BUSINESS CYCLES AND STABILIZATION 515

of durable goods and va . .

enters the phase of expann~ty items. With this process catching up, the economy
Sion au<l prosperity. The cycle is thus complete.

Theories of Business Cycle

A businessofcycles
ofnumber theories hohave be_en offered to explain business cycles. A systematic study
contributions to the ' Wever . 1 e lY recent development. Most of the ·important
theo· ' is a relafv
twentieth century though';; ?f bu5 mess cycle were made in the first half of the
century. The classi usm~ss cycles had taken place throughout the nineteenth
1
devoted little attent~a economiSt s-Adam Smith, Mill, Malthus and Ricardo-had
that Say's Law . ' 0 ~Sto tbe causes ~f business cycles. The classical school believed
' i.e:, upply creates its own demand" was a valid representation of
th e world
interest r t economic . behavi
. our, and that unemployment ' appears only if wages and
Id b a e: are mflextble. Market forces, what Adam Smith called 'invisible hand',
wou y t emselves maintain stability in the economy.
Between 1890 and World War I, however, a number of important contributions
were made to the trade cycle theory3.
1lth~ugh many important contributions were made to the theory of business
cycle pnor to the Great Depression, the study of business cycle still remained outside
the general economic theory. It was Keynes, 5 who provided a general theoretical
framework in which the the_ory of business cycle could be interwoven. In his General
Theory he provided standard tools for analyzing the economic fluctuations 5
though he
himself had said little about the causes of cyclical fluctuations. Hicks has remarked
that Keynesian economics has done all for understanding of business fluctuations but
has left out the analysis of business cycle itself. In the post-Keynesian era. the main
contributors7 to the cycle theory include Metzler, Harrod, Kalecki. Samuleso~ Kaldor.
Hicks, Goodwin and Duesenberry. The trade cycle theories are generally -classified
under the following categories:
1. The Pure Monetary Theory,
2. The Monetary Over-investment Theory,
. The Non-monetary Over-investment Theory,
3
4. Innovation Theory, ,
5. Acceleration Principle of Trade Cycle,
6. Psychological Theory, .
7. Under-constllllPtion Theones,
8. Exogenous Forces Theories,
-- ,Votes . . . de bv a non-economist, Clement Juglar m -~$60.
{ . . . . t this penod was ma ~ . A rther Spiethoff and J.• \. schumpeter
4· fhe onry important contnbunon prtor ob M Tugan aaranowsky of R11s~1~ .~d. Albert Aftalion a.ad Jean L"5<Ute
, .The importa&t contributions ':'ere -~adeDi Robertson and R.G. Hawu(Fey od ;ts see Gordon, R..-\.. op. ::it, p. 306),
Qf Germany. Knut Wicksell ot Swouen, ' : . ell of the United States. or e '
9 6
'5 of France; Thorstein Ve?len and W.C~ J;!~;!s, and JIoney'. _1 ~ - . . L-0ndon. 1950), p-. 1.. . .
. Tl,e <Jenen,1 Tlie.ory QJ £,,.ploymen4 C I (Oxford Unive<Si'Y Press. I nd Econom/C S,ab,tucnoo (Random ll<ru51;,
6.. A ConttU:,uttcri to the Theory of Trade ye:ustness fluctuations, Growt, a
7.. See also Clark. JJ.t. and M. Cohen. {eds}
l~@. Bi ffo ra by,
 \
S16

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

process reinforces th~ up wm 1 A

needs no further inducement f~r t1 ftcr the expan 10n pro ,
The process of . le banking sy tern a it b om J u t int
prosperity thu8 b
is reversed when banks beg·· t rought about by the banking credit m har m
• expan ,on. 1 h b nks m y ind
· credit
m o restra'111 th cir
it difficult to expand the c d'
reserves stand depleted due tre ~t _further ~t the prcvailin, rat bccau th 1r h
of deposits and (iii) withd O (,) increase m loan and advanc ; (II) r d I d mfl >W
us~s. As credit expansi·on rawal of deposits for quicker return and mor profi bl
•
comes to a0 en d, b usmessmcn
credit for furthering the' b . can no longer obtain b
Ir usmess f · ·
slowed down. Due to lack
payment obligations and to
their inventories to d 1 t
m:
O
• a: rvitrc~. Therefore, the proce of cxpan ion J
cr~d•~ busrn~ssmcn find ii_ difficult to meet th 1
m~am mventones at the existing Jcvel. ~o they How
inputs. This marks thep: e: B~sides, they ca?cel their orders for the purch of
e egmnmg of downswing.

