4 Essential Theories of Business Cycles – Discussed!

Here we detail about the four essential theories of business cycles.

The six theories are: (1) Sun-Spot Theory, (2) Hawtrey’s Monetary Theory, (3) Under-Consumption Theory, and (4) Hayek’s Over-Investment Theory.

Theory 1# Sun-Spot Theory:

This is perhaps the oldest theory of business cycles. Sun-spot theory was developed in 1875 by Stanley Jevons. Sun-spots are storms on the surface of the sun caused by violent nuclear explosions there. Jevons argued that sun-spots affected weather on the earth.

Since economies in the olden world were heavily dependent on agriculture, changes in climatic conditions due to sun-spots produced fluctuations in agricultural output. Changes in agricultural output through its demand and input- output relations affect industry. Thus, swings in agricultural output spread throughout the economy.

Other earlier economists also focused on changes in climatic or weather conditions in addition to those caused by sun-spots. According to them, weather cycles cause fluctuations in agricultural output which in turn cause instability in the whole economy. Even today weather is considered important in a country like India where agriculture is still important.

In the years when due to lack of monsoon there are drought in the Indian agriculture, it affects the income of farmers and therefore reduces demand for the products of industries. This causes industrial recession. Even in USA in the year 1988 a severe drought in the farm belt drove up the food prices around the world. It may be further noted that higher food prices reduce income available to be spent on industrial goods.

Critical Appraisal:

Though the theories of business cycles which emphasize climatic conditions for business cycles contain an element of truth about fluctuations in economic activity, especially in the developing counties like India where agriculture still remains important, they do not offer an adequate explanation of business cycles.

Therefore, much reliance is not placed on these theories by modern economists. Nobody can say with certainty about the nature of these sun-spots and the degree to which they affect rain. There is no doubt that climate affects agricultural production. But the climate theory does not adequately explain periodicity of the trade cycle.

If there was truth in the climatic theories, the trade cycles may be pronounced in agricultural countries and almost disappear when the country becomes completely industrialised. But this is not the case. Highly industrialised countries are much more subject to business cycles than agricultural countries which are affected more by famines rather than business cycles. Hence variations in climate do not offer complete explanation of business cycles.

Theory 2# Hawtrey’s Monetary Theory of Business Cycles:

An old monetary theory of business cycles was put forward by Hawtrey. His monetary theory of business cycles relates to the economy which is under gold standard. It will be remembered that economy is said be under gold standard when either money in circulation consists of gold coins or when paper notes are fully backed by gold reserves in the banking system.

According to Hawtrey, increases in the quantity of money raises the availability of bank credit for investment. Thus, increasing the supply of credit expansion in money supply causes rate of interest to fall. The lower rate of interest induces businessmen to borrow more for investment in capital goods and also for investment in keeping more inventories of goods.

Thus, Hawtrey argues that lower rate of interest will lead to the expansion of goods and services as a result of more investment in capital goods and inventories. Higher output, income and employment caused by more investment induces more spending on consumer goods. Thus, as a result of more investment made possible by increased supply of bank credit economy moves into the expansion phase.

The process of expansion continues for some time. Increases in aggregate demand brought about by more investment also causes prices to rise. Rising prices lead to the increase in output in two ways. First, when prices begin to rise, businessmen think they would rise further which induces them to invest more and produce more because prospects of making profits increase with the rise in prices.

Secondly, the rising prices reduce the real value of idle money balances with the people which induces them to spend more on goods and services. In this way rising prices sustain expansion for some time.

However, according to Hawtrey, the expansion process must end. He argued that rise in incomes during the expansion phase induces more expenditure on domestically produced goods as well as on imports of foreign goods. He further assumes that domestic output and income expand faster than foreign output.

As a result, imports of a country increase more than its exports causing trade deficit with other countries. If exchange rate remains fixed, trade deficit means there will be outflow of gold to settle its balance of payments deficit. Since the country is on gold standard, outflow of gold will cause reduction in money supply in the economy.

The decrease in money supply will reduce the availability of bank credit. Reduction in the supply of bank credit will cause the rate of interest to rise. Rising interest rate will reduce investment in physical capital goods. Reduction in investment will cause the process of contraction to set in.

As a result of reduced order for inventories, producers will cut production which will lower income and consumption of goods and services. In this state of reduced demand for goods and services, prices of goods will fall. Once the prices begin to fall businessmen begin to expect that they will fall further.

In response to it traders will cut order of goods still causing further fall in output. The fall in prices also causes real value of money balances to rise which induces people to hold larger money holdings with them. In this way contraction process gathers momentum as demand for goods starts declining faster and with this economy plunges into depression.

