The following points highlight the top eight theories of business cycle. The theories are: 1. Hawtrey’s Monetary Theory 2. Hayek’s Monetary Over-Investment Theory 3. Schumpeter’s Innovations Theory 4. Keynes’s Theory 5. Friedman’s Theory 6. Hicks’s Theory.
1. Hawtrey’s Monetary Theory:
According to Prof. R.G. 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. He opines that non-monetary factors like strikes, floods, earthquakes, droughts, wars, etc. may at best cause a partial depression, but not a general depression.
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. Bank credit is the principal means of payment in the present times.
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 increases or decreases the flow of money in the economy and thus brings about prosperity or depression.
The expansion phase of the trade cycle starts when banks increase credit facilities. They are provided by reducing the lending rate of interest and by purchasing securities. These encourage borrowings on the part of merchants and producers. This is because they are very sensitive to changes in the rate of interest.
So when credit becomes cheap, they borrow from banks in order to increase their stocks or inventories. For this, they place larger orders with producers who, in turn, employ more factors of production to meet the increasing demand. Consequently, money incomes of the owners of factors of production increase, thereby increasing expenditure on goods.
The merchants find their stocks being exhausted. They place more orders with producers. This leads to further increase in productive activity, income, outlay, and demand, and a further depletion of stocks of merchants. According to Hawtrey, “Increased activity means increased demand, and increased demand means increased activity. A vicious circle is set up, a cumulative expansion of productive activity.”
As the cumulative process of expansion continues, producers quote higher and higher prices. Higher prices induce traders to borrow more in order to hold still larger stocks of goods so as to earn more profits. Thus optimism encourages borrowing borrowing increases sales, and sales raise optimism.
According to Hawtrey, prosperity cannot continue limitlessly. It comes to an end when banks stop credit expansion. 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.
Another factor is the export of gold to other countries when imports exceed exports as a result of high prices of domestic goods. These factors force the banks to raise interest rates and refuse to lend. Rather, they ask the business community to repay their loans. This starts the recessionary phase.
In order to repay bank loans, businessmen start selling their stocks. This sets the process of falling prices. They also cancel orders with producers. The latter curtail their productive activities due to fall in demand. These, in turn, lead to reduction in the demand for factors of production. There is unemployment. Incomes fall.
Falling demand, prices and incomes are the signals for depression. Unable to repay bank loans, some firms go into liquidation, thus forcing banks to contract credit further. Thus the entire process becomes cumulative and the economy is forced into depression.
According to Hawtrey, the process of recovery is very slow and halting. As depression continues, traders repay bank loans by selling their stocks at whatever prices they can. As a result, money flows into the reserves of banks and funds increase with banks. 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. This deadlock can be broken by following a cheap money policy by the central bank which will ultimately bring about recovery in the economy.
Monetarists like Friedman have supported Hawtrey’s theory. But the majority of economists have criticised him for overemphasising monetary factors to the neglect of non-monetary factors in explaining cyclical fluctuations.
Some of the points of criticism are discussed below:
(1) Credit not the Cause of Cycle:
None can deny that expansion of credit leads to the expansion of business activity. But Hawtrey believes that an expansion of credit leads to a boom. This is not correct because the former is not the cause of the latter.
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. Even then, it fails to bring a revival. Similarly, contraction of credit cannot bring about a depression. At best, it can create conditions for that. Thus expansion or contraction of credit cannot originate either boom or depression in the economy.
(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.
(3) Traders do not depend Only on Bank Credit:
Hamberg has criticised Hawtrey for the role assigned to wholesalers in his analysis. The kingpin in Hawtrey’s theory is the trader or the wholesaler who gets credit from banks and starts the upturn or vice-versa. In actuality, traders do not depend exclusively on bank credit but they finance business through their own accumulated funds and borrowing from private sources.
(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. 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. But they do not react favourably during the depression phase because traders expect a further reduction every time the interest rate is reduced. On the other hand, if traders finance their stocks with their own funds, interest rate changes will have little effect on their purchases.
(5) Factors other than Interest Rate More Important:
It is an exaggeration to say that the decisions of traders regarding accumulation or depletion of stocks are solely governed by changes in interest rate. As a matter of fact, factors other than the rate of interest are more important in influencing such decisions. They are business expectations, price changes, cost of storage, etc.