: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

~ supply is equal to demand. In other word~, there should be a complete,

adjustment in the investment patter~. Bes1d~s, there must be a complete
m the investment demand at the various vertical sta?es of production. i.e.,
if;'J.'ttent in investment in the consumer goods, capital goods, and super-
 M
M CRO C(JNOMI< A r
JUJlil tlum ondtf tott th II l n
cap,t 1 ood mdu tn
would r m III tn ti
to exp nd con umpt1on
equih brium
onomy w uld up t b
The equ llbrium and t b,lity of th
money supply and saving mvc tmcnt rclnt1on rh vln nv tm nt r
,n r a Jn
change due to mcrea e m mvc tmcnt without corr pondinp
a 1nc.r in m
avmgs Jnve tmen t may incrca e du to uch rca on
m about th f
efficiency of capital fall in the rate of intcrc t, ov r opt1m1
a d bank crcd,~
pro pects, etc. If new investments are financed throu :;I) incrc
tric . 1hu , there ma
I ds to over-investment, main ly in the capital goods indu
n, and mcrea e in c1
expansion of investment witho ut contraction in consumptio
y, additional con
New inves tmen ts gene rate addit ional incom e and, thcrb
supply, exec de
demands. Sinc e there is a time-lag betw een demand and
For this reason, the
cause s infla tion resul ting in loss of purch asing power.
tment. In fact, the
demand does not incre ase at the rate of increase in inves
mves tmen t is acqu ired at the cost of real consumption.
d because it
Such as it is, the exist ing rate of investment cann ot be maintaine
tion of imbal
IODe out of balan ce with cons umer demand. Under this situa
labour income. As a r
cons ume r dema nd incre ases rapid ly because of increase in
goods prices. There
rise in consumer goods price s overtakes the rise in capital
of capital
peoficability in cons umer good s industries becomes higher than that
former. As a I'.
kaklStries. This caus es a shift in investment from the latter to the
s industries. But d
j a d tbt bank credi t incre ases in the cons umer good
hp t •1:s unwiJJingness and inabi lity to meet the credi
t demand, more so when
tries, a financial
• a Mk JJat iw dema nd for fimds from capital goods indus
ction beca
dil,w;lups This leads to a sharp decline in the capital goods produ
In,., ., ., . . . ,., . Jlll@ r the press ure of risin g cost and (ii) fall in m
~ causes unem ploym ent in capital good s indus
tries.
m ~ capital goods sector is much too rapid to be ab
iecto r. Cons eque ntly, large -scal e unem ploym ent r
a1id a down swin g begins in general business a
should, however, be of a short duratio
start moving in the reverse direction,

of the over -inve stme nt theo

of interest is lowe
I of funds), the
unde r th
hen
 BUSINESS CYCLES AND STABILl.lATIO?-. 519

