9 Major Limitations of Hick’s Theory of Trade Cycle

Read this article to learn about the nine major limitations of Hick’s theory of trade cycle.

(i) Some of the assumptions on which Hicks theory of trade cycle is based have been criticized severely.

Firstly, the constant accelerator and multiplier as assumed in the model are not realistic.

A constant accelerator means that the ratio of investment to an increase in output remains unchanged throughout the business cycle. The accelerator can be constant only if we assume that the output capital ratio is determined by technical factor and cannot change.

In actual practice, additional investment depends not only on the increase in output but also on other factors like the availability of finance, expectations of businessmen, profitability of investment and so on.

During upswing or downswing the nature and composition of investment changes a lot. It has been seen that short-term investments become more attractive towards the ceiling of a cycle and long-term investments go attractive as the downswing proceeds. Recent statistical findings, according to EcKaus, go against the principle of acceleration.

He cites the investigations made by Simon Kuznets and J. Tinbergen on the subject and lays emphasis for taking into consideration the expectations of the businessmen in assigning a value to the accelerator. Arthur Smithies has also questioned the use of accelerator as an explanation of investment during either the upswing or downswing.

(ii) What is true of the accelerator applies also to the assumption of a constant value of the multiplier during the different phases of the cycle. Hicks seems to follow Keynes in assuming stable consumption function but recent empirical studies have shown that the marginal propensity to consume is not constant in relation to cyclical change in income.

As Friedman has shown that there is no certain and predictable relationship between the transitory income and consumption element. As the economy changes from one cyclical phase to another, the multiplier varies. It, thus, follows that if the multiplier is not constant as assumed by Hicks, it would not be able to produce cycles in the manner shown by him.

(iii) According to Prof. Kaldor the use of ‘Accelerator’ by Hicks is most pernicious and leads to misleading results. This principle presupposes absence of excess capacity in capital equipment, plant and machinery and also takes for certain permanent increase in demand. Kaldor has shown that industries which are subject to cyclical fluctuations are likely to maintain excess capacity in plant and equipment as a normal routine and suffer from variable demand mostly temporary in nature.

(iv) Hicks explanation is highly mathematical and mechanical whereas movements in real world never follow any precise mechanical process as shown by Hicks. He fails to take into account the psychological factors like expectations, uncertainty which play an important part in a dynamic investment function. Different critics focus on what they regard as the major deficiencies of Hicks’ model, but they all pay some attention to the fact that the model is based on the acceleration principle in a rigid form. According to Kaldor, this is the major weakness of the model.

If the accelerator in rigid form is unacceptable than the multiplier-accelerator interaction that incorporates it and is at the heart of Hicks’ model is also unacceptable. As Duesen-berry has put it, “The basic concept of multiplier accelerator interaction is an important one but we cannot really expect to explain observed cycles by a mechanical application of that concept.”

(v) Another criticism of Hicks’ model relates to the use of floor and the ceiling which keep fluctuations within an upper and lower limit. It is highly doubtful as to whether downturns are caused by resource limitations. At any rate, the upper limit does not properly explain the onset of depressions. It may play a part in checking growth but not in causing depressions. Duesenberry points out that an examination of the 1953-54 recession in USA does not prove that ceilings can effectively cause depressions.

Shortages of resources are not likely to cause a very large or sudden drop in investment. For example, the cause of major depressions in the USA in the half century period of 1873 to 1921 are mentioned which do not include shortage of resources. Hicks himself admits that depression may start even before full employment of resources is reached. As Harrod remarks this may be due to the temporary rise in the propensity to save above its normal level as a result of profit inflation.

(vi) Again, the floor or the lower limit comes into play because there is a maximum possible rate of disinvestment in fixed equipment which checks the downward movement from accelerating beyond a certain speed. Autonomous investment at the lower limit exerts an upward pressure which is stronger than the downward pressure of disinvestment, but the explanation of the lower turning point based on this principle is not convincing.

Further, Harrod doubts, whether autonomous investment is likely to be advancing at the bottom of the slump. Perhaps, the greater possibility is that a depression would retard rather than encourage autonomous investment. In his study of American business cycles in the 19th century, Rending’s Fels points out that revival was not due to the wearing out of excess capacity and upturn did not wait till induced investment was reduced to zero. In actual fact in many instances, expansion got up stream in spite of the existence of excess capacity.

(vii) Some critics of the theory have even doubted the validity of drawing a distinction between autonomous and induced investment. In the short period every investment, they maintain, is autonomous and in the long period much of autonomous investment, becomes induced. It has also been observed that of the same investment, as for instance, in plant and machinery, a part of the investment may be induced and a part may be of the autonomous type. The significance of this division is, therefore, questioned in empirical investigation as well as in the formulation of any theory.

(viii) Another weakness of Hicks’ theory is that the full employment ceiling as defined by him is independent of the path of output. It depends rather on the population growth, technological progress, etc. and is, thus, assumed to grow at the same rate as autonomous investment. But the full-employment level of output depends on the magnitude of the resources which are available to the economy.

The capital stock is one such source. This means that the ceiling is raised in any period during which the capital stock is increasing. Since the rate at which output increases determines the rate at which the capital stock changes, the ceiling level of output will vary depending upon the time path of output. It is not, therefore, possible to separate the long-run full-employment trend from what happens during a cycle.

(ix) Again, although, we find that Hicks started with the objective of combining trends with cycle, yet no satisfactory attempt is made to show how the forces, which account for fluctuations also account for economic expansion and growth. The accelerator by itself is weak to generate forces of growth. Prof. Hutt adds, “I maintain that we cannot find in the relation between demand for goods of lower order (consumption goods), and the demand for goods of a higher order (investment goods), an explanation of cyclical variation in the demand for growth. Nor can we find in those factors the source of great cyclical changes in entrepreneurial optimism affecting prospective yields, the rate of interest offered and the flow of savings. We cannot even observe those factors to be influenced which induce the cyclical withholding and release of capacity. In the study of all these issues, the relationship which the acceleration principle tries to express is wholly irrelevant.”

Thus, we find regarding the turning points of a trade cycle, no satisfactory explanation is yet available which is complete and free from controversy. Various viewpoints bring to the fore the main differences in emphasis among the varied factors which are at work to produce cyclical variations. A satisfactory theory, perhaps, would take into account all the complex forces and their role in generating a cycle.

According to Prof. Samuelson, “Both external or non-monetary and internal or monetary facts are important in explaining the business cycle.” Most economists would like to produce a synthesis of monetary and non-monetary cycle theories, which is a far cry, till such a general attempt is made business cycle may be regarded as a problem which still goes abegging.