(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. But fluctuations in inventory investment can at best produce minor cycles which are not cycles in the true sense of the term.
(7) Does not Explain Periodicity of Cycle:
The theory also fails to explain the periodicity of the cycle.
(8) Ignores Non-Monetary Factors:
Hawtrey’s theory is incomplete because it emphasises only monetary factors and totally ignores such non-monetary factors as innovations, capital stock, multiplier-accelerator interaction, etc.
2. Hayek’s Monetary Over-Investment Theory:
F.A. Hayek formulated his monetary over-investment theory of trade cycle. He explained his theory on the basis of Wicksell’s distinction between the natural interest rate and the market interest rate. The natural rate of interest is that rate at which the demand for loanable funds equals the supply of voluntary savings.
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. 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.
Trade cycles in the economy are caused by inequality between market and natural interest rates. When the market interest rate is less than the natural rate, there is prosperity in the economy. On the contrary, when the market interest rate is more than the natural rate, the economy is in depression.
According to this theory, prosperity begins when the market rate of interest is less than the natural rate of interest. In such a situation, the demand for investment funds is more than the supply of available savings. The demand for investment funds is met by the increase in the supply of money. As a result, the interest rate falls. Low interest rate induces producers to get more loans from banks. The producers get more loans to invest for the production of more capital goods.
They adopt capital-intensive methods for producing more of capital goods. As a result, production costs fall and profits increase. The production process becomes very lengthy with the adoption of capital-intensive methods. This has the effect of increasing the prices of capital goods in comparison to consumer goods.
There being full employment in the economy, they transfer factors of the production from consumer goods sector to capital goods sector. Consequently, the production of consumer goods falls, their prices increase and their consumption decreases. Forced savings increase with the fall in consumption which are invested for the production of capital goods.
This leads to increase in their production. On the other hand, with increase in the prices of consumer goods, their producers earn more profits. Induced by high profits, they try to produce more. For this, they pay higher remuneration to factors of production in comparison with the producers of capital goods. There being competition between the two sectors, prices of factors and prices in the economy continue to rise. This leads to the atmosphere of prosperity in the country and monetary over-investment on factors spreads the boom.
According to Hayek, when the prices of factors are rising continuously, the rise in production costs bring fall in profits of producers. The producers of capital goods invest less in the expectation of loss in the future. Consequently, the natural interest rate falls. Simultaneously, banks impose restrictions on giving loans to them. With low profits and reduction in loans, producers reduce the production of capital goods and adopt labour-intensive production processes.
There is less investment in capital goods. Production process being small and labour-intensive, the demand for money is reduced, which increases the market interest rate which is more than the natural interest rate. Producers transfer the factors from the production of capital goods to that of consumer goods. But more factors cannot be used in the consumer goods sector as compared to the capital goods sector. This leads to fall in the prices of factors and resources become unemployed. Thus, with the continuous reduction in the prices of goods and factors in the economy, a long period of depression and unemployment begins.
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. This encourages investment and the process of revival begins in the economy.
The monetary over-investment theory of Hayek has been criticised on the following counts:
(1) Narrow Assumption of Full Employment:
This theory is based on the assumption of full employment according to which capital goods are produced by reducing consumer goods. In reality, there is no full employment of resources. If resources remain unutilized, the expansion of both the capital goods sector and consumer goods sector may occur simultaneously. In such a situation, there is no need of transferring resources from one sector to the other.
(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. This is because the equilibrium may deviate due to both internal and external reasons.
(3) Interest Rate not the only Determinant:
Hayek assumes changes in the rate of interest as the cause of fluctuations in the economy. This is not correct because besides changes in the rate of interest, the expectations of profit, innovation, invention, etc. also affect trade cycles.
(4) Undue Importance to Forced Savings:
Prof. Strigl has criticised this theory for giving undue importance to forced savings. 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.
(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 is not correct. According to Keynes, the marginal productivity of capital increases with the increase in profits of consumer goods. As a result, investment in capital goods also increases and does not fall.
(6) Incomplete Theory:
Hayek’s theory is incomplete because it does not explain the various phases of trade cycle.