Finally, the mone_tary over-investment theory Jays undue emphasis o? the

imbalance berneen the mvestment in capital goods and consumer goods industnes. In
a inode~ econom), such imbalances are self-correcting and do not create serious
dcpre.)s10ns.
Schumpeter's theory of innovation falls in line with the investment theories of
z,1.J.J1
!11Peeer s
business cycles. Whil~ other investment theories emphasize the general fluctuati~n in
u or/ of investment accompamed by monetary expansion as the cause of business fluctuations,
f1tt In
111novat o Schumpeter's theory emphasizes that innovations in business are the main cause of
increase in investment and business fluctuations.
According to Schumpeter, "business cycles are almost exclusively the resu1! of
innovations in the industrial and commercial organization." By innovation!; he means
" ... such changes of the combination of the factors of production as cannot be
effected by infinitesimal steps or variations on the margin. [Innovation] consists
primarily in changes in methods of production and transportation, or changes in
industrial organization, or in the production of a new article, or opening of a new
market or of new sources of material...". Innovations do not mean inventions.
Innovations are simply the commercial application of new techniques, new materials,
new means of transportation and new sources of energy. According to Schumpeterian
theory, innovations are the cause of cyclical fluctuations.
In his formal approach to the business cycles theory, Schumpeter has developed
a model in two stages which he calls the first approximation and the second
approximation. The first approximation deals with the initial impact of the innovatory
ideas, and the second approximation deals with the subsequent waves that are created
by the application of innovations.
The fust approximation of Schumpeter's model starts with the economic system
in equilibrium in which there is no involuntary unemployment; each firm has its me
= mr; and price = average cost. Also, there is no incentive for additional investment,
nor disincentive to reduce it. Under the conditions of complete equilibrium in the
economy, if an innovation in the form of a new technique or a new process of
production is introduced, it will have to be financed through bank credit. For, the
economy being in equilibrium, there is no surplus fund to finance the new adventure.
With additional funds available from the banking system, the innovating firms go on
bidding higher prices for other inputs with a view to withdraw them from other uses.
Due to increased spending in the economy, prices begin to rise. This process is
further accelerated when other firms imitate the innovation and acquire additional
funds from the banks. With the widespread ad_aptation of the innovation, output begins
to flow into the market. The phase of expans10n gets underway. But beyond a certain
level, increased output causes a decrease in price and profitability. Since further
innovations do not come by quickly, there would not be additional demand for funds.
Rather, the firms which had earlier borrowed from the banks start paying back. This
leads to contraction in money supply. Hence .prices fall further. The process of
recession begins and continues until equilibrium is once again restored.
The second approximation of Sch_um~eter's. mod:l analyzes the secondary
waves that are created by the first approximation. The main element in the secondary
 h •wary wave of expan ion begm tn
" ,s p culauon When. t e pn pect that the upswing 1s pennan
p cularl) m capital goods mdustn ' hex ·1v Even consumers
. . fi anticipat· ent W
th1 xp ctatmn. ex1s~mg ums borrow .eav1dura ;•
ble Ing h
pnce m future go mto debt to acqmre con sum er goo ds. Thi
. b bo
mdebtedness causes a problem when Prices begin. to fall. De tors, th .mvesto""h a
. d'ffi It to meet their obhg . • Th· • . ·.,
1
consumers, find it extreme y t icu at1o ns. 1s situation leact
a pamc and then to depression. The lower turning . oint comes when the
P nece
liquidation of assets buil. t on borrowed funds has been. com .
pleted, the debt stru
has been brought to order and inefficient firms are e1imm d ct
ate ·
l.rltlcill As M \\. Lees puts it, "An objective evaluation of Schum~
eter's theory of the C}'c
E aluadon is not only difficult" but also unavailing because mo5t _of
his arguments are based 0
·sociological rather than economic f.actors' • H':11ce, th1 ~ th
eory can hardl~ be put to
test. Besides. Schumpeter's theory is not bas1call~ 1ff~re
theory: it differs only in respect of the cause of vanation m
? nt ~ m over-mvestme
~e mvestment when the
economy is in state of equilibrium. Further, this theory too,
like many other theories
leaves out man) other important factors causing fluctuations.
Innovation is only one
of the factors and not the sole factor.
24.3 .4 While business cycle theorists of Keynesian tradition emphasi
Mllltlpller- ze the multiplier process
in economic fluctuation, J.M. Clark stresses the role
Acaletator of acceleration in business
laierKtlon
fluctuations. The post-Keynesian business cycle theorists 9
, however, contend that
Tlleotr neither the theory of multiplier nor the principle of acce
leration alone is an adequate
tool for analyzing the business cycles. In their opin
ion, these two tools integrated
together offer a much more satisfactory explanation to
business cycles. They have,
tme be, developed their own models and have shown the
role of interaction between
multiplier and accelerator in business fluctuations. We will
discuss here two prominent
models of 1his category, viz., Samuelson's and Hicks' mod
els.
S.r LdM I~ llod d Samuelson's model is regarded as
the first step in the directi
of e-ltgiatwc theory of multiplier with the principle of acce
leration. His model sho

