S.

S JAIN SUBODH LAW COLLEGE

Dr.Bhimrao Ambedkar Law University

2021-2022

SUBJECT - “Economics“

PROJECT ON

Keynes’s Theory of Business Cycle

SUBMITTED TO: SUBMITTED BY:

Mrs. Khushboo Rathore Prateek Rajpurohit

Assistant Professor Semester IV

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 DECLARATION

I Prateek Rajpurohit do here by declare that, this research project titled “Keynes’s Theory
of Business Cycle” is an outcome of the research conduct by me under the guidance of Mrs.
Khushboo Rathore Asst. Prof. at S.S Jain Subodh Law College in fulfilment for the award
of the degree of B.A LL.B at the. Dr. Bhimrao Ambedkar Law University. I also declare that
this work is original, except where assistance from other sources has been taken and
necessary acknowledgements for the same have been made at appropriate places.

(Prateek Rajpurohit)

B.A LL.B Sem IV

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 CERTIFICATE

This is to certify that Prateek Rajpurohit student of S.S JAIN SUBODH LAW COLLEGE
Affliated to Dr. Bhimrao Ambedkar Law University, Jaipur has completced his project on

“ Keynes’s Theory of Business Cycle ” under the supervision and guidance of supervisor
Mrs. Khushboo Rathore To best of my knowledge the report is original and not been copied
or submitted anywhere else. It is an independent work done by him.

Mrs. Khushboo Rathore

Assistant Professor

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 ACKNOWLEDGEMENT

When I embarked this project, it appeared to, as an onerous task. Slowly as I progressed,

I did realized that I was not alone after all.

I wish to express my gratitude to DR. ALPANA SHARMA, director, S.S. JAIN SUBODH
LAW COLLEGE FACULTY MEMBER, & Program coordinator who have extended their
kind help, guidance but also for the freedom she rendered me during this project work.

I’m deeply indebted to my guide Mrs. Khushboo Rathore for not only her valuable and
enlightened, guidance but also for the freedom she rendered me during this project work.

I’m thankful to my group member and other classmates, well-wishers who with their
magnanimous and generous help and support made it a relative easier affair. My heart goes
cut to my parents who bear with me all the trouble I caused them with smile during the entire
study period and beyond.

Prateek Rajpurohit

Student signature

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 CONTENTS

1. Introduction...……………..…………………………………………….06

2. Explanation of the Keynes’s Theory.……………………….....…..……07

3. The Critical Appraisal of Keynes’s Theory…...………...……..…....….12

4. Criticisms of Keynes’s Theory of Business Cycle ………….………….14

5. Bibliography ……………………………………………………………15

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 INTRODUCTION1

John Maynard Keynes was an British economist. He wrote book ‘General Theory of
Employment, Interest and Money’ in 1936.

According to Keynes’s theory, in the short run, the level of income, output or employment is
determined by the level of aggregate effective demand. In a free private enterprise, the
entrepreneurs will produce that much of goods as can be sold profitably. Now, if the
aggregate demand is large (if the expenditure on goods and services is large), the
entrepreneurs will be able to sell profitably a large quantity of goods and therefore they will
produce more. In order to produce more they will employ a larger amount of resources.

In short, a higher level of aggregate demand will result in greater output, income and
employment. On the other hand, if the level of aggregate demand is low, smaller amount of
goods and services can be sold profitably. This means, that the total quantity of national
output produced will be small. And a small output can be produced with a small amount of
resources. As a result, there will be unemployment of resources.

The changes in the level of aggregate effective demand will bring fluctuations in the level of
income, output and employment.

According to Keynes, the fluctuations in the economic activity are due to the fluctuations in
the aggregate effective demand. Fall in aggregate effective demand will creates the
conditions of recession or depression. If the aggregate demand is increasing, economic
expansion will take place.

1
https://www.libertarianism.org/media/around-web/business-cycles-explained-keynesian-theory

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 Explanation of the Keynes’s Theory2

Let’s start from the phase of economic expansion to explain Keynes’s theory of business
cycles.

We first explain how in Keynesian theory expansion comes to an end and recession sets in.

During an economic expansion two factors eventually work to cause investment to fall.

First, during the expansion phase increase in demand for capital goods due to large scale
investment activities leads to the rise in the prices of the capital goods. Higher prices of the
capital goods raise the cost of investment projects (cost of production) and reduces marginal
efficiency of capital (expected rate of return).

Secondly, as income rises during the expansion phase, the demand for money increases
which raises interest rate. Higher interest rate makes some potential, projects unprofitable.
This causes fall in marginal efficiency of capital on one hand and a rise in interest rate on the
other which in turn causes decline in investment demand. Declining trend of investment,
raises doubts about the prospective yield (profits) on capital goods which is more important
factor in determining marginal efficiency of capital (rate of return) than the cost of
investment projects and rate of interest.