3. Schumpeter’s Innovations Theory:
The innovations theory of trade cycles is associated with the name of Joseph Schumpeter. According to Schumpeter, innovations in the structure of an economy are the source of economic fluctuations. Trade cycles are the outcome of economic development in a capitalist society. Schumpeter accepts Juglar’s statement that “the cause of depression is prosperity,” and then gives his own view about the originating cause of the cycle.
Schumpeter’s approach involves the development of his model into two stages. The first stage deals with the initial impact of innovation and the second stage follows through reactions to the original impact of innovation.
The first approximation starts with the economic system in equilibrium with every factor fully employed. Every firm is in equilibrium and producing efficiently with its costs equal to its receipts. Product prices are equal to both average and marginal costs. Profits and interest rates are zero.
There are no savings and investments. 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. In the circular flow, the same products are produced every year in the same manner.
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.
By innovation Schumpeter means “such changes in the production of goods as cannot be affected by infinitesimal steps or variations on the margin.”
An innovation may consist of:
(1) The introduction of a new product;
(2) The introduction of a new method of production;
(3) The opening up of a new market;
(4) The conquest of a new source of raw materials or semi-manufactured goods; and
(5) The carrying out of the new organisations of an industry.
Innovations are not inventions. According to Schumpeter, there is nothing that can explain that inventions occur in a cyclical manner. It is the introduction of a new product and the continual improvements in the existing ones that are the principal causes of business cycles.
Schumpeter assigns the role of an innovator not to the capitalist but to an entrepreneur. The entrepreneur is not a man of ordinary ability but one who introduces something entirely new. He does not provide funds but directs their use.
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. According to Schumpeter, a reservoir of untapped technical knowledge exists in a capitalist society which he can make use of. Therefore, credit is essential for breaking the circular flow.
The innovating entrepreneur is financed by expansion of bank credit. 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. Money incomes increase. Prices begin to rise, thereby stimulating further investment.
The new innovation starts producing goods and there is an increased flow of goods in the economy. Consequently, supply exceeds demand. Prices and cost of production of goods start declining until recession sets in. Because of the low prices of goods, producers are not willing to expand production. During this period of recession, credit, prices and interest rate decline but total output is likely to average larger than in the preceding prosperity.
Thus Schumpeter’s first approximation consists of a two-phase cycle. 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. This new equilibrium will be at a higher level of income than the initial equilibrium because of the innovation which started the cycle. This is shown as the “Primary Wave” in Figure 2.
The second approximation of Schumpeter follows through the reaction of the impact of original innovation. 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.
Consequently, money incomes and prices rise and help to create a cumulative expansion throughout the economy. With the increase in the purchasing power of consumers, the demand for the products of old industries increases in relation to supply.
Prices rise further. Profits increase and old industries expand by borrowing from the banks. It induces a secondary wave of credit inflation which is superimposed on the primary wave of innovation. Over-optimism and speculation add further to the boom. After a period of gestation, the new products start appearing in the market displacing the old products and enforcing a process of liquidation, readjustment and absorption.
The demand for the old products is decreased. Their prices fall. The old firms contract output and some are even forced to run into liquidation. As the innovators start repaying bank loans out of profits, the quantity of money is decreased and prices tend to fall. Profits decline.
Uncertainty and risks increase. The impulse for innovation is reduced and eventually comes to an end. Depression sets in, and the painful process of readjustment to the “point of previous neighbourhood of equilibrium” begins. Ultimately, the natural forces of recovery bring about a revival.
Schumpeter believes in the existence of Kondratieff long wave of upswings and downswings in economic activity. Each long wave upswing is brought about by an innovation which leads to abundance of goods for the masses. Once the upswing ends, the long wave downswing begins.
Thus the second approximation of Schumpeter’s theory of trade cycle develops into a four phase cycle with the recession which was the second phase in the first approximation continuing downward to give the depression phase. This extension of cycle is followed by a period of revival which continues till the equilibrium level is reached. This is shown as the “Secondary Wave” in Figure 2.
Schumpeter’s treatment of the different phases and turning points of the cycle is novel and different from all other economists. But it is not free from certain criticisms.
