Over-Investment Theory of Business Cycle | Firm

In this article we will discuss about the over-investment theory of business cycle. Also learn about the criticisms of the theory.

A major variant of the pure monetary theory of the business cycle is the over-investment theory developed by Prof. V. Hayek. According to him, the over-issue of bank credit at artificially low interest rates is responsible for causing fluctuations in the level of economic activity.

Following Knit Wicksell, Hayek draws a distinction between the natural rate of interest and market rate of interest. So, long as the market or actual rate coincides with the natural or expected rate of interest the economy operates smoothly and remains in a state of equilibrium.

However, a discrepancy between the two creates problems. When, for instance, the market rate of interest is less than its natural rate, the demand for funds for purpose of investment will surely exceed the available supply of savings.

Consequently, the gap between the demand for and the supply of savings will have to be bridged by the required expansion of bank credit. The additional bank credit will add to the stock of money in circulation. This, in its turn, will raise the price level resulting in inflation or boom.

On the other hand, if the market rate of interest exceeds the natural rate, the demand for funds for investment purposes will now be less than the available supply of savings. The demand for and supply of bank credit will fall. Consequently, there will be a corresponding fall in the stock of money in circulation, which, in its turn, will lead to a fall in the general price level, resulting in depression.

According to Hayek’s theory, the business cycle would not occur if the demand for funds for investment was totally financed by voluntary savings, i.e., if commercial banks took care not to expand credit to meet the demand for investment funds. It was the over-expansion of bank credit which led to over-investment and the resulting business fluctuations in the economy.

Criticisms:

Hayek also falls to provide a comprehensive explanation of business cycles. He completely ignores non-monetary factors which are equally important in causing business cycles. Thus, this theory is, at best, incomplete.