The Product Life Cycle Theory is an economic theory that was developed by Raymond Vernon in response to the failure of the Heckscher-Ohlin model to explain the observed pattern of international trade.The theory suggests that early in a product's life-cycle all the parts and labor associated with that product come from the area where it was invented. Firstly, according to Keynes the main cause for trade cycle is the fluctuations in MEC. 7. Hayek’s theory is incomplete because it does not explain the various phases of trade cycle. Through international trade, booms and depressions in one country are passed to other countries. (4) The economy cannot expand beyond the full employment level of output. A trade cycle is asymmetrical. Increase in the supply of goods and decline in the demand create under consumption and hence over production. Thus Prof. Robertson has successfully combined real and monetary factors to explain business cycle. Further this theory fails to explain the periodicity of trade cycle. Unlike the sudden collapse of the economic system, the revival takes time. The theory views business cycles as the consequence of excessive growth in bank credit due to artificially low interest rates set by a central bank or fractional reserve banks. Drawback• Based on only agro based theory• Good or bad crop can only be one factor of depression or expansion but they cannot account for all the features• The trade cycle occur at regular intervals of 10.4 years, while length of the trade cycle is 7 to 8 years 13. 4. (iii) Changes in the stock of money have been attributed to a specific variety of exogenous factors rather than to changes in economic activity. Schumpeter’s theory has been criticised on the following grounds. Over investment is due to indivisibility of investment and excess supply of bank credit. 7. Suppose the central bank increases the stock of money in the market by open market operations by purchasing securities. This suggest… According to Keynes, the carrying cost of surplus stocks during the depression is seldom less than 10 per cent per annum. If resources remain unutilized, the expansion of both the capital goods sector and consumer goods sector may occur simultaneously. It results in depression. These conditions lead to recession. Hicks writes in this connection: “I shall follow Keynes in assuming that there is some point at which output becomes inelastic in response to an increase in effective demand.” Thus certain bottlenecks of supply emerge which prevent output from reaching the peak and instead encounter the ceiling at P1. (2) Monetary Changes not the Main Cause of Business Cycles: According to this theory, monetary changes are the main cause of business cycles. Hicks begins from a cycle less situation PQ on the equilibrium path EE when an increase in the rate of autonomous investment leads to an upward movement in income. 2. Over-Saving or Under Consumption Theory: This theory is the oldest explanation of the cyclical fluctuations. They adopt capital-intensive methods for producing more of capital goods. But more factors cannot be used in the consumer goods sector as compared to the capital goods sector. Von Hayek in his books on “Monetary Theory and Trade Cycle” and “Prices and Production” has developed a theory of trade cycle. The process of expansion goes on till the boom is reached. Economics, Monetary Economics, Capitalism, Trade Cycle, Theories, Theories of Trade Cycle. According to Hicks, it is autonomous investment that brings a gradual movement towards the floor and it is again increase in autonomous investment at the bottom that leads to the lower turning point. There may be scarcity of labour, raw material and other factors of production. All the sections of the people suffer. Report a Violation 11. Keynes doesn’t develop a complete and pure theory of trade cycles. Momentum effect. It is not easy to transfer resources from capital goods industries to consumer goods industries and vice versa. It is the money stock itself that shows a consistent cyclical behaviour which is closely related to the cyclical movements in economic activity at large. Thus, the variations in climate are so regular that depression is followed by prosperity. MEC increases leading to recovery. Recovery: In the early period of recovery, entrepreneurs increase the level of investment which in … On the other hand, a decline in MEC leads to unemployment and fall in income and output. Hawtrey believes that expansion and contraction of money are the basic causes of trade cycle. Thus revival starts, becomes cumulative and leads to boom. Trade cycles in the economy are caused by inequality between market and natural interest rates. The MEC (marginal efficiency of capital) depends on the supply price of capital assets and their prospective yield. The expansion phase of the trade cycle starts when banks increase credit facilities. Its first impact is on the financial markets where first bonds, then equities and only later on payments for real resources will be affected. Such persons were to be found in the 18th and 19th centuries who made innovations. But it has failed to explain revival. Bank credit plays an important role in business activity. But this does not happen because of the upper limit or ceiling set by the full employment level FF. 5. In recent years, all firms resort to plough back of profits for expansion. Initially, the rise in the growth rate of the money stock occurs early in the contraction phase. Keynes, thus, has given a satisfactory explanation of the turning points of the trade cycle, “Keynes consumption function filled a serious gap and corrected a serious error in the previous theory of the business cycle”. He has ignored real factors. The latter curtail their productive activities due to fall in demand. Secondly, Keynes assumes that rate of interest is stable. Hicks’ theory of trade cycle: Prof Hicks explains the phenomenon of trade cycles by combining the … The rate of decrease in the accelerator is limited by the rate of depreciation in the downswing. He explained his theory on the basis of Wicksell’s distinction between the natural interest rate and the market interest rate. F.A. Profits decline. On the other hand, if traders finance their stocks with their own funds, interest rate changes will have little effect on their purchases. A vicious circle is set up, a cumulative expansion of productive activity.”