(1) Innovator not Necessary for Innovations:
Schumpeter’s analysis is based on the innovator. Such persons were to be found in the 18th and 19th centuries who made innovations. But now all innovations form part of the functions of joint stock companies. Innovations are regarded as the routine of industrial concerns and do not require an innovator as such.
(2) Innovations not the Only Cause of Cycles:
Schumpeter’s contention that cyclical fluctuations are due to innovations is not correct. As a matter of fact, trade cycles may be due to psychological, natural or financial causes.
(3) Bank Credit not the Only Source of Funds:
Schumpeter gives too much importance to bank credit in his theory. Bank credit may be important in the short run when industrial concerns get credit facilities from banks. But in the long run when the need for capital funds is much greater, bank credit is insufficient. For this, business houses have to float fresh shares and debentures in the capital market. Schumpeter’s theory is weak in that it does not take these factors into consideration.
(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. Consequently, in an underemployed economy an innovation financed through voluntary savings might not generate a cycle.
(5) Full Employment Assumption Unrealistic:
Schumpeter’s analysis is based on the unrealistic assumption of full employment of resources to begin with. But the fact is that at the time of revival, the resources are unemployed. Thus the introduction of an innovation may not lead to the withdrawal of labour and other resources from old industries. Thus the competitive impact of an innovation would not increase costs and prices. Since full employment is an exception rather than the rule. Thus Schumpeter’s theory is not a correct explanation of trade cycles.
4. Keynes’s Theory:
The Keynesian theory of the trade cycle is an integral part of his theory of income, output and employment. Trade cycles are periodic fluctuations of income, output and employment. Keynes regards the trade cycle as mainly due to “a cyclical change in the marginal efficiency of capital, though complicated and often aggravated by associated changes in the other significant short-period variables of the economic system.”
According to Keynes, the principal cause of depression and unemployment is the lack of aggregate demand. Revival can be brought about by raising aggregate demand which, in turn, can be raised by increasing consumption and/or investment. Since consumption is stable during the short-run, revival is possible by increasing investment. Similarly, the main cause of the downturn is reduction in investment.
Thus in the Keynesian explanation of the trade cycle, “the cycle consists primarily of fluctuations in the rate of investment. And fluctuations in the rate of investment are caused mainly by fluctuations in the marginal efficiency of capital.”
The MEC (marginal efficiency of capital) depends on the supply price of capital assets and their prospective yield. 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. Fluctuations in the rate of investment are also caused by fluctuations in the rate of interest. But Keynes gives more importance to fluctuations in the MEC as the principal cause of cyclical fluctuations.
To explain the course of the Keynesian cycle, we start with the expansion phase. During the expansion phase, the MEC is high. Businessmen are optimistic. There is rapid increase in the rate of investment. Consequently, output, employment and income increase. Every increase in investment leads to a multiple increase in income via the multiplier effect. This cumulative process of rising investment, income and employment continues till the boom is reached.
As the boom progresses, there is a tendency for the MEC to fall due to two reasons. First, as more capital goods are being produced steadily, the current yield on them declines. Second, at the same time the current costs of new capital goods rise due to shortages and bottlenecks of materials and labour.
During the downturn, investment falls due to a fall in the MEC and rise in the rate of interest. This leads to a cumulative decline in employment and income via the reverse operation of the multiplier. Further, the fall in the MEC may shift the consumption function downward thereby hastening the depression. 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.
Unlike the sudden collapse of the economic system, the revival takes time. It depends on factors which bring about the recovery of the MEC. “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.
The shorter the length of life of durable assets, the shorter the depression. 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.”
According to Keynes, the carrying cost of surplus stocks during the depression is seldom less than 10 per cent per annum. So for a few years, disinvestment in stocks will continue till the surplus stocks are exhausted. Optimism takes the place of pessimism. The MEC increases. Fresh investment starts taking place. Revival has started.
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.
(1) Overemphasis on the Role of Expectations:
Keynes has been criticised for his analysis of business cycle based on expectations. In fact, he over-emphasised the role of expectations in influencing the MEC. According to Hart, Keynes relied on “convention” for forecasting changes in business expectations. The reliance on the conventional hypothesis makes Keynes’ concept of expectations superfluous and unrealistic.