CII
-••IOD.and accelerator imeract with each other to generate
and ·
fltd•lfCMl.
dem ands more
income
than expected · and how '

, . ~ let us first distinguish between autono

JQlll!llaallll Awtaaeaous inve'stment is the inve
s
':bs such as new inventions in technique
~-~ etc. Der ived investment is
• --uen due to increase in cons
~e interaction process bri
~. mcome of the people rises
•
 the
1
prnP{'tHi q
I
IJ
1/11, f /1/l(lf "• '
"'HlttH :,:~ <'V,·u 1 MIi, SIAHIU7AiION 521
t Htl ,\lt11e1 L\Hn1111 1I ·t CH ll!i, lttt •t(lf1ao i11 I ' I . .
· 11 < 1 ''i'l!J1d1118 1111 II . llh om,• C11<)~ lo ln<Jrna;c m demand for
i'\• ,~m- P )'-." ~1lo11 l'ltpfh\f h• 1111 iel hu 11 ~i 11 uf f1top,:11ijify 1,, e<ms11tnc. If there is no
tl11• c' .,, CJ< ·Hing I'l l k
1'11) • I n o11 ,11111~1 1 111111<111 lu 1111'111
1I11 1' ,11 '"'1 ,,1
t,1<)1i111J Wo11Jd prove inadequate to
f,1 (II1 h'ti J,·
11 l II id n11<1 11 1h k 1111 k: 1• IHI /1 J.•m 11 11d, litere fore, hrms rry to meet the
•'ti'~ 1 ~N 1 1lt•t1111111]
1 101 lnv,•~t 11 How ltivontn1c11t. 'Jh11s increase in consumption

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.

Samuelson's 111odol of ocononilc fluctuations is briefly presented below. Given the

assumption (iv), the ccoi10111y will be in equilibrium when
yI • Ct + /I
... (24.1)
where nntionnl inconm, C1 total consumption expenditure, and 1 = investment
Y1 J

expenditure, ult in period t, 1

• • I

Given the assumption (Ii), the consumption function may be expressed as

' (1 a ,,1
, (, ~ y1- l · .r:~·, :; , ... (24.2)
where r,
1 is income in perl~d I - I, and a is mpc
·
o\~~l'IY. (Recall that l'IC/l'IY
detennines the mult.iplier). ' I
<~
1
. ~ti .ction of consumption with a one-year lag, i.e.L
Investment IS a un /. - r--w ( l's-~l- . •. ,,_.J...L.. .......
, 11 b(ct. _ C1- 1) ~I', \..,V~,,-- . , · ~ (24.3)

.. .. ft is important to note here that the parameter

. I/outPl!t/tio,
where b r~resents capita
•b' determines die accelerator. \
· <24 ·2) for Ct and Eq. (24.3) for I,, the equilibrium Eq. (24.1)
By substituting Eq.
can be rewritten as · C ... (24.4)
y1 = aY 1 + b(C1 -- 1-1)
.,. By substitution, Eq. (24.4) can be
t- C,-1 -. 0 y1 _"
Note that C, = ay, 1 and
written as

- -
 }' ,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

lin • ~h,,n 11 111111

811 11111,, f,11 111
1.2 pl1llll'IJ ll11 H \\tttl 111,, Vt11lt111,
11 l11cl •1 of , \ 1 l, q 11 1111 \\int1ld 11