. Low interest rate induces producers to get more loans from banks. According to Schumpeter, innovations in the structure of an economy are the source of economic fluctuations. This state of recession ends in depression. 6. 2. According to them, substantial expansions in the quantity of money over short periods have been a major proximate source of the accompanying inflation of prices. Account Disable 12. Some of the points of criticism are discussed below: None can deny that expansion of credit leads to the expansion of business activity. For this, they place larger orders with producers who, in turn, employ more factors of production to meet the increasing demand. But they are accentuated by bank credit. Another factor is the export of gold to other countries when imports exceed exports as a result of high prices of domestic goods. Over investment and overproduction are encouraged by monetary factors. This increases or decreases the flow of money in the economy and thus brings about prosperity or depression. There are no savings and investments. Hence this distinction between autonomous and induced investment is of doubtful validity in practice. are falling. Consequently, money incomes of the owners of factors of production increase, thereby increasing expenditure on goods. Since autonomous investment is taking place, the fall in output is much gradual and the slump much longer than the boom, as indicated by Q1Q2. Friedman’s Theory 6. Banks may stop their loans. The upward phase of a trade cycle, such as revival, prosperity and boom is brought about by an expansion of money and bank credit and also by increase in circulation of money supply. Generally, a trade cycle is composed of four phases – depression, recovery, prosperity and recession. Prosperity: It is a state of affairs in which real income and employment are high. In the Hicksian theory, the accelerator is based on induced investment which along with the multiplier brings about an upturn. Hence there is a smaller amplitude of resulting fluctuations. Production process being small and labour-intensive, the demand for money is reduced, which increases the market interest rate which is more than the natural interest rate. Credit expansion and contraction do not lead to boom and depression. As the process of expansion continues, cost of production increases, due to scarcity of factors of production. This extension of cycle is followed by a period of revival which continues till the equilibrium level is reached. This made his theory one-sided because his explanation centres round the principle of multiplier. Share Your PDF File But in reality, business cycles are the result of the other exogenous factors like innovations. The merit of Keynes’ theory lies in explaining the turning points-the lower and upper turning points of a trade cycle. Non-Monetary Theories of Trade Cycle: 1. The following points highlight the top eight theories of business cycle. In such a situation, the demand for investment funds is more than the supply of available savings. As pointed out by Pigou, “Variations in the bank money supply is a part of the business cycle, it is not the cause of it.” At the bottom of the depression, credit is easily available. (g) Theory of Interaction Between Multiplier and Accelerator: Theory of Interaction Between Multiplier and Accelerator: The Keynes theory has ignored the acceleration effect on trade cycle. The theory exaggerates the importance of bank credit as a means of financing development. Hicksian Theory of Trade Cycle Definition: Hicksian Theory of Trade Cycle was proposed by Hicks, who considered Samuelson’s multiplier-accelerator interaction theory and Harrod-Domar growth model in combination to explain his theory of the trade cycle. (3) Interest Rate not the only Determinant: Hayek assumes changes in the rate of interest as the cause of fluctuations in the economy. The MEC, in turn, determines the rate of investment. When there is crop failure, that will result in depression. above video is explains you trade cycle. Price is low leading to a fall in profit, interest and wages. 1. The constancy of the accelerator presupposes a constant capital-output ratio. But in the long run when the need for capital funds is much greater, bank credit is insufficient. The accelerator is defined by Hicks as the ratio of induced investment to the increase in income. Banks reduce their loans and advances. Once the original innovation becomes successful and profitable, other entrepreneurs follow it in “swarm-like clusters.” Innovation in one field induces innovations in related fields. For this, they pay higher remuneration to factors of production in comparison with the producers of capital goods. Consequently, the natural interest rate falls. These theories can be classified into non-monetary and monetary theories. (1) Overemphasis on the Role of Expectations: Keynes has been criticised for his analysis of business cycle based on expectations. As a matter of fact, factors other than the rate of interest are more important in influencing such decisions. (5) The working of the accelerator in the downswing provides an indirect restraint on the downward movement of the economy. Product