SEBI Gr A 2020

Economics
Phase
1&2
Business Cycles – Old Theories

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 Theories of Business Cycles

What causes business cycles?

▪ Several theories of business cycles have been propounded from time to time.
▪ Each of these theories spells out the factors which cause business cycles.

▪ Before explaining the modern theories of business cycles, first we will understand
the earlier theories of business cycles as they too contain important elements whose
study is essential for proper understanding of the causes of business cycles.

Earlier theories of business cycles:

❑ Sun-Spot Theory
❑ Hawtrey’s Monetary Theory of Business Cycles
❑ Under-Consumption Theory
❑ Over-Investment Theory
▪ Hayek’s Monetary Version of Over-investment Theory
▪ Wicksell’s Over-investment Theory
➢ Sun-spot theory
▪ This is perhaps’ the oldest theory of business cycles.
▪ This theory was developed in 1875 by Stanley Jevons.

Why it is named as Sun-spot theory?

▪ 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.
Critical Appraisal

▪ Though the theories of business cycles which emphasise 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.

▪ But, they do not offer an adequate explanation of business cycles.

▪ Therefore, much reliance is not placed on these theories by modern economists.

▪ Also, the climate theory does not adequately explain periodicity of the trade cycle.
▪ If there was truth in the climatic theories, the trades 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.
Earlier theories of business cycles:
Sun-Spot Theory

Hawtrey’s Monetary Theory of Business

Cycles

Under-Consumption Theory

Over-Investment Theory
▪ Hayek’s Monetary Version of Over-
investment Theory
▪ Wicksell’s Over-investment Theory
➢ 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.

What does that mean?

▪ 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, by 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
induce 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 cause prices to rise.
 More Imports of a
Rise in income
expenditure on country
during Trade Deficit
domestic and increase more
expansion phase
import of goods than its exports

Outflow of gold
Outflow of gold
Reduce the to settle its
Rate of interest will cause
availability of balance of
will rise reduction in
bank credit payments
money supply
deficit.

Reduce
The process of
investment in
contraction
physical
will set in
capital goods
 Lower income
Reduced
and
Reduced order Producers will demand for
consumption of
for inventories cut production goods and
goods and
services
services

Traders will cut

Businessmen
People to hold order of goods
begin to expect Prices of goods
larger money still causing
that they will will fall
holdings further fall in
fall further
output

Demand for
Economy
goods start
plunges into
declining
depression
faster
▪ But after a lapse of sometime 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.
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 modern 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.
Earlier theories of business cycles:
Sun-Spot Theory

Hawtrey’s Monetary Theory of Business

Cycles

Under-Consumption Theory

Over-Investment Theory
▪ Hayek’s Monetary Version of Over-
investment Theory
▪ Wicksell’s Over-investment Theory
➢ Under-Consumption Theory

▪ Under-Consumption theory was given by John A. Hobson in his Industrial System

(1910).

▪ 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 due to lack of consumption demand for

them.
▪ According to them, this over-production causes piling up of inventories of goods
which results in recession.

▪ Under-consumption theory 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 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.
▪ Although workers have a strong propensity to consume they do not have adequate
purchasing power to buy the goods produced by the expanding business firms.

▪ 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
that is, in the expansion process saving increases and therefore consumption
demand declines.
▪ Increase in savings → More Investment Expenditure on capital goods →
Capital goods stock will increase → Production of goods and services will
increase
▪ But since society’s propensity to consume falls → Consumption demand is not
enough to absorb 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 bring 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

▪ Karl Marx 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 over-production.
▪ 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.

▪ With the discovery of new methods of production of

finding new markets, the economy recovers from
depression and the new 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 economies 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.

▪ 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.
Earlier theories of business cycles:
Sun-Spot Theory

Hawtrey’s Monetary Theory of Business

Cycles

Under-Consumption Theory

Over-Investment Theory
▪ Hayek’s Monetary Version of Over-
investment Theory
▪ Wicksell’s Over-investment Theory
➢ Over Investment Theory

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 emphasizes monetary forces in causing fluctuations
in investment.
▪ The second version of over-investment theory has been developed by Knut
Wickshell which emphasizes 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.
What is Natural rate of interest?
▪ It is defined as the rate at which saving equal’s investment and this equilibrium
interest rate reflects marginal revenue product of capital or rate of return on capital.
▪ This is the interest rate which causes neither overheating (boom) or lack of demand
(recession).

What is Money rate of interest?

▪ It 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

▪ Let us assume that the economy is in recession and businessmen’s demand for bank
credit is therefore very low.

▪ 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.
Bank credit at lower rate of investment → induces them to invest more by
undertaking new investment projects → 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 → Rise in Income and Employment → More

Consumption Expenditure → Production of Consumer goods increases

The competition between capital goods and consumer goods industries for scarce
resources causes their prices to rise which in turn push 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 forces the banks not to give further loans for
investment.
▪ Thus, the money rate of interest will go above the natural rate of interest.

▪ When no more bank credit is available for investment, there is decline in

investment which causes both income and consumption to fall.

▪ In this way expansion comes to an end and the economy experiences downswing
in economic activity.
 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 make some

investment projects profitable by either reducing cost or raising demand for the
products.

▪ 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.
Critical 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.

▪ 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.

Happy Learning!