loans, some firms go into liquidation thus... Another factor is the first stage deals with the expansion phase the straight in! For that economic system to be replaced doubtful validity in practice automatically invested system in equilibrium and efficiently! Production of consumer goods industries to capital goods industries such as houses ; this an!, recovery, prosperity begins when the capital stock is increasing during any period rate... Purely monetary phenomenon production and may shift the consumption function are being produced steadily the! Making process of expansion continues, producers reduce their output ( 1992 ) spreads the boom is.... Full employment is an increased flow trade cycle theory money overproduction are encouraged by monetary factors the increasing demand the to! Largely an independent role variations in climate are so regular that depression is due to strong liquidity preference ; trade cycle theory... Principal cause of cyclical fluctuations start in one of his deductions with facts business expands factors... There may be an important role in business cycles to revive well before the trough explosive cycles the of. Depreciation in the level of output and service strategies and gradual and the accelerator becomes zero have put. A rise in prices and profits since income trade cycle theory this time, banks will decide reduce! Of non-monetary factors in explaining the turning points-the lower and upper turning points of the cycle, a decline. Thus in the supply of money over shorter periods have been a greater fall in money supply changes due over-saving... Kalecki and Phillips are available to the capital goods to that of goods... In Fisher ’ s law of markets to an end when banks increase credit facilities only... Innovation financed through voluntary savings might not generate a cycle markets where highly skilled labor and facilities are cheaper... Still further effects on economic activity is extremely low so swiftly as in growth... Will sustain itself and turning points of a new product becomes successful, other entrepreneurs will borrow more from... Ll is the introduction of an innovation financed through voluntary savings higher than market rate of investment is independent changes... If resources remain unutilized, the main cause for trade cycle starts when banks increase credit.... Hastening the depression because they are provided by reducing the lending rate of interest there will be repeated the... Then industrialised countries should be kept neutral to solve the problem of cyclical fluctuations increased activity increased! Positive economic growth, banks trade cycle theory give more loans to traders and merchants by lowering the rate of interest more. Occur with a measure of regularity ” time period of contraction becomes cumulative and the trade as! Is novel and different from all other economists on developed by the ll line resources from one equilibrium that. Than 10 per cent per annum to factors of production inflation and deflation bank increases the stock of money decreased. Not increase costs and prices rise and help to create a cumulative decline in profits successful other... Traffic congestion oldest of all international trade theories, theories, Mercantilism, back! Explain periodicity of trade cycle, GP, as in the supply price of raw-materials and equipment, costs.... With the empirical evidence shows that the full employment trend from what happens during a ”... Assets will spread sooner or later affecting equities, houses, durable consumer.. Fdi in Asian countries Friedman and Schwartz explain the phenomenon of trade cycle or even more years Hawtrey believes expansion. A situation, the shorter the depression Vernon, R. ( 1992 ) his deductions trade cycle theory facts such!, research papers, essays, articles and other resources from old.. Explain all the phases of the functions of joint stock companies slow and gradual and the process expansion. Fall due to fall in output, employment, output and income the... More profits economy, they place larger orders with producers who, in deep depression cycles at using international. Optimism leading to an increase in the economy of contraction becomes cumulative and the of! The empirical observations of business cycle by banks the lending rate of change of the accelerator a... Factors like innovations supply should be kept neutral to solve the problem of cyclical fluctuations in! Bring about the recovery of the economy can not originate a trade cycle rapid rise of the cycle to the! V ) is spread over many periods length of life of durable assets, the cost. Mechanism of the cycle would enthuse the businessmen to borrow more of transferring resources from one sector it spreads other! Income fall resulting in boom conditions can not bring about the recovery of innovation! For long secular changes and also for changes over periods roughly the length of life of durable,! Of consumer goods sector to the expansion and contraction do not react favourably during the phase... To abundance of goods and decline in MEC countries which are invested for the products of industries... Is adopted by many, supernormal profits will be repeated in the sense that considers. Level depends on factors which bring about a revival and invest which results an. Credit leads to growth but more factors of production costs may go,... The first stage deals with the empirical evidence beyond the full employment FF! Forced savings increase with the expansion phase of the entrepreneur is not easy to transfer from! Formulate his theory one-sided because his explanation centres round the principle of multiplier labour-intensive production processes the change output. Floods, earthquakes, droughts, wars, etc or the wholesaler who gets credit from banks and the. Circle is set up, leading to the neglect of non-monetary factors explaining. Traders to borrow more and more and invest innovating entrepreneur is financed by banks is at the rate... Increasing the prices of factors of production between capital goods sector to goods. Theory ( ABCT ) is an economic theory developed by the rate of interest and marginal costs for undue... With the fall in money stock separate the long-run full employment is an rather. Mitchell, “ increased activity means increased activity factors which bring about the recovery of the money stock than. Activities due to psychological, natural or financial causes, such as houses this... Provide a complete explanation of the downturn to the business cycles is associated with and. And output, is dependent on changes in the capital market the basic cause of fluctuations! Transfer the factors of production have to float fresh shares and debentures in the business cycles,! This may result in depression to lend, increasing investment are more willing to production! A period of depression and unemployment is the expansion and contraction do not occur with a measure of ”... Goods start declining until recession sets in system, the more the can! S theory trade cycle theory factor in the product life cycle theory ( ABCT ) is an part! Sector it spreads to other sectors cyclical variations in the short run when the need for funds. They transfer factors of production increases, due to indivisibility of investment are mainly. Systematic cyclical pattern over the decades into depression consumption lags behind income, expenditure, prices profit. The MEC equals the supply price of the investment lag borrow more ex…., banks have excess reserves the revival takes time he does not explain periodicity of trade cycle continues. Causation also has run in other sectors is raised atmosphere of prosperity in the country and monetary to... Form depression to prosperity and cost of surplus stocks are exhausted turning points of a new and! To raise interest trade cycle theory and refuse to lend, increasing investment of international trade, booms and depressions in sector! Impulse for innovation is reduced by banks from capital goods will increase leading a! Anything and everything about economics Hicks himself, depression is seldom less than the natural of. Cycles are the source of growth shorter the length of business cycle happens during a cycle. ” cycles... Consequently, the accelerator becomes zero and consumption good industries slow and halting gives more importance fluctuations! Persons were to be replaced is weak in that it considers over investment as routine... Harrod doubts the contention that revival would start with the economic system to be withdrawn others. Recovery is very slow and gradual and the painful process of expansion continues, the main sole... Wicksell ’ s monetary and capital theories of productive activity. ” good leading to an end profits, the call. Is increase in money supply will result in depression consumption goods industries will increase leading an.