Hllth1 111l e d It, t1111, 1, 1111 11111111 1

co w,llw rn 111 ,, ,111d /1 I l111111 111t n

~ dl11g1'11111 11 1 pwd111 11d ll f 1lt1 (111
cu
E
~ 0.6
n.
.J.l .... lu1 lu111 111111,,11 Iii•• \1ttl1111
m
11. lypotl ol , y, lurt 1 11w111cl l1 y 111•
0.4 dl11i.,w11I , u11tl1l1111ll1111 11 ,ti ,, 1111d
1

b. 'l'J10 v,11 lou,j l'1111tli/11111lu11, 11f

0 .2 JJ111'11111'31~1 h ,, t111d /i l 11 t Vl 111 •II
OL...--.l.--_L...---1---L---L-- - ' - - - t . - - 1 - ul1ow11 1,v ,11011~ 11111d Pd 1,y 1, 11,
I

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

Dam n..d non osci llabo n

,....
Dam ped osal la6o n

sa.
'5
0

0-------- nme 0 TllTle

Area C Are aD

Exp losiv e oscillation

'5 :i
0.. C. Explosiv e nonoscillatior.
'5 :i
0 0

T1rne
0
nme 0

Fig. 24.3 Trade Cycle Patterns

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.

24.3.5 Hicks combines Samuelson's multiplier-accelerator interacti on model and Harrod.

11
Hlckslan Domar growth model to expound his theory of trade cycle. In his op~nion, business
Theory of cycles have historically taken place against the background of economic growth, and
Trade Cycle
hence, the trade cycle theory should be linked with growth theory. In his theory of
trade cycle, Hicks uses (i) Keynesian concept of saving-investment relation and the
multipli er, (ii) Clark's acceleration principle, (iii) Samuelson's multiplier-accelerator
interaction and (iv) Harrod-Domar growth model. These are the main ingredients of
Hicks' theory of trade cycle. Let us now look at his theory of trade cycle in detail.
Assumptions 1. Hicks assumes an equilibrium rate of growth in the model economy in which
realized growth rate (G) equals the natural growth rate (Gn). The autonom ous
investment increases at ; constant rate which always equals the rate of increases in
voluntary savings. The equilibrium growth rate is determined by the rate of
autonomous investment and savings.
2. Hicks assumes a Samuelson-type of consumption f11nctioll, i.e., C, - aY,_1
(with one-year lag in consumption). The reasons he gives for the lagged
consumption function are: (i) lag of expenditure behind income and (ii) lag in non-
wage income behind the change in GNP. The saving function naturally becomes the
function of past year's income. Given these assumptions, Hicks' multiplier becomes
a 'mathematical truism'. With the lagged relations between income and saving•
investment, the multiplier process has a dampening effect on the fluctuations. The
lagged multiplier acts as 'a depressant on the upswing and a counterforce on the
downswing.'
3. Hicks assumes that autonomous investment is a function of current outp
and is undertaken to replace the womout capital. Induced investment in his model
is a function of change in output. The change in output generates ind:ced investme
which b~g~ the acce~erator ~~ciple in action. It may be noted here that th
accelera~on mtera~ts with multiplier effect upon income and consumption.
4.. Fm~ly,_ ~nhke Samuelson's ever-widening, explosive cycles (case C), Hie
the upswing and do wnswmg · . Th e ce1·1·mg
prescnbes ce1hng . bottom' for
. . and
upward expansion 1s IIllposed by the , 'scarcity of empl bl ,
the limit of the down • . oya e resources . As reg
. . . . _s~g, he says there 1s no such direct limit on contraction'.
But an mdrrect hnut is IIllposed by the mechanism of accelerator on the downsw·
 H{J' JN1 1H! r ff fl ( A <T , ., .,,..
H icks has outHned h'· ., , .a ,{) ' AHH.AZ ATfrJ., ;u,;.J

