Business Cycle Theories
There are many schools of economic thought-classical, monetarists, Keynesian and others- who accept that in a market economy business cycle is a reality. However, the explanation given to these cycles differ depending on their perception of the working of the market. Hence, the solution to these business cycles and the stabilization policies will vary.
Some of these business cycle theories are explained below:
1. The Pure Monetary Theory
2. The Monetary Overinvestment Theory
3. The Non-monetary Overtime Theory
4. Innovation Theory
5. Psychological Theory
7. Cobweb model or Cobweb theory
8. Multiplier-Accelerator Interaction theory
9. Samuelson’s Model
10. Hicksian Theory of trade cycle
1. The Pure Monetary Theory
The early business cycle theorists lay major emphasis on the monetary and credit system in their analysis of business cycle. Their theories of business cycle are, therefore, jointly known as monetary theory of business cycle. According to this theory, the main cause of business fluctuation is the unstable monetary and credit system. The fluctuation in the supply of money and bank credit is the basic casual factor at work in the cyclical process. Hawtrey, the main proponent of this theory, maintains that business cycles are nothing but successive phases of inflation and deflation. According to him, all changes in the levels of economic activities are only reflections of changes in money flows. When money supply expands, prices rise, profits increase and the total output increase. When money supply falls, prices decrease, profits decrease, production activities become sluggish and production falls. Briefly speaking, Hawtrey relies implicitly on the quantity theory of money for explaining the price behavior.
According to Hawtrey, the principal factor affecting the money supply is the credit mechanism. An upswing is caused when there is an expansion in the bank credit. The conditions in the economy are conductive for credit creation. The rates at which the loans are offered are low. Thus, firms borrow from the banks and increase their investments leading to capital formation. There is an increase in the profits of business. The expansion of bank credit continues leading to an economic prosperity, thus sustaining the upswing.
A downswing is caused when there is a reversal and banks put on hold the expansion in the bank credit. Thus, firms find it difficult to borrow from the banks. They cut back on their investments. The expansion in economic activity slows down.
i. One of the shortcomings of the pure monetary theory is that in its explanation of business cycles it lays too much emphasis on the monetary factors. Non-monetary factors such as business expectations, demand for new investments and costs also play a very crucial role in business cycles.
ii. Inspite of the fact that monetary factors play an important role in the cumulative process of expansion and contraction they do not fully explain the turning points. At turning points, non-monetary factors have been found to have played a major role.
iii. Monetary theorists conviction that businessmen are highly sensitive to the changes in interest rates is highly doubtful. A more important factor in business decisions are future business prospects and the marginal efficiency of capital.
In spite of these shortcomings, the pure monetary theory of business cycles has been regarded as a sound reasoning and logical explanation of economic fluctuations.