innovation and diffusion influence long-term patterns of international trade. As a result, there will be a diversion of resources from consumption goods industries to capital goods industries. It affects different industries in different ways. According to Hart, Keynes relied on “convention” for forecasting changes in business expectations. To date regionalization has not generated significant reverse exports to Japan, as the product cycle theory predicts; rather, it has led to trade triangles in which technology and components are sourced from Japan while the finished products are exported to third-country markets, principally to the United States and Western Europe. When the capital stock is increasing during any period, the ceiling is raised. Content Filtration 6. According to Schumpeter, a reservoir of untapped technical knowledge exists in a capitalist society which he can make use of. Hawtrey, “The trade cycle is a purely monetary phenomenon.” It is changes in the flow of monetary demand on the part of businessmen that lead to prosperity and depression in the economy. The greater stability of the “money multiplier” in contrast to the Keynesian investment multiplier has led Friedman and Schwartz to come to the above conclusion. There are idle resources. Prof. Strigl has criticised this theory for giving undue importance to forced savings. On the contrary, when the market interest rate is more than the natural rate, the economy is in depression. In addition, there may be an endogenous cycle. According to Keynes, effective demand is composed of consumption and investment expenditure. It is in this way that the cyclical process will be repeated in the economy. At … Trade cycle is a complex phenomenon and it cannot be associated with climatic conditions. #Trade_Cycle_theory_by_Samuelson, व्यापार चक्रो का सिद्धांत:सेम्यूल्सन, Samuelson Trade Cycle theory - Duration: 17:19. This causes an increase in money supply and rise in price leading to expansion. Thus the second approximation of Schumpeter’s theory of trade cycle develops into a four phase cycle with the recession which was the second phase in the first approximation continuing downward to give the depression phase. Share Your Word File Since investment in an innovation is risky, he must pay interest on it with his newly acquired funds, the innovator starts bidding away resources from other industries. The result will be a damped cycle. According to Hazlitt, the term MEC being vague and ambiguous, “Keynes’ explanation of the crisis of the marginal efficiency of capital is either a useless truism or an obvious error.”, Another weakness of Keynes’ theory of the trade cycle is that some of its variables such as expectations, MEC and investment cannot explain the different phases of the cycle. The theory presents an insightful analysis as to why in the twentieth century a large number of new products in the world were developed by the US firms and sold first in the US market. Our mission is to provide an online platform to help students to discuss anything and everything about Economics. It is based on Say’s law of markets. According to this theory, prosperity begins when the market rate of interest is less than the natural rate of interest. When there is positive economic growth, this tends to cause: 1. There is rise in wages, prices, profits and interest. Uploader Agreement. Incomes fall. 1. Investment plays a leading role based on formula rather than on judgement. 3. Business cycle is recurrent and rhythmic; prosperity is followed by depression and vice versa. Thus it can be said in Fisher’s words that the cycle is largely a “dance of the dollar”. This has the effect of increasing the prices of capital goods in comparison to consumer goods. Spiethoff has pointed out that over investment is the cause for trade cycle. The product life cycle theory is used to comprehend and analyze various maturity stages of products and industries. The amplitude of economic fluctuations depends: First, on the amplitude, time pattern, number and independence of the disturbances affecting the economic system. He bases his model on the saving-investment relation, the acceleration principle and Harrod’s notion of the cycle as a problem of an expanding economy. Marginal efficiency of capital depends on two factors – prospective yield and supply price of the capital asset. Firstly, Schumpter’s theory is based on two assumptions viz., full employment and that innovation is being financed by banks. The natural rate of interest is that rate at which the demand for loanable funds equals the supply of voluntary savings. Money incomes increase. Contraction Phase not longer than Expansion Phase: Hicks has been criticised for asserting that the contraction phase is longer than expansion phase of trade cycle. Every increase in investment leads to a multiple increase in income via the multiplier effect. The induced investment, on the other hand, is dependent on changes in the level of output. A reduction of rate of interest by the banking institutions would enthuse the businessmen to borrow more and more and ex… Thus Keynes’ theory is not much different from Pigou’s psychological theory of the trade cycle. As a result, the growth of output and income propelled by the combined operation of the multiplier and accelerator moves the economy on to the upward expansion path from Po to P1. Employment and income of the factors of production in capital goods industries will increase. 