But after a lapse of some time depression will also come to an end and the economy will start to recover. This happens because in the contraction process imports fall drastically due to decrease in income and consumption of households, whereas exports do not fall much. As a result, trade surplus emerges which causes inflow of gold.

The inflow of gold would lead to the expansion of money supply and consequently availability of bank credit for investment will increase. With this, the economy will recover from depression and move into the expansion phase. Thus, the cycle is complete. The process, according to Hawtrey, will go on being repeated regularly.

Critical Appraisal:

Hawtrey maintains that the economy under gold standard and fixed exchange rate system makes his model of business cycles self-generating as there is built-in tendency for the money supply to change with the emergence of trade deficit and trade surplus which cause movements of gold between countries and affect money supply in them. Changes in money supply influence economic activity in a cyclical fashion.

However, Hawtrey’s monetary theory does not apply to the present-day economies which have abandoned gold standard in 1930s. However, Hawtrey’s theory still retains its importance because it shows how changes in money supply affect economic activity through changes in price level and rate of interest. In modem monetary theories of trade cycles this relation between money supply and rate of interest plays an important role in determining the level of economic activity.

Theory 3# Under-Consumption Theory:

Under-consumption theory of business cycles is a very old one which dates back to the 1930s. Malthus and Sismodi criticised Say’s Law which states ‘supply creates its own demand and argued that consumption of goods and services could be too small to generate sufficient demand for goods and services produced. They attribute over-production of goods to lack of consumption demand for them. This over-production causes piling up of inventories of goods which results in recession.

Under-consumption theory as propounded by Sismodi and Hobson was not a theory of recurring business cycles. They made an attempt to explain how a free enterprise economy could enter a long- run economic slowdown. A crucial aspect of Sismodi and Hobson’s under-consumption theory is the distinction they made between the rich and the poor.

According to them, the rich sections in the society receive a large part of their income from returns on financial assets and real property owned by them. Further, they assume that the rich have a large propensity to save, that is, they save a relatively large proportion of their income and, therefore, consume a relatively smaller proportion of their income.

On the other hand, less well-off people in a society obtain most of their income from work, that is, wages from labour and have a lower propensity to save. Therefore, these less well-off people spend a relatively less proportion of their income on consumer goods and services.

In their theory, they further assume that during the expansion process, the incomes of the rich people increase relatively more than the wage-income. Thus, during the expansion phase, income distribution changes in favour of the rich with the result that average propensity to save falls, that is, in the expansion process saving increases and therefore consumption demand declines.

According to Sismodi and Hobson, increase in saving during the expansion phase leads to more investment expenditure on capital goods and after some time-lag, the greater stock of capital goods enables the economy to produce more consumer goods and services. But since society’s propensity to consume continues to fall, consumption demand is not enough to absorb the increased production of consumer goods.

In this way, lack of demand for consumer goods or what is called under-consumption emerges in the economy which halts the expansion of the economy. Further, since supply or production of goods increases relatively more as compared to the consumption demand for them, the prices fall.

Prices continue falling and go even below the average cost of production bringing losses to the business firms. Thus, when under-consumption appears, production of goods becomes unprofitable. Firms cut their production resulting in recession or contraction in economic activity.

Karl Marx and Under-Consumption:

It is worth mentioning that Karl Marx, the philosopher of scientific socialism, had also predicted the collapse of the capitalist system due to the emergence of under-consumption. He predicted that capitalism would move periodically through expansion and contraction with each peak higher than its previous peak and each crash (i.e., depression) deeper than the last.

Ultimately, according to Marx, in a state of acute depression when the cup of misery of working class is full, they will overthrow the capitalist class which exploits them and in this way the new era of socialism or communism would come into existence.

Like other under-consumption theorists, Marx argues that driving force behind business cycles is ever increasing income inequalities and concentration of wealth and economic power in the hands of the few capitalists who own the means of production. As a result, the poor workers lack income to purchase goods produced by the capitalist class resulting in under-consumption or over­production.

With the capitalist producers lacking market for their goods, capitalist economy plunges into depression. Then the search for ways of opening of new markets is started. Even wars between capitalist countries take place to capture other countries to find new markets for their products. With the discovery of new methods of production of finding new markets, the economy recovers from depression and the ne v upswing starts.

Critical Appraisal:

The view that income inequalities increase with growth or expansion of the economy and further that this causes recession or stagnation is widely accepted. Therefore, even many modern economists suggest that if growth is to be sustained (that is, if recession or stagnation is to be avoided), then consumption demand must be increasing sufficiently to absorb the increasing production of goods.