When among businessmen pessimism sets in about future profitability of investment projects
stock prices tumble. The crash in stock prices worsens the situation and causes investment to
fall even more. Fall in prices of shares, reduces wealth of household.

Wealth according to Keynes is an important factor determining consumption. So the decline

in stock prices, reduces autonomous consumption demand of household with the fall in both
investment and consumption demand, aggregate demand declines, which result in
accumulation of unintended inventories, with the firms. This induces the firms to cut
production of goods.

2
https://www.imf.org/external/pubs/ft/fandd/2014/09/basics.htm

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Besides the rise in cost of capital goods and the rise in interest rate towards the end of the
expansion phase, it is the fall in expected prospective yields that reduces the marginal
efficiency of capital (rate of return) and causes investment demand to fall.

This induces a wave of pessimistic expectations among businessmen and speculators. These
pessimistic expectations, cause stock prices to tumble. They cause a further fall in the
marginal efficiency of capital. Turning Point from expansion to contraction is caused by a
sudden collapse in marginal efficiency of capital.

A sudden fall in the marginal efficiency of capital causes a leftward shift in the investment
demand curve.

Decrease in investment does not automatically decrease the rate of interest.

According to Keynes, a decrease in investment expenditure causes a decline in income,

which in turn reduces consumption expenditure. The reduction in consumption expenditure
further reduces income and the process of reduction in income continues further.

The total fall in income (change in income or ∆Y) due to an initial decline in investment (∆I)
will be equal to change in investment multiplied by the value of multiplier.

If Marginal Propensity to Consume is 0.75, the multiplier will be equal to four. Thus, a
decline in investment by 100 crores will lead to a decline in income by 400 crores.

The multiplier process magnifies the effect of decline in investment expenditure on aggregate
demand and income and further deepens the depression.

As income and output are falling rapidly under the multiplier effect, the employment also
goes down.

So, the Keynes theory of income multiplier plays and significant role in causing magnify the
changes in income, output and employment, following a reduction in investment.

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In Keynes’s views, wages and prices are not flexible enough to offset the decline in
investment expenditure, and restore full employment.

This is in sharp contrast to the classical theory, where changes in wages and prices ensures
continues full employment.

In Keynes model wages and prices are ‘sticky’ downward, which implies that through wages
and prices do not remain constant, But when demand falls wages and prices will fall, but not
sufficient to restore full employment in the economy.

Since wage and price flexibility does not ensure the recovery of the economy, out of the state
of depression. Keynes thinks that marginal efficiency of capital must rise to stimulate
investment.

During depression investment falls to a very low level capital stock begin to wear out, and
requires replacement, some existing capital equipment become technologically obsolete and
has to be abandoned. This generates demand for replacement investment. A long period of
time is necessary for existing capital to depreciate because most capital goods are durable, as
well as irreversible.

By durability of capital goods, mean that they last for a long time and by irreversibility,
mean, that they cannot be used for purposes other than those for which they are meant.

Collapse of marginal efficiency of capital is the main cause of upper turning point. Similarly,
the revival of the marginal efficiency of capital (rate of return) is the cause of lower turning
point which is recovery from the recession.

Restoration of Businessmen’s confidence is the most important, yet, the most difficult to
achieve. Even if the rate of interest is reduced, the investment will not increase. This is
because of the absence of confidence, that profitability in investment may remain so low that
reduction in the interest rate will stimulate investment.3

3
https://www.imf.org/external/pubs/ft/fandd/2014/09/basics.htm

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The interval between the upper turning point, and lower turning point is conditioned by two
factors.

1. The time necessity for wearing out of durable capital assets, and

2. The time required to absorb the excess stocks of goods left over from the boom.

As the stock of capital goods goes down, there grows a scarcity of capital goods, then the
expected rate of returns (profits) rises, which induces the businessmen to invest more. When
level of investment increases, income increases by a magnified amount due to the multiplier
effect.

Over time as depreciation of capital stock occurs, some existing capital equipment becomes
technologically obsolete, the size of capital stock declines. New investment must be
undertaken even to produce a reduced depression level of output.

Once investment increases, it induces further rise in income and consumption demand
through the multiplier process. Now, the multiplier works to magnify the effect of increase in
investment on raising aggregate demand. The businessmen becomes optimism, which
increases stock prices. All these factors increases the economic activity.

However, this recovery process takes a very long time. So, Keynes suggests that the
government should not wait for long for the natural recovery to occur. He advocated for the
active intervention by the government to raise aggregate through fiscal policy (that is
increasing its expenditure or reducing taxes).

He argued for the adoption of policy of deficit budget to boost aggregate demand, and lift the
economy out of recession or depression.

Keynes business cycle theory is self generating. In it the economy passes through a long
phase of expansion, but eventually some forces automatically work, for example, the growing
abundance of capital stock, which reduces marginal efficiency of capital. Pessimism which
overtakes businessmen. This causes a reduction in investment, which is responsible for
bringing downswing in the economy.