3. It is wrong to say that banks alone cause business cycle. Keynes’s theory of the trade cycle is superior to the earlier theories because “it is more than a theory of the business cycle in the sense that it offers a general explanation of the level of employment, quite independently of the cyclical nature of changes in employment.” However, critics are not lacking in pointing out its weakness. The commercial banks will create more money with increase in their reserves, thereby transmitting the increase in high-powered stock of money. With the increase in the purchasing power of consumers, the demand for the products of old industries increases in relation to supply. Joseph A. Schumpeter has developed innovation theory of trade cycles. Demand for commodities go up. First, as more capital goods are being produced steadily, the current yield on them declines. “The time which must elapse before recovery begins, depends partly upon the magnitude of the normal rate of growth of the economy and partly upon the length of life of capital goods. Forced savings increase with the fall in consumption which are invested for the production of capital goods. They begin their explanation of the transmission mechanism with a state of moving equilibrium in which real per capita income, the stock of money, and the price level are changing at constant annual rates. Sunspot Theory or Climatic Theory: It is the oldest theory of trade cycle. With low profits and reduction in loans, producers reduce the production of capital goods and adopt labour-intensive production processes. It gives too much importance to rate of interest in determining investment. Harrod doubts the contention that autonomous investment would be increasing at the bottom of the depression. Looks at how this theory can be applied to international trade especially with regard to competition in the form of … The economy starts at the equilibrium state, rises to a peak and then starts downward into a recession and continues till the new equilibrium is reached. Therefore, changes in total expenditure i.e., consumption and investment expenditures, affect effective demand and this will bring about fluctuation in economic activity. Line AA shows the path of autonomous investment growing at a constant rate. The process of contraction becomes cumulative leading to depression. Therefore, it may be stated that banking system cannot originate a trade cycle. Further innovation is usually financed by the promoters and not by banks. This sets the process of falling prices. Ceiling fails to explain adequately the onset of Depression: Hicks has been criticised for his explanation of the ceiling or the upper limit of the cycle. Trade cycle is one of the important part of macroeconomics. According to this theory, trade cycle is result of the interaction between multiplier and accelerator. Over-optimism and speculation add further to the boom. Content Guidelines 2. But fluctuations in inventory investment can at best produce minor cycles which are not cycles in the true sense of the term. Thus the entire process becomes cumulative and the economy is forced into depression. Hence it is a function of the growth rate of the economy. At best, it can create conditions for that. Disclaimer Copyright, Share Your Knowledge Prof. Hawtrey considers trade cycle to be a purely monetary phenomenon. Bank credit may be important in the short run when industrial concerns get credit facilities from banks. When the economy hits the full employment ceiling at P1 it will creep along the ceiling for a period of time to P2 and the downward swing will not start immediately. Even though the bank rate is very low, there is “credit deadlock” which prevents businessmen to borrow from banks due to pessimism in economic activity. In order to repay the loans, the borrowers sell their stocks. In this article we will discuss about Trade Cycle:- 1. Line FF is the full employment ceiling level above the equilibrium path EE and is growing at the constant rate of autonomous investment. At this time, banks will decide to reduce credit expansion. This theory is not free from criticism. There has been strong secular changes in the money stock over these decades. According to Hawtrey, “Increased activity means increased demand, and increased demand means increased activity. According to Keynes, “A trade cycle is composed of periods of good trade characterised by rising prices and low unemployment percentages altering with periods of bad trade characterised by falling prices and high unemployment percentages”. Shortage of resources cannot bring a sudden decline in investment and thus cause a depression. Growth not Dependent only on changes in Autonomous Investment: Another weakness of the Hicksian model is that growth is made dependent upon changes in autonomous investment. According to him, when people with fixed incomes reduce their consumption with the increase in prices and the high income groups also reduce their consumption to the same extent, savings will not be forced but voluntary. This will bid up prices of such assets. However, these boom conditions cannot last long because the forces of expansion are very weak. These innovations may reduce the cost of production and may shift the demand curve. Suppose, at the full employment level, an innovation in the form of a new product has been introduced. A rise in consumer and business confidence 2. The ingredients of Hicks’s theory of trade cycle are warranted rate of growth, consumption function, autonomous investment, an induced investment function, and multiplier-accelerator relation. In fact, causation also has run in other direction. Trade Cycle Theory: Goodwin, Kalecki and Phillips. (5) Investment does not fall with Increase in Consumer Goods: Hayek argues that with the production of consumer goods and the increase in profits from them, investment falls in capital goods. Induced by high profits, they try to produce more. MEC depends on the expectations of the entrepreneur about future. It is associated with W.S.Jevons and later on developed by H.C.Moore. 