Business Cycle
Business Cycle
r\
J Cw, ,1 )fi t th 'l.l I l
of this bllOk Iht:r fo~ • " " 1ll dr~c
P re.lSOJl th.it the) h \ c l
1
on nic thcorks th.it \\C "111 u1~ us" mclud t O\\ t
Pure Monctal) Theo~,
:. Monetnr) Over-ime~tment fhocl),
3 Schumpeter's lnno ,atio n fheo r),
4. Mult1plier-Accelemtor Interaction Theo() and
5 Hicks' Them) of Trade C)dc .
24.3. 1 The earl) business cycle theorists In) major emphus1s on the lll(l11
Ctuf) nd erect t
The Pure system in their analysis of business C)clc s. Their theories of busm
Monetary ess C) ch.: are
Theory
therefore. jointly know n as mone tan· thcor v of busm 'SS l'dc. According to th~
theor). the main cause of business cycle is the fluctuation in
monetlll) nnd credit
markets. The :fluctuation in the supply of mone) and bnnk credi
t is the basic causJI
factor at work in the cyclical process. Ha,\trcy. the main prop
onent of this theol)
maintained that business cycles are nothing but successh e phn~
cs of inflntion nnd
deflation. According to him, all changes in the le, els of economic
acti\! ities ure onh
reflections of changes in money flows. When mone) suppl) expa
nds. prices rise.
profits increase, and the total output increases. and, final!). growth
tukes place. When
money supply falls, prices decrease, profits decrease, production
acth ities become
sluggish, and production falls. This marks depression. Briefly speaking,
Hnwtre) relies
implicitly on the quantity theory of money for explaining the price
behaviour.
According to Hawtrey. the principal factor affecting the money
~upply is the
credit mechanism. In modem economies, the principal source of mon
e) suppl) is the
volume of credit created by the banking system. The upswing of
the cycle begin~
with an expansion of bank credit and continues as long as credit
expansion continues
Banks expand credit facility because conditions are such that bank
s find it profitable
to offer credit on easier tenns (i.e., at a relatively lower intere
st rate). TI1is is the most
effective inducement for entrepreneurs to undertake prod
ucti~ e nctivities
Consequently, bank credits flow into different types of capital form
ation act1' 1ties
including both widening and deepening of capital. Borrowing from
banks continues
even if interest rates begin to move up\o\11:Up. This is so beca
use of increased
profitability.
Ttll this process continues, the general level of price rises, beca
use beyond
oertain limit, demand increases at a rate higher than the rate
of increase m s1ml1lm-
Supply increases at a lower tate due to the limited production capa
,...tod of new investments. Thus, credit expansion accelerates theandproce
city aesta11
economic expansion, on the one hand, and helJB rise m pnces, on
ss
the other.
l I I II 17
:valu~1on of P~re Monetary Theory The pure monetary theory remained in vo :ru
or qw _e some time and it still retains its relevance in explaining modem b ine
fluctuatwns. It has, however, been criticized on the following grounds.
Fir~t, thoug~ monetary factors are certainly major contributors to busine
flu~n:~t10ns, busmess cycles are not purely a monetary phenomenon. Econom ·c
act1v1ttes have also fluctuated because of change in non-monetary factors like
aggregate demand, demand for new investments cost structure expectations of
businessmen, etc. ' '
Secondly, in spite of the fact that monetary factors play an important role in the
cumulative process of expansion and contraction, they do not fully explain the turning
points. At turning points, non-monetary factors have been found to have played a
major role. .
Thirdly, monetary theorists' conviction that businessmen are highly sensitive to the
changes in interest rates is highly doubtful. A more important factor in business
decisions are future business prospects and the marginal efficiency of capital.
In spite of these shortcomings, the pure monetary theory of business cycles has
been regraded as a sound reasoning and logical explanation of economic fluctuations.
24.3.2
The monetary over-investment theory emphasizes the role of imbalance between the
onetary desired and actual investments in economic fluctuation, i.e., actual investment
Over- exceeding the desired investment. Hayek, perhaps the pioneer of this theory, stresses
...... nt that to keep the economy in equilibrium, investment pattern should correspond to the
•oeory pattern of consumption and for the economy to remain in st~b/e equilibrium, it is
necessary that voluntary savings are equal t~ the . actual_ investment. The total
investment is distributed between the vanous mdustnes that each industry
~ oilly as much as is demanded by the consumers, i.e., in case of each
50
of interest is lowe
I of funds), the
unde r th
hen
BUSINESS CYCLES AND STABILl.lATIO?-. 519
CII
-••IOD.and accelerator imeract with each other to generate
and ·
fltd•lfCMl.
dem ands more
income
than expected · and how '
l t 11 ' ••
w tt,n
,;I 0 \'1 /, 1, 1thm ttr~Jr'nv t1t'III 'Ihis is t(,·rl1•c1/ l11v,wtme~; This ~1ark1 the beginning
tlu1 Ivt, I 111 1
t111 I \0 I 1 111110 1HnH11ot M It 1 ' vl'hh11c111 lnkc~ place, incomes rise further
lnJ1pu11a
WIH~l 1 1111 f • '
11,·11•11,,,1 11 lhl11111t , (1,,1111111 ,i I'111,
1 imonious 111vcs lmcol lakes places. With
IIt,· 111 , , Ir, 11 h 11• I11 11, 1111,1 wIt 11 1
.