(2) Psychological Theory:
Keynes considers the trade cycle as mainly due to fluctuations in the MEC. The MEC, in turn, determines the rate of investment. And investment decisions, depend upon the psychology of businessmen or producers. Thus Keynes’ theory is not much different from Pigou’s psychological theory of the trade cycle.
(3) Explanation of Crisis Wrong:
Keynes attributes the downturn to the sudden collapse in the MEC. 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.”
(4) Incomplete Theory:
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. 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.”
(5) Not Based on Empirical Data:
Saulnier criticises Keynes’s for lacking in factual proof. According to him, Keynes makes no attempt to test any of his deductions with facts. Dillard also points toward this defect when he writes that Keynes “does not examine closely the empirical data of cyclical fluctuations.”
(6) One-Sided Theory:
One of the serious omissions of Keynes’s theory of the trade cycle is the acceleration principle. This made his theory one-sided because his explanation centres round the principle of multiplier. 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.”
5. Friedman’s Theory:
Friedman and Schwartz have argued on the basis of US historical data that business cycles are mostly monetary in origin. 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.
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
(iii) Changes in the stock of money have been attributed to a specific variety of exogenous factors rather than to changes in economic activity.
Thus changes in the money stock are a consequence as well as independent cause of changes in economic activity. But once they occur, they will, in turn, produce still further effects on economic activity. There is also much evidence that during business cycles the money stock plays largely an independent role.
In one of his earlier writings, Friedman emphasises that the concept of lag is related to the business cycle. These cycles are mostly monetary in origin. 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. Thus it can be said in Fisher’s words that the cycle is largely a “dance of the dollar”.
Major US historical economic fluctuations include inflationary and deep depression cycles. According to Friedman and Schwartz, the empirical evidence justifies the generalisations noted above. These show that the stock of money has displayed a systematic cyclical pattern over the decades. The money stock generally reaches its peak before the ‘reference’ peak of the cycles. Similarly, it reaches its trough before the ‘reference’ trough.
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.
The lag of economic activity appears to be greater for peaks than for troughs. There has been strong secular changes in the money stock over these decades. On the other hand, in deep depression cycles, there has been a greater fall in money stock. But in mild depressions, there has been a reduction in the growth rate of the money stock rather than any actual fall.
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. These cycles are superimposed over a long run secular growth path, GP, as shown in Figure 3.
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. Second, this is true both for long secular changes and also for changes over periods roughly the length of business cycles.
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. 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.
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. 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.
Substantial contractions in the quantity of money over shorter periods have been a major factor in producing severe economic contractions. Cyclical variations in the quantity of money may well be an important element in the ordinary mild business cycle.
Next, Friedman and Schwartz explain the mechanism which brings about monetary changes leading to the business cycles. 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. Suppose the central bank increases the stock of money in the market by open market operations by purchasing securities.
The non-bank sellers and commercial banks will try to readjust their portfolios. The commercial banks will create more money with increase in their reserves, thereby transmitting the increase in high-powered stock of money. 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 will bid up prices of such assets. As the process continues, the initial impacts will spread throughout the economy. The increased demand for assets will spread sooner or later affecting equities, houses, durable producer goods, durable consumer goods, etc. All these will bid up the prices of assets and of both producer and consumer goods. People will tend to consume more services, such as renting houses rather than purchasing them. This will tend to raise service prices.
These effects will raise interest rates on the whole range of assets. Ultimately, expenditures rise on all directions without any change in interest rates at all. “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.
This explanation of the transmission mechanism fits with the empirical observations of business cycles. Initially, the rise in the growth rate of the money stock occurs early in the contraction phase. Its first impact is on the financial markets where first bonds, then equities and only later on payments for real resources will be affected. The financial markets tend to revive well before the trough. This is what has happened historically.
The dynamic process of transition from one equilibrium path to another involves a cyclical adjustment process. Exogenous fluctuations in the money stock will lead to fluctuations in the demand for goods and services. In addition, there may be an endogenous cycle.
A rise in demand raises prices. 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 initial rise in demand will thus be followed by a fall in demand. The result will be a damped cycle.