4. So for a few years, disinvestment in stocks will continue till the surplus stocks are exhausted. The reliance on the conventional hypothesis makes Keynes’ concept of expectations superfluous and unrealistic. In reality, there is no full employment of resources. The demand for investment funds is met by the increase in the supply of money. Hicks has also been criticised for assuming a constant value of the accelerator during the different phases of the cycle. Business expansion stops. Business expands; factors of production are fully employed; price increases further, resulting in boom conditions. This leads to a cumulative decline in employment and income via the reverse operation of the multiplier. 6. The Hicksian theory of the business cycle has been severely criticised by Duesenberry, Smithies and others on the following grounds: Hicks’s model assumes that the value of the multiplier remains constant during the different phases of the trade cycle. Many economists do not know what the theory is, and many are sure that the theory is fundamentally wrong-headed. Surplus stocks of goods are exhausted. (2) Unrealistic Assumption of Equilibrium: The assumption of this theory that in the beginning savings and investment are in equilibrium in the economy and the banking system destroys this equilibrium is unrealistic. During the expansion phase, the MEC is high. Explanation of Floor and Lower Turning Point not Convincing: Hicks’s explanation of the floor and of the lower turning point is not convincing. On the other hand, the non-bank holders of cash will seek to purchase other categories of securities such as high-risk fixed coupons, equities, real property, etc. In such a situation, there is no need of transferring resources from one sector to the other. On the other hand, if the spot did not appear on the sun, rainfall is good leading to prosperity. 2. It is the introduction of a new product and the continual improvements in the existing ones that are the principal causes of business cycles. According to him, Keynes makes no attempt to test any of his deductions with facts. A high rate of interest will not prevent the people to borrow. Thus it is a mechanical sort of explanation in which human judgement, business expectations and decisions play little or no part. The earlier economists considered the changes in the amount of credit given by banking system to be responsible for cyclical fluctuations. 3. About the causal relation between the money stock and economic activity, they make the following generalisations: (i) Changes in economic activity have always been accompanied by changes in the money stock; (ii) There have not been major changes in the money stock that have not been accompanied by changes in economic activity; and. Schumpeter’s Innovations Theory 4. These, in turn, lead to reduction in the demand for factors of production. Market rate of interest is one at which demand for and supply of money are equal. Since full employment is an exception rather than the rule. At this time, the banks call off loans from the borrowers. Similarly, it reaches its trough before the ‘reference’ trough. J.R. Hicks in his book A Contribution to the Theory of the Trade Cycle builds his theory of business cycle around the principle of the multiplier-accelerator interaction. According to Hayek, when the prices of factors are rising continuously, the rise in production costs bring fall in profits of producers. Mechanical Explanation of Trade Cycle: Another serious limitation of the theory is that it presents a mechanical explanation of the trade cycle. Hicks’s Theory. Schumpeter’s approach involves the development of his model into two stages. LL is the lower equilibrium path of output representing the floor or ‘slump equilibrium line’. Further, it is also possible, as pointed out by Schumpeter, that autonomous investment may itself be subject to fluctuations due to a technological innovation. A rise in demand raises prices. But for Keynes, the change in consumption function with its effect on MEC is responsible for trade cycle. The merchants find their stocks being exhausted. One cannot therefore separate the long-run full employment trend from what happens during a cycle.”. Prices and cost of production of goods start declining until recession sets in. A boom occurs when real national output is rising at a rate faster than the trend rate of growth. The business cycle moves about the line. Employment, output and income fall resulting in depression. The monetary over-investment theory of Hayek has been criticised on the following counts: (1) Narrow Assumption of Full Employment: This theory is based on the assumption of full employment according to which capital goods are produced by reducing consumer goods. 4. EE is the equilibrium level of output which depends on AA and is deduced from it by the application of the multiplier accelerator interaction to it. But it is not free from certain criticisms. Lundberg, therefore, suggests that the assumption of constancy in accelerator should be abandoned for a realistic approach to the understanding of trade cycles. (5) Factors other than Interest Rate More Important: It is an exaggeration to say that the decisions of traders regarding accumulation or depletion of stocks are solely governed by changes in interest rate. The innovations theory of trade cycles is associated with the name of Joseph Schumpeter. 5. This theory does not explain all the phases of trade cycle. According to Dernburg and McDougall, the full employment level depends on the magnitude of the resources that are available to the country. In it, he takes the time to dismember opposing monetary theories of the trade cycle, discarding faulty analysis and maintaining sound foundations, as to lead to his own monetary theory of the trade cycle. Trade cycles are periodic fluctuations of income, output and employment. Next, Friedman and Schwartz explain the mechanism which brings about monetary changes leading to the business cycles. If the slump is severe, induced investment will quickly fall to zero and the value of the accelerator becomes zero. According to Friedman, the lag plays an important role in business cycles. 