t
115111111
'r H< mds t isos, ·1his fr; how the multiplier and
111:;tt~r llum l'\Jl1.~l' lt'(I 1, 1 1l'~ IL' ofht:r 1111 d mukc the i11<.,0111cs grow at a rate much
• ' )1' c,1 o"< ogi r J
11,1~ l'll~lllt:, 111 lll\llli1Jll,•1· nno,•. '11' 11110: 1•' IIC(O'.'S cud to '1U(ono~ous investmen_i,
Is lt,'<·\'l~mtlon ul hiv,•~hn,•n 1 l, !•i •ttt1lhphor cllocl creates derived investment. ThJS
f\~l\•~lrrntion. fhl:-l i\i t' '111 1 ' l lu,'IVod hivcHh11cut creates mu/ti plier effect leading to
' • ;I u, lllll/t/1,llt'r•cwc.:derution interaction.
In hi~ n1111ly:-ds or inlol'lll'tlo11 .,,
ossumpt ium~: process, Samuelson makes the foJlowing
ti) no C~co~~ production cupo,city;
lf /) Ollt' ..)'l'Ul' lug 111 l'OllliUlllpt:ion ; ,
(/If) ono-y0111· lug In l11~rc1rno 111 cousumptlon and investment demand and
(II-) 1111 gowrn111cn1 nclivlty nnd no foreign trade.
• • I
- -
}' ,1>'1 I t /l(o), I
I
B) simplif)lllg Fq. (l ·~."1 ), \\ l' fll'f 1~111
>'1 8 ,1(1 I /1) ) 1 I 11/1),J
11
Eq. (24 .(>) t$ (he lin:tl fotm nl l'1p1ll ili1111111 t.: q t11tf11111 , 1ldH~l ftlllrl 1 111 11 1 ~ ~\
111
neccssan.
• 'J
·, , .
pll:ClS · ·
O f tllf()("ll\ll(tt.)ll hll 1111111\.hlU lh li li11,l1h'~'4 ...,,,11. ~. t \l 11I ~ 11 11111
(i) thot iCvulucs lc)r (/ HIid "· :llld llll' Ollll' ', ,,, l\\11 l'l ~l.")l!lllll~l 't''IIP~ Ill 1 1
income for an.) pn~t <H' f11tt1rl' 'l'111 l,111 lil' d,•1,, 111ll11t1d 111111 • 1111,\,11 tli~11
(ii) that the mtl' or vuriutlon In 11tl' o111c' w,u,ld dl•11~111I ,111 111,, , ,11,1i ,q 11 11 1
a and b. .,_ IH 1 11111~11
0 .5 1.0 1.5
Paromotor b
2.0 2.5 3.0 3.5 4.0
<' 11ml
•I 'J
011u ll 1111 vl11g II dl/luc11I 1,.
p11f1t1 111 u l t111d1 t,y, ldti Iii@
ig. 24.2 Combination of Parameters a and b and 7h1de ( yd,,,,, dlll ht·,,111 1mll o11 w 111 1wil, 1 y1 I,·
resulting from different combiuutlona of N sllld /J 111·0 11l1mv11 111 1111 •11•1 ,11 11. ,1 111,,l 11
D marked in Fig. 24.3. Tho various 00111blrwtJ011u ol a uod /, 1111d 1111 1 t,11 c~111 11ill ~·
natures of cycles may be brio11y do~cdlnJd un lullow~.
Area A. All the combinations of a 1111d h folli11g 111 111·011 II 111111w llu 111, ""'"8 ,,,,,ve 111 1
upward or downward al decreasing rules 11sy111ploil1mlly 1111" 11/1111 11 1u w , q11ll il11 i11 111(
In this area, rise or fall is om,~wuy. II croulo~ rlr1111;Jt.•rl 11,,11r1,d/l,,t1,111, 119 81,, ,w
part A of Fig. 24.3. 11 1
Area 8. The com blnations of fl u11d /, /11 Ill, •., II I" 11d1 u·•• cyulo• ol 1•1 .,pill11 '1~
growing smaller and smaller 11111 ii tho cyc;/on dlm,111""" 11111 I 1/i, , , , ,1J• ,111y I~ 11111 /1111111 1• 1 j
stabiHzed. ~111is, according to Sumuo/~011, 1n ti,o w1tu.: 11I rl,1111111,,I , vuJuq 0 1 h l" '
osci/latlon. 11/ I
Area C. Combinations of a und /, /11 ,ucu I' 111t,d11<, 11 sudu~ "' 1111do 1,y, /, 11 111~
larger and larger amplitude. Combl11n11tm1 of 11 1,ud /, /11 1/,fo 111u11 u11J1ll ,. 1 "
cycles, as shown in area <' of Fig. 24, J,
Area D. Combination! of a und h /oiling 111 111r11 /J 11111k• II,,. 1,,. .,,,,o 111• ''111 ' ' (t•I
1
decrease) al an exponentJaJ rate until 1hc ccllln~ I111 '"'""111, I•; /1II ii 111• J1 11 ' 'n
of one-way explo1don, that creuteH t..'Xf'lo,t/vE' wtdllr1/l1111 11~ t.l1,,w11 111 1 v
BIU ZAT IOH 523
BUS INE SS CYC LES AND STA
Ate aA
Area B
sa.