For this, deliberate efforts should be made to reduce inequalities in income distribution. Further, under-consumption theory rightly states that income redistribution schemes will reduce the amplitude of business cycles.

Besides, the suggested behaviour of average propensity to save and consume of the property owners and wage earners in this theory have been found to be consistent with the observed phenomena. Even in the theory of economic development the difference in average propensity to save (APS) of the property owners and workers has been widely used.

It is clear from above that under-consumption theory contains some important elements, especially the emergence of the lack of consumption demand as the cause of recession but it is regarded as too simple. There are many features other than growing income inequalities which are responsible for causing recession or trade cycles. Although under-consumption theory concentrates on a significant variable, it leaves too much unexplained.

Theory 4# Hayek’s Over-Investment Theory of Business Cycles:

It has been observed that over time investment varies more than that of total output of final goods and services and consumption. This has led economists to investigate the causes of variation in investment and how it is responsible for business cycles.

Two versions of over-investment theory have been put forward. One theory offered by Hayek emphasises monetary forces in causing fluctuations in investment. The second version of over-investment theory has been developed by Knut Wick-shell which emphasises spurts of investment brought about by innovation.

It is worth noting that in both the versions of this theory distinction between natural rate of interest and money rate of interest plays an important role. Natural rate of interest is defined as the rate at which saving equals investment and this equilibrium interest rate reflects marginal revenue product of capital or rate of return on capital. On the other hand, money rate of interest is the rate at which banks give loans to the businessmen.

Hayek’s Monetary Version of Over-Investment Theory:

Hayek suggests that it is monetary forces which cause fluctuations in investment which are prime cause of business cycles. In this respect Hayek’s theory is similar to Hawtrey’s monetary theory except that it does not involve inflow and outflow of gold causing changes in money supply in the economy.

To begin with, let us assume that the economy is in recession and businessmen’s demand for bank credit is therefore very low. Thus, lower demand for bank credit in times of recession pushes down the money rate of interest below the natural rate. This means that businessmen will be able to borrow funds, that is, bank credit at a rate of interest which is below the expected rate of return in investment projects. This induces them to invest more by undertaking new investment projects.

In this way, investment expenditure on new capital goods increases. This causes investment to exceed saving by the amount of newly created bank credit. With the spurt in investment expenditure, the expansion of the economy begins. Increase in investment causes income and employment to rise which induces more consumption expenditure.

As a result, production of consumer goods increases. According to Hawtrey, the competition between capital goods and consumer goods industries for scarce resources causes their prices to rise which in turn pushes up the prices of goods and services.

But this process of expansion cannot go on indefinitely because the excess reserves with the banks come to an end which force the banks not to give further loans for investment, while demand for bank credit goes on increasing.

Thus, the inelastic supply of credit from the banks and mounting demand for it cause the money rate of interest to go above the natural rate of interest. This makes further investment unprofitable. But at this point of time there has been over-investment in the sense that savings fall short of what is required to finance the desired investment.

When no more bank credit is available for investment, there is decline in investment which causes both income and consumption to fall and in this way expansion comes to an end and the economy experiences downswing in economic activity.

However, after a lapse of some time the fall in demand for bank credit lowers the money rate of interest which goes below the natural rate of interest. This again gives boost to investment activity and as a result recession ends. In this way alternating periods of expansion and contraction occur periodically.

Wicksell’s Over-Investment Theory:

Over-investment theory developed by Wicksell is of non-monetary type. Instead of focusing on monetary factors it attributes cyclical fluctuations to spurts of investment caused by new innovations introduced by entrepreneurs themselves. The introduction of new innovations or opening of new markets makes some investment projects profitable by either reducing cost or raising demand for the products.

The expansion in investment is made possible because of the availability of bank credit at a lower money rate of interest. The expansion in economic activity ceases when investment exceeds saving. Again it may be noted that there is over-investment because the level of saving is insufficient to finance the desired level of investment. The end of investment expenditure causes the economy to go into recession.

However, another set of innovations occurs or more new markets are found which stimulates investment. Thus, when investment picks up as a result of new innovations, the economy revives and moves into the expansion phase once again.

Appraisal:

Though the over-investment theory does not offer an adequate explanation of business cycles, it contains an important element that fluctuations in investment are the prime cause of business cycles. However, it does not offer a valid explanation as to why changes in investment take place quite often.

Many exponents of this theory point to the behaviour of banking system that causes diverges between money rate of interest and natural rate of interest. However, as Keynes later on emphasised, investment fluctuates quite often because of changes in profit expectations of entrepreneurs which depends on several economic and political factors operating in the economy. Thus, the theory fails to offer adequate explanation of business cycles.