3. Banks will further contract credit. In actuality, cyclical fluctuations are caused by expansion and contraction of bank credit which, in turn, lead to variations in the flow of monetary demand on the part of producers and traders. Businessmen will undertake investment in-spite of high rate of interest if they feel that the future prospects are bright. Prices rise further. Useful Notes on Product Life-Cycle Theory of International Trade. The impact of a trade cycle is differential. A monetary change effects different economic magnitudes, some of which adjust faster than others which cause distortions in economic activity, thereby giving rise to the business cycles. As pointed out by Sir John Hicks, “The theory of acceleration and the theory of multiplier are two sides of the theory of fluctuations, just as the theory of demand and the theory of supply are the two sides of the theory of value.”. Thus the introduction of an innovation may not lead to the withdrawal of labour and other resources from old industries. The recession of 1953-54 in America was not caused by shortage of resources. This causes a general glut in the market. These effects will raise interest rates on the whole range of assets. Google Scholar Lundberg (E.) (1937): Studies in the Theory of Economic Expansion (King, 1937), Chapter IX. Rather, they ask the business community to repay their loans. At the same time, as majority of the people are poor, they have low propensity to consume. Then fall in employment leads to fall in income, expenditure, prices and profits. Depression sets in, and the painful process of readjustment to the “point of previous neighbourhood of equilibrium” begins. Consequently, the production of consumer goods falls, their prices increase and their consumption decreases. Keynes states that, “Trade cycle can be described and analyzed in terms of the fluctuations of the marginal efficiency of capital relatively to the rate of interest”. These cycles are mostly monetary in origin. He opines that non-monetary factors like strikes, floods, earthquakes, droughts, wars, etc. Features of a Trade Cycle 3. There is no wastage of materials. In this way, Hicks’ model of the trade cycle represents an important step towards integrating a theory of cyclical fluctuations with the factors of economic expansion. The two models of investments can be looked at using the international product cycle of Vernon’s model. (2) Innovations not the Only Cause of Cycles: Schumpeter’s contention that cyclical fluctuations are due to innovations is not correct. Higher prices induce traders to borrow more in order to hold still larger stocks of goods so as to earn more profits. The first stage deals with the initial impact of innovation and the second stage follows through reactions to the original impact of innovation. The economy does not turn upward immediately from Q2 but will move along the slump equilibrium line to Q3 because of the existence of excess capacity in the economy. So when credit becomes cheap, they borrow from banks in order to increase their stocks or inventories. But it is the advanced, industrialised countries which are affected by trade cycles. The prosperity phase is slow and gradual and the phase of depression is rapid. According to Hawtrey, the process of recovery is very slow and halting. Before publishing your Articles on this site, please read the following pages: 1. This sudden disposal of goods leads to fall in prices and liquidation of marginal firms. Content Guidelines 2. The usual cycle consists of a contraction phase in which economic activity declines to trough of the cycle, followed by expansion and reaching the peak of the cycle. This theory was developed by A.C. Pigou. Howtrey’s Monetary Theory Of Trade Cycle: Prof. Hawtrey regards business cycle as purely a monetary phenomenon. This leads to increase in their production. Full Employment level not Independent of Output Path: Another criticism levelled against Hicks’s model is that the full employment ceiling. If equilibrium rate of interest is higher than market rate of interest there will be prosperity and vice versa. (7) It is assumed that the average capital-output ratio (v) is greater than unity and that gross investment does not fall below zero. Copyright 10. (3) Time Lag of Peaks and Troughs not Long and Variable: According to Friedman, the time lag of peaks and troughs in the rate of change of the money stock relative to economic changes in business cycles is both long and variable. (5) The carrying out of the new organisations of an industry. In the modern society, there is great inequalities of income. But this is not a realistic assumption, as Friedman has proved on the basis of empirical evidence that the marginal propensity to consume does not remain stable in relation to cyclical changes in income. Consequently, money incomes and prices rise and help to create a cumulative expansion throughout the economy. 4. Fall in income will lead to a decline in demand for goods and services produced by other sectors. 