Business Cycle/Trade Cycle – Meaning, Definitions, Features, Phases and Theories

2. The Monetary Overinvestment Theory

The theory has been presented by Prof Hayek. The industries fall under two categories , consumer goods industries and capital goods industries. According to this theory, there occurs an expansion in the economy when the expansion in the capital goods industry is greater than the expansion in the consumer goods industry. In a similar manner, there occurs a contraction in the economy when the contraction in the capital goods industry is greater than the contraction in the consumer goods industry. The growth of the consumer goods industries are dependent on the consumer’s demand. The demand for capital goods depends on the demand for consumer goods and is thus a derived demand. The capital goods industries reflect the demand for consumer goods.

Suppose the market rate of interest is lower than the natural rate of interest. This will lead to an increase in the demand for bank credit and hence there will be an increase in investment in the economy. The level of employment will increase and ultimately a full employment situation will be achieved. But to the full employment scenario, the expansion in the capital goods industry will involve a shift of factors from consumer goods industry to the capital goods industry. Hence, the expansion in the capital goods industry will be greater than the expansion in the consumer goods industry leading to an expansion in the economy.

With an expansion in the economy, the demand for consumer goods will increase leading to an increase in the price of these goods, which now overtakes the increase in the price of the capital goods. Thus, the profitability in the capital goods industry decreases when compared with that in the consumer goods industry. Hence, there is a shift in investment from the capital goods industry to the consumer goods industry. In addition, the contraction in the capital goods industry is greater than the contraction in the consumer goods industry. This results in a contraction in the economy, which will continue until steps are taken to revive the economy. According to the theory, fluctuations in economic activities are caused by overinvestment.

 Criticism

i. The theory presumes that when market rate of interest is lower than the natural rate ( which would equalize demand for and supply of funds), the new bank credit flows to the capital goods industries. This would apply only under the conditions of full employment . But, business cycles have taken place even when resources were not fully employed.

ii. The theory stresses upon the change in the interest rate as the main determinant of investment. It ignore many other important factors such as businessmen’s own expectations, cost of capital equipment etc.

iii. The monetary overinvestment theory lays undue attention on the imbalance between the investment in capital goods and consumer goods industries. In modern economy, such imbalances are self-correcting and do not create serious depression.

Business Cycle/Trade Cycle – Meaning, Definitions, Features, Phases and Theories

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