'5
0
Area C Are aD
'5 :i
0.. C. Explosiv e nonoscillatior.
'5 :i
0 0
T1rne
0
nme 0
ude
e in which cycles are of equal am plit
Point E in Fig. 24. 2 shows a special cas
and con tin ue forever. Ke , nes iarr
son 's mo del , hig hly acc laim ed as a sound attempt to integrate the
Sam uel ~ of the
Critical
lier the ozy and Cla rk's acc ele rati on principle, is discreclited on accoun
Era/uatlon mu ltip
fol low ing sho rtc om ing s. to
son 's mo del is reg ard ed by its critics as far too sim ple a mo del
First, Sam uel
at act ual ly hap pen s dur ing the per iod of economic fluctuations. In the
fully exp lai n wh
cri tics , this mo del has bee n developed on highly sim pli fyi ng
opi nion of his
assumptions. ph~ ize s the r?le of 1:11ultiplier and accele
rator,
Second ly, Sam uel son 's mo del em
ories.
ctio n bet we en the m in eco nom ic fluctuanons. Like many earlier the
and int era ant
es little con sideration to ma ny other import
Samuelson,5 model too leaves out or giv ant role in _business cycles~ ~.g., the rol e of
factors which might play an equally import en. changmg consumers~
psychology of busmessm
pro duc er's ~t at in ns , changing
preferences and exogenous ~ctors.
524 Part VI: MACRCJECOJ'-,~ l"N~ -•-n,, -~ - - - - - -- - -
Thirdly, one of the major shortcomings of the model is that it assumes const
of capital/output ratio whereas there is a great likelihood of changes in this ratio d:~cy
the periods of upswings and downswings. If this assumption is dropped, cycles ~ng
have different shapes and amplitudes from those suggested by the model. ay
Finally, as Shapiro 10 has pointed out, many cyclic patterns suggested by the
model do not conform to the real world experience.
terized b
the process of declin e in outpu t may be slower, a situation charac st
is reduc eJ ~rnp i4·
does take place in due course, Here, the autonomous investment
a httte
below the nonna l level, while induced investment is zero.
te quantity C
TI1e course of slump is shown by curve Q 1Q2 • That is, the absolu
line LL. An thof r
output decreases along the curve Q1Q2 towards the slump equilibrium 1
plunges down~ - er
cours e of possib le slump is show n by Q1q, when the outpu t
is Q 1Q2• ""clrd
indefinitely. which is a rare possibility. The normal course of slump
moving alo
Turni ng to recovery, when the down swing hits the bottom, it starts· ng
the lower eqm·1·b . 1·
1 num me LL. This line is linked to the auton
omou s investment lin
AA, and rises with it. Thus, at this stage outpu t will again start
to rise. This increase
the beginning 0~
in output shoul d bring the accelerator back into action . This marks
process of multiplier
recov ery. Once the auton omou s investmer.1t starts coming in, the
grow on the path of
and. later. its intera ction with accelerator makes the econo my
expan sion towards equilibrium path EE. This completes the cycle.
mode m and a highly
C rJtlcJ l Hicks ian theory of trade cycle is regarded as13an up-to-date, most
orates all the best
E\ .11uatlon
stream lined theory of trade cycle. As Lee remarks, "It incorp
not proved out in
featur es of earlie r mode ls and scrapes most of those which have
betwe en the roles
the past.·· Besid es, Hicks has pointed out that there is a difference
downswing, the
of accel erato r at the upswi ng and at the down swing . On the
Hicks ian theory of
accele rator is inope rative because of excess capacity. However,
trade cycle has been criticized on the following grounds.
First critic ism ( a general one) of Hicksian theory of trade cycle
is that like other
s for the linear
theori es of this tradit ion, it too does not provide sufficient reason
during the phases
consu mptio n functi on and a constant multiplier. It is quite likely that
ing the marginal
of expan sion and contra ction, incom es are redist ribute d affect
prope nsity to consu me and hence the multiplier.
dynamic
Secon d, the assum ption regarding the const ancy of multi plier under
ical evidence. the
condi tions is looke d upon with skepticism. Without a sound empir
cter and. in that
whole discu ssion on acceleration principle assum es an abstra ct chara
also not provided:
case, it retain s only academic interest. The empirical14 studies have
evide nce to the assum ption of constant accelerator •
highly abstrad
Third, Hisksian theory, like some other theories, is regard ed as a
n of fluctuations in
formu lation which seems incapable of expla ining the pheno meno
real life.
ered to
Despi te these limitations, the Hicksian theory of trade cycle is consid
the most sound theory of trade cycle.