According to Friedman, the lag plays an important role in business cycles. The amplitude of economic fluctuations depends: First, on the amplitude, time pattern, number and independence of the disturbances affecting the economic system. Second, on the reaction mechanism of the economic system to the disturbances.
The lag may be long because the effects of monetary disturbances are distributed over an extended period. A long lag may mean a larger damping of disturbances than a short lag. Hence there is a smaller amplitude of resulting fluctuations.
The lags in economic activity behind peaks and troughs in the rate of change of the money stock are not uniform. 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.
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. But critics point out that the direction of causation is just the opposite of it. It is changes in the level of business activity which cause changes in the growth rate of the money stock.
(2) Monetary Changes not the Main Cause of Business Cycles:
According to this theory, monetary changes are the main cause of business cycles. But in reality, business cycles are the result of the other exogenous factors like innovations. Monetary changes may be one among other factors, and not the only factor.
(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.
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.
Second, it implies that monetary change has been an exogenous variable and that causation runs only from monetary change to economic change. In fact, causation also has run in other direction. Despite these criticisms, it cannot be denied that one of the important causes of business cycles is “a dance of the dollar.”
6. Hicks’s Theory:
J.R. Hicks in his book A Contribution to the Theory of the Trade Cycle builds his theory of business cycle around the principle of the multiplier-accelerator interaction. 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.
Ingredients of the Theory:
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.
The warranted rate of growth is the rate which will sustain itself. It is consistent with saving-investment equilibrium. The economy is said to be growing at the warranted rate when real investment and real saving are taking place at the same rate. According to Hicks, it is the multiplier-accelerator interaction which weaves the path of economic fluctuations around the warranted growth rate.
The consumption function takes the form Ct= aYt-1 . Consumption in period t is regarded as a function of income (Y) of the previous period (f-1). Thus consumption lags behind income, and the multiplier is treated as a lagged relation.
The autonomous investment is independent of changes in the level of output. Hence it is not related to the growth of the economy.
The induced investment, on the other hand, is dependent on changes in the level of output. Hence it is a function of the growth rate of the economy. In the Hicksian theory, the accelerator is based on induced investment which along with the multiplier brings about an upturn.
The accelerator is defined by Hicks as the ratio of induced investment to the increase in income. Given constant values of the multiplier and the accelerator, it is the ‘leverage effect’ that is responsible for economic fluctuations.
Assumptions of the Theory:
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.
(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.
(3) Hicks assumes constant values for the multiplier and the accelerator.
(4) The economy cannot expand beyond the full employment level of output. Thus “the full employment ceiling” acts as a direct restraint on the upward expansion of the economy.
(5) The working of the accelerator in the downswing provides an indirect restraint on the downward movement of the economy. The rate of decrease in the accelerator is limited by the rate of depreciation in the downswing.
(6) The relation between the multiplier and accelerator is treated in a lagged manner, since consumption and induced investment are assumed to operate with a time lag.
(7) It is assumed that the average capital-output ratio (v) is greater than unity and that gross investment does not fall below zero. Thus the cycles are inherently explosive but are contained by ceilings and floors of the economy.
The Hicksian Theory:
Hicks explains his theory of the trade cycle in terms of Fig. 5. Line AA shows the path of autonomous investment growing at a constant rate. 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.
Line FF is the full employment ceiling level above the equilibrium path EE and is growing at the constant rate of autonomous investment. LL is the lower equilibrium path of output representing the floor or ‘slump equilibrium line’.
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. As a result, the growth of output and income propelled by the combined operation of the multiplier and accelerator moves the economy on to the upward expansion path from Po to P1.
According to Hicks, this upswing phase relates to the standard cycle which will lead to an explosive situation because of the given values of the multiplier and the accelerator. But this does not happen because of the upper limit or ceiling set by the full employment level FF.
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.
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. The economy will move along the ceiling from P1 to P2 depending upon the time period of the investment lag.
The greater the investment lag, the more the economy will move along the ceiling path. Since income at this level is decreasing relative to the previous stage of the cycle, there is a decreased amount of investment. This much of investment is insufficient to keep the economy at the ceiling level, and then the downturn starts.