2. Accelerator theory of investment. On the other hand, with increase in the prices of consumer goods, their producers earn more profits. A trade cycle is cumulative and self-reinforcing. As a matter of fact, trade cycles may be due to psychological, natural or financial causes. People will tend to consume more services, such as renting houses rather than purchasing them. But Keynes gives more importance to fluctuations in the MEC as the principal cause of cyclical fluctuations. This has led Hicks to formulate his theory of the trade cycle in a growing economy. There are bottlenecks and shortages. The economy is said to be growing at the warranted rate when real investment and real saving are taking place at the same rate. Production Cycle Theory of Vernon Production cycle theory developed by Vernon in 1966 was used to explain certain types of foreign direct investment made by U.S. companies in Western Europe after the Second World War in the manufacturing industry. This will lead to a fall in MEC. The capital stock is one of the resources. Pessimism gives way to optimism. This will create over production in other sectors. Schumpeter’s theory starts with the breaking up of the circular flow by an innovation in the form of a new product by an entrepreneur for earning profit. It is also possible that part of a particular investment may be autonomous and a part induced, as in the case of machinery. Despite these apparent weaknesses of the Hicksian model, it is superior to all the earlier theories in satisfactorily explaining the turning points of the business cycle. Thus changes in the money stock are a consequence as well as independent cause of changes in economic activity. Firms incurring losses will go out of business. During the period of good trade, entrepreneurs become optimistic which would lead to increase in production. Thus the value of the multiplier changes with different phases of the cycle. Below is a more detailed description of each stage in the business cycle: Equilibrium rate of interest is one at which savings are equal to investment. With economic growth, banks are more willing to lend, increasing investment. There is less investment in capital goods. (2) The introduction of a new method of production; (4) The conquest of a new source of raw materials or semi-manufactured goods; and. According to Pigou, the main cause for trade cycle is optimism and pessimism among business people and bankers. As pointed out by Lundberg, every investment is autonomous in the short run and a major amount of autonomous investment becomes induced in the long run. Therefore, credit is essential for breaking the circular flow. Given constant values of the multiplier and the accelerator, it is the ‘leverage effect’ that is responsible for economic fluctuations. Prices begin to rise, thereby stimulating further investment. The product life cycle theory has been less able to explain current trade patterns where innovation and manufacturing occur around the world. This leads to fall in the prices of factors and resources become unemployed. (6) Inventory Investments do not Produce True Cycles: Hamberg further points out that in Hawtrey’s theory cumulative movements in economic activity are the result of changes in stocks of goods. The entrepreneur is not a man of ordinary ability but one who introduces something entirely new. This theory assumes that the amount saved would be automatically invested. Hayek’s Monetary Over-Investment Theory 3. Hicks’s model also pinpoints the fact that in the absence of technical progress and other powerful growth factors, the economy will tend to languish in depression for long periods of time.” The model is at best suggestive. This results in increase in employment and income leading to an increase in demand for goods. But this concept of neutrality of money is based on old quantity theory of money which has lost its validity. Roger W. Garrison* I. Fresh investment starts taking place. Second, on the reaction mechanism of the economic system to the disturbances. They are provided by reducing the lending rate of interest and by purchasing securities. This is unrealistic because financial crisis in a slump may reduce autonomous investment below its normal level. Their prices fall. But now all innovations form part of the functions of joint stock companies. On the basis of the above analysis, Friedman and Schwartz point toward two propositions: First, appreciable changes in the growth rate of the money stock are necessary and sufficient conditions for appreciable changes in growth rate of economic activity or money income. The new innovation starts producing goods and there is an increased flow of goods in the economy. This theory is realistic in the sense that it considers over investment as the cause of trade cycle. Thus consumption lags behind income, and the multiplier is treated as a lagged relation. As there is full employment already, factors of production have to be withdrawn from others to manufacture the new product. Boom. Ultimately, expenditures rise on all directions without any change in interest rates at all. Innovations are regarded as the routine of industrial concerns and do not require an innovator as such. This will result in cumulative expansion and prosperity. According to this theory, depression is due to over-saving. It comes to an end when banks stop credit expansion. “Interest rates and asset prices may simply be conduit through which monetary change is transmitted to expenditures without being altered at all, just as a greater inflow into a tank may, after an interval, simply increase the rate of outflow without altering the level of the tank itself.” All these forces operate simultaneously and there are cyclical fluctuations. The Hicksian theory of trade cycle is based on the following assumptions: (1) Hicks assumes a progressive economy in which autonomous investment increases at a constant rate so that the system remains in a moving equilibrium. Banks refuse to lend further because their cash funds are depleted and the money in circulation is absorbed in the form of cash holdings by consumers. 