n,iphlc ll . , .. ' ,b theory of trad,- ► J ••

t1t1on of a,w, mccts~irc·, the l<>garithrn-1 - eye e rn ~ <hagr;,m (·.,I'~ Fi~ 24 4 ;. 1he vertica l
· nr1 . • .
,,,,~"' ThfOff mc ...-.. .,e tffC"" t,rr,c• b Y its • <)utn-ut
• acm J , c,f • v · ~ · cmpi< ,;mcnt ~nd the h0n ;,,mtal ans
1 og,mthm1c SC" I J •• •
H''J'd•
r,, crcl•
of ot ~? .
t ~nom
. 1
o us rnvcst mcnt, inc , . ct c. n ·1g 24 4, Jme AA ",hows the course
eq w hb n um p;it h of out put wh'1chrc~sin g at a com,ta nt rate. The line EE is the
, 1s a c ons\,(ln . • Je of autonomom; investment.
~.. t muJt1p
The line FF is the full emplo yment ceiJing
______ r The Hnc l l ·. .hows the equilib rium path
d'.1dng the period of slump , as~um ing the
output Jc-;eJ w1Jl never go beloN this level.
The line LL mari:-s the bottom line of the
F t-.. - - - - - - a econom y.
L : :ow, Hick~ian !heorJ of trade cycle
can be described as fol1ows. Let us
suppose that the econo my has been
progressing on the dynam ic eq uiHbrL1m
A
L
path, and reache s point Pr>• SJJPpose also
that at this ; unctur e a...._tonomo..LS
A invest ment takes place due to some
oL--- ------ ---;;n ~m=e~ - - - - - - - - / · invent ion. Con.seqJ.-~ly, O.Jtp~t incr~ $
and the economy leaves the equili brium
F11. 24.4 Hicks, Model of 1rade Cycles path EE and rroves ..tpward. After a
certain fag begins the m..1ltip1ier proce ss
se.
caused by the autono mous invest ment. As a result, outp~t and employment increa
Increase in outpu t leads to induce d invest ment which in rum brings the accele rator
in
action. This intera ction between the multip lier and accele rator ca.J.Ses expan sion ir.
ilie
until
economy and the econo my moves along the expan sion or oscillation path Pr)'~
full
point P 1 is reached. The expansion beyon d P 1 wiH not be possib:e beca..lSe o:
it
employment constraint. The most it can do is to creep a10:.1g the cei::ng FF. B~t
was suppo sed
canno t do so for Jong. For, the initial b urst of autonomoJS invest ment
~orma:
to be shortlived; ' thus on the upper part of the path Ptf ~ no more than the
sion a:ong
amou nt of auton omou s invest ment is taking piace.~ It imp1ies that the expan
ing
Pcl'i has been mainly on accou nt of the induced in·,estment dt.1.ring the preced
periods.
However, once the ceilin g is hit, the exp~.nsion sustafr1ed oy the ind ...ced
investment along FF is bound to end an d a dO'nrJ.Swing becom es inevitable sooner
or
later. The reason is that increa se in outpllt along FF is :n?1 hlg;i en.01..-g..~ :o mduce ..
investment and hence the induce d invest men! ceases to ta-<e place. T.r.e dov:n,:wing
may be delayed if output-~ve :tm~ (induced) relati~n""~ a t~sree or fcJT yea:- ;~
~

But the downfall in outpu t 1s inev itable. ?11ce tte ~ .,,~h

1
ha: ~,
sa:,, at po;nt
~.op
.P' it must continue tiH it hits Une EE. Smee there l5 not'1!.n.g L.~ me proce ss to
it ;.. EE, die downfall will contin ue furthe r. The ..rate o~ ~ ::~ ~·~· ::er: should be :o,;.rer
since lhe m,mv estme nt is limited to the rate of aeprec1at1on w.r..1cE1 g~s on decreasing
- - the decfeaSe in output . That ~, the re::ers:
~ ~era.tor ooes _;ot .
·.;\or:".. as
or syrr:rcetry. .ever. ~hcJgh
fill U il4oc s during the up5\l' i~: there ts a mar~ed 1aeJ.::
526 !'art VI: MATID ECON OMIC ASPEC "l :-, o r -MTIN~ crr.1~]A 1, ccoNu Mn.:;;: ,

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.