In this article we will discuss about the pure monetary theory of business cycle. Also learn about its criticisms.
The business cycle literature abounds in monetary or financial theories. (Most of such theories lie in the mere general category of expectations theories since they rely on endogenous changes in expectations to provide cycle turning points.) A pioneering attempt to develop such a theory was made by the R.G. Hawtrey. He attributed prime responsibility for business fluctuations to monetary instability.
Let us start with a situation of recession. Hawtrey simply assumes that banks are now flushed with funds (i.e., have excess reserves). They extend loans with these and at low rates of interest. At low rates of interest the cost of holding inventories would naturally be low.
This itself would stimulate (encourage) inventory investment. The increase in planned inventory investment raises production and income, raising sales. In turn, there is expectation of increased future sales, stimulating inventory investment which raises production and income. The process goes on continuously in the expansionary phase of the cycle.
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Under the circumstances the banking system becomes eager to extend loans to profitable businesses. In an expanding economy, it thus supports the cumulative expansion through credit extension out of its loanable reserves. But, this process cannot go on for long. In fact, the banking system’s loanable reserves must finally be depleted, simultaneously causing the interest rate to rise. The boom comes to an end.
With the rise in interest cost of holding inventories, planned investment in inventories is cut. This, in its turn, would reduce production and income. Consequently, sales will fall. This again will erode confidence in future sales. Business inventory would be further reduced. The cumulative contraction is underway.
Business firms start repaying existing (high-interest) loans. They do not borrow additional funds to finance new inventory purchases. So, the volume of credit extended by the banking system falls. Its loanable reserves are, therefore, replenished. The end result is that interest rates fall. And, the stage is set for another boom.
According to Hawtrey, the unstable behaviour of the banking system is the root cause of all crises. It is inimical to economic stability. In the expansionary phase, banks collectively extend more credit than would be required for a full employment equilibrium output level, as they share the business community’s optimistic expectations about future business conditions.
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Likewise, after the peak in activity they allow a contraction in credit larger than that required to restore full employment equilibrium. So, the cycle continues. Hawtrey’s theory was developed further by Milton Friedman and his co-workers.
Criticisms of Pure Monetary Theory of Business Cycles:
The purely monetary theory of the business cycle, developed by R.G. Hawtrey and refined and modified by the monetarists like M. Friedman and others at a later stage, is not free from defects.
It has been criticised on the following grounds:
(i) Neglect of Real Variables:
Firstly, the theory has totally ignored real variables such as saving and investment in explaining business cycles. But economists generally agree on the view that most business cycles in the past have occurred largely due to investment fluctuations. So, Hawtrey’s theory is incomplete. By ignoring non-monetary factors he has failed to provide a complete explanation of the business cycles.
(ii) Undue Reliance on Monetary Factors:
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Secondly, in Hawtrey’s model there is undue reliance on monetary factors. Critics argue that business cycles are not actually caused by frequent changes in the lending policies of commercial banks. Business cycles are caused by other factors. Undue expansion of contraction of credit during the depression or the prosperity phase of the business cycle only accentuates the problem.
(iii) Business Confidence:
Thirdly, Hawtrey has totally ignored the expectations and confidence of business people. It is often argued that just an expansion of credit cannot cause a boom. If it was so, a country would come out of deep depression or age-old stagnation just by expanding bank credit.
In fact, during the great depression of 1929-33 many countries tried, in vain, to revive business activity and stimulate the economy through an excessive expansion of bank credit. But, hardly any positive result was achieved. So, the prediction is that, so long as business people do not have the necessary confidence, it is not possible to lift the economy out of stagnation just by expanding bank credit.
(iv) Internal Financing of Business:
Fourthly, Hawtrey’s theory has placed undue emphasis on bank credit in the business world. Business firms no doubt borrow money to finance their development and expansion activities. But, big firms in the private corporate sector do not distribute their entire profits as dividends. To the extent companies resort to a policy of ploughing back of profits for achieving internal growth from within the importance of bank credit in initiating the boom gets diluted.
(v) Expected Return on New Investment:
Finally, it is pointed out that whatever the rate of interest no business firm will borrow money to undertake an investment project unless the expected rate of return on new investment (or what Keynes calls the marginal efficiency of capital) is sufficiently high.
On the other hand, businesspeople will borrow on a large scale, even at a high rate of interest, so long as the marginal efficiency of capital is sufficiently high, if they felt that future business prospects are bright. In fact, the most important determinant of MEC is the expected or prospective rate of return on new investment.
Conclusion:
In this analysis business cycles are attributed to the instability of bank policy. Hawtrey’s theory however does not explain how the initial momentum towards credit creation arises nor why the expansion and contraction take place in approximately the same length of time. According to Pigou, variations in the bank money supply is a part of the business cycle, it is not the cause of it.