41 Downloads; Abstract. But Hawtrey believes that an expansion of credit leads to a boom. The demand for the old products is decreased. Rising asset prices such as houses; this causes a rise in wealth and consumer spending. He gives the example of a railway company which lays down one more track to avoid traffic congestion. For instance, if the market rate of interest is lower than equilibrium rate of interest due to increase in money supply, investment will go up. The theories are: 1. Terms of Service Privacy Policy Contact Us, Business Cycles: Meaning, Characteristics and Control, Keynesianism versus Monetarism: How Changes in Money Supply Affect the Economic Activity, Keynesian Theory of Employment: Introduction, Features, Summary and Criticisms, Keynes Principle of Effective Demand: Meaning, Determinants, Importance and Criticisms, Classical Theory of Employment: Assumptions, Equation Model and Criticisms, Classical Theory of Employment (Say’s Law): Assumptions, Equation & Criticisms. As the boom progresses, there is a tendency for the MEC to fall due to two reasons. Uncertainty and risks increase. Schumpeter’s theory is weak in that it does not take these factors into consideration. (2) Money Supply cannot continue a Boom or Delay a Depression: Haberler has criticised Hawtrey for “his contention that the reason for the breakdown of the boom is always a monetary one and that prosperity could be prolonged and depression stayed off indefinitely if the money supply were inexhaustible.” But the fact is that even if the supply of money is inexhaustible in the country, neither prosperity can be continued indefinitely nor depression can be delayed indefinitely. Hence, due to competition for factors of production costs may go up, leading to an increase in price. According to Prof. R.G. Image Guidelines 4. The consumption function takes the form Ct= aYt-1 . Expanding trade cycle theory beyond that purpose and function was, he believed, fallacious. Hence they save and invest which results in an increase in the volume of goods. The MEC increases. Mercantilism. Investment depends on rate of interest and marginal efficiency of capital. Theories. The basic cause of boom or depression according to Hawtrey is the changes in the volume of money which are brought about by the changes in the rate of interest. Similarly, the main cause of the downturn is reduction in investment. Major US historical economic fluctuations include inflationary and deep depression cycles. One of their estimates of the lag between turning points in the growth of the money stock and in the level of economic activity reveals that during the seven cycles between 1927 and 1970, peaks in the rate of change in the money stock precede reference cycle peaks (in economic activity series) before downturns by 20 months on an average, and troughs in the rate of change of the money stock precede reference troughs by about 11 months on an average before upturns. But rate of interest does play an important role in decision making process of entrepreneurs. Further, price of the product falls due to abundant supply leading to a decline in profits. This equilibrium is characterised by Schumpeter as the “circular flow” which continues to repeat itself in the same manner year after year, similar to the circulation of the blood in an animal organism. Economists have criticised Friedman’s theory of money and business cycles on the following grounds: (1) Monetary Changes not the Only Cause of Changes in Economic Activity: Friedman argues that it is monetary changes that cause changes in economic activity. Hicks explains his theory of the trade cycle in terms of Fig. According to him the basic cause of business cycles is the expansion and contraction of money. During the downturn, investment falls due to a fall in the MEC and rise in the rate of interest. The Austrian business cycle theory (ABCT) is an economic theory developed by the Austrian School of economics about how business cycles occur. When the spot appears, it will affect rainfall and hence agricultural crops. It does not say anything about recovery. An innovation includes the discovery of a new product, opening of a new market, reorganization of an industry and development of a new method of production. This is shown as the “Secondary Wave” in Figure 2. This will lead to rise in market rate of interest above the equilibrium rate of interest. According to Mitchell, “Business cycles are of fluctuations in the economic activities of organized communities. And also, the more rapid the rate of growth, the shorter the depression.” Another factor which governs the duration of depression is the “carrying costs of surplus stocks.”. Dillard also points toward this defect when he writes that Keynes “does not examine closely the empirical data of cyclical fluctuations.”, One of the serious omissions of Keynes’s theory of the trade cycle is the acceleration principle. The warranted rate of growth is the rate which will sustain itself. In the diagram above, the straight line in the middle is the steady growth line. This explanation of the transmission mechanism fits with the empirical observations of business cycles. But the term marginal efficiency of capital is vague. Prof. According to Prof. Smithies, the source of growth should he within the system. (5) It ignores the effects of monetary changes upon business cycles. Be free from cyclical fluctuations, all firms resort to plough back profits. They occur, they pay higher remuneration to factors of production to meet increasing! The structure of an economy are caused mainly by fluctuations in the economy, income, expenditure,,... Rich people have large income but their marginal propensity to consume is less than the natural forces of recovery about... To provide an online platform to help students to discuss anything and everything about economics responsible. 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