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The idea that it is the fluctuations in investment that brings about the fluctuations in the level
of economic activity, is an important contribution, made by Keynes.

Keynes provided a definite relationship between a change in investment and the resulting
change in income and employment, this relationship is given in his theory of multiplier.4

4
https://www.imf.org/external/pubs/ft/fandd/2014/09/basics.htm

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 The Critical Appraisal of Keynes’s Theory5

Keynes has made three important contributions to the business cycle theory.

First, it is fluctuations in investment in that cause changes in aggregate demand, which bring
changes in economic activity (income output and employment).

Secondly, fluctuations in investment demand are caused by changes in expectations of

businessmen. Regarding making a profits (marginal efficiency of capital, or the rate of
return).

Thirdly, Keynes put forward an important theory of multiplier which tells us how changes in
investment, bring magnified changes in the level of income and employment.

But, Kingston’s theory of multiplayer alone does not offer a full and satisfactory explanation
of cycles, a basic feature of the cycles is its cumulative character, both in upswing and
downswing. That is, once economic activity starts rising or falling, It gathers momentum for
a time.

So, what we have to explain is the cumulative character of economic fluctuations. The theory
of multiplayer alone does not gives adequate explanation for this.

For example, suppose that investment raises by 100, rupees, and that the magnitude of
multiplayer is 4, from the theory of multiplayer, that national income will arise by 400. And
if multiplayer is the only force at work, that will be the end of the matter, with the economy
reaching a new stable equilibrium at a higher level of national income. But in real life this is
not likely to be so, for a rise in income produced by a given rise in investment will have
further repercussions in the economy. This reaction is described in the principle of the
accelerator.

5
https://ecoaim.in/2020/05/10/keyness-theory-of-business-cycles/

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According to the principle of acceleration, a change in national income will tend to induce
changes in the rate of investment.

While multiplier refers to the change in income as a result of change in investment, the
acceleration principle describes the relationship between a change in investment, as a result
of change in income.

In the above example, an income has risen in by 400 rupees, people spending power has risen
by an equivalent amount. This will induce them to spend more on goods and services. When
the demand for the goods rises, initially, this will be met by overworking the existing plant
and machinery. All this leads to an increase in profits with the result that businessman will be
induced to expand their productive capacity and install new plants.

They will invest more than before, which will income which in turn will lead to a further
induced increase in investment. The accelerator describes this relation between an increase in
income and the resulting increase in investment.6

6
https://ecoaim.in/2020/05/10/keyness-theory-of-business-cycles/

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 Criticisms of Keynes’s Theory of Business Cycle7

Keynes’ theory is not free from defects. Its main weaknesses are listed below:

1. Keynes based his theory only on internal causes of a trade cycle. Moreover, he has
developed his explanation with the help of multiplier principle alone. He has ignored
induced investment and the acceleration effect. A complete explanation of a trade
cycle must consider external causes of a trade cycle and the role of the accelerator in
causing investment and income fluctuations.

2. Keynes has not explained clearly the determinants of ‘marginal efficiency of capital’
which influence the investment decisions of entrepreneurs.

3. Keynes does not attach due importance to the rate of interest. He considers the rate of
interest only as an item of the cost of production of goods. He, on the other hand,
holds that rate of interest does not exercise any influence on investment decisions.

4. The periodical aspect or the phases of the business cycle is left in darkness in Keynes’
theory. Keynes has mainly discussed the problems of economic depression, with
which he was primarily concerned.

5. Borrowing causes higher interest rates and financial crowding out. Keynesian
economics advocated increasing a budget deficit in a recession. However, it is argued
this causes crowding out. For a government to borrow more, the interest rate on bonds
rises. With higher interest rates, this discourages investment by the private sector.

6. Resource crowding out. If the government borrows to finance higher investment, the
government is borrowing from the private sector and therefore, the private sector has
fewer resources to finance private sector investment.

7. Inflation. A problem of fiscal expansion is that it often comes too late when economy
is recovering anyway and therefore, it causes inflation.

7
https://www.economicshelp.org/blog/glossary/criticism-keynesianism/

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 BIBLIOGRAPHY

1. Abel, A. B. & B. S. Bernanke (2006). Macroeconomics, Pearson, Delhi.

2. Begg, D., S. Fisher & R. Dornbusch (1994). Economics, McGraw-Hill, Berkshire.

3. Shapiro, E. (2005). Macroeconomic Analysis, Galgotia, New Delhi.

4. Bortz, P. G. 2017. “The road they share: the social conflict element in Marx,
Keynes and Kalecki.” Review of Keynesian Economics 5(4): 563–75.

5. Hirai, T. 2008. Keynes’s Theoretical Development. From the Tract to the General
Theory. London: Routledge.

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