During the downswing, “the multiplier-accelerator mechanism sets in reverse, falling investment reducing income, reduced income reducing investment, and so on, progressively. 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. But in the downswing, the accelerator does not work so swiftly as in the upswing. If the slump is severe, induced investment will quickly fall to zero and the value of the accelerator becomes zero.
The rate of decrease in investment is limited by the rate of depreciation. Thus the total amount of investment in the economy is equal to autonomous investment minus the constant rate of depreciation. 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. At Q2, the slump reaches the bottom or floor provided by the LL line.
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. 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. It is in this way that the cyclical process will be repeated in the economy.
The Hicksian theory of the business cycle has been severely criticised by Duesenberry, Smithies and others on the following grounds:
1. Value of Multiplier not Constant:
Hicks’s model assumes that the value of the multiplier remains constant during the different phases of the trade cycle. This is based on the Keynesian stable consumption function. But this is not a realistic assumption, as Friedman has proved on the basis of empirical evidence that the marginal propensity to consume does not remain stable in relation to cyclical changes in income. Thus the value of the multiplier changes with different phases of the cycle.
2. Value of Accelerator not Constant:
Hicks has also been criticised for assuming a constant value of the accelerator during the different phases of the cycle. The constancy of the accelerator presupposes a constant capital-output ratio. 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. Lundberg, therefore, suggests that the assumption of constancy in accelerator should be abandoned for a realistic approach to the understanding of trade cycles.
3. Autonomous Investment not Continuous:
Hicks assumes that autonomous investment continues throughout the different phases of the cycle at a steady pace. This is unrealistic because financial crisis in a slump may reduce autonomous investment below its normal level. Further, it is also possible, as pointed out by Schumpeter, that autonomous investment may itself be subject to fluctuations due to a technological innovation.
4. 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. It is a burst of autonomous investment from the equilibrium path that leads to growth. According to Prof. Smithies, the source of growth should he within the system. In imputing growth to an unexplained extraneous factor, Hicks has failed to provide a complete explanation of the cycle.
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. 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.
It is also possible that part of a particular investment may be autonomous and a part induced, as in the case of machinery. Hence this distinction between autonomous and induced investment is of doubtful validity in practice.
6. 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. According to Duesenberry, the ceiling fails to explain adequately the onset of depression. It may at best check growth and not cause a depression. Shortage of resources cannot bring a sudden decline in investment and thus cause a depression.
The recession of 1953-54 in America was not caused by shortage of resources. Further, as admitted by Hicks himself, depression may start even before reaching the full employment ceiling due to monetary factors.
7. Explanation of Floor and Lower Turning Point not Convincing:
Hicks’s explanation of the floor and of the lower turning point is not convincing. 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. Harrod doubts the contention that autonomous investment would be increasing at the bottom of the depression. Depression may retard rather than encourage autonomous investment.
Further, Hicks’s contention that revival would start with the exhaustion of excess capacity has not been proved by empirical evidence. 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. Rather in certain cases, revival started even when there was excess capacity.
8. Full Employment level not Independent of Output Path:
Another criticism levelled against Hicks’s model is that the full employment ceiling. As defined by Hicks, it is independent of the path of output. According to Dernburg and McDougall, the full employment level depends on the magnitude of the resources that are available to the country.
The capital stock is one of the resources. When the capital stock is increasing during any period, the ceiling is raised. “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. One cannot therefore separate the long-run full employment trend from what happens during a cycle.”
9. Explosive Cycle not Realistic:
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. Thus explosive cycles are inherent in his model. But empirical evidence shows that the response of investment to a change in output (v) is spread over many periods. As a result, there have been damped cycles rather than explosive cycles.
10. Mechanical Explanation of Trade Cycle:
Another serious limitation of the theory is that it presents a mechanical explanation of the trade cycle. This is because the theory is based on the multiplier-accelerator interaction in rigid form, according to Kaldor and Duesenberry. Thus it is a mechanical sort of explanation in which human judgement, business expectations and decisions play little or no part. Investment plays a leading role based on formula rather than on judgement.
11. 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. 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.
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. 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.
It serves especially to emphasise that in a capitalist economy characterised by substantial amounts of durable equipment, a period of contraction inevitably follows expansion. 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.