Business Cycles

385
causes both income and consumption to fall and in this way
which

economy
experiences lownswing in economic activity. expansion co
comes to an end
the
and However, after.a lapse of
some time the fall
in demand for bank credit
ch below the natural rate of lowers the money
interest goes
which
interest. This
te of
activity a n d as a result recession ends. In this way again gives boost to investment
raction occur periodically.
alternating periods of expansion and con-
c ksell's Over-investment Theory. Over-investment theory developed Wicksell' is of
nstead of
0n-monetary type. Inste focusing on monetary factors it attributes by
spurts o f investn ent caused by new innovations introduced by cyclica fluctuations to

spuetion of new innovations or entrepreneurs themselves. The

opening of new markets make some investment
nule by either reducing cost or raising demand for the products. The projects
profita

ble
made possible because of the expansion
in invest-
nt is
T h e expansion in economic
availability
activity ceases
of bank credit lowersaving.
at a
when investment exceeds rate of
money Again it
b e noted that there is over-investment because the level of saving is insufficient to finance
hdesired level of nvestment. The end of
investment expenditure causes the economy to go
to recession. However, another set of innovations occurs or more new markets are found which
ehimulates investment. Thus, when investment picks up as a result of new innovations, the econ-
ony revives and moves into the expansion phase once again.
Appraisal. Though the over-investment theory does not offer an adequate explanation of
husiness 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. Many exponents of this theory point to the behaviour of
banking system that causes diverges between money rate of interest and natural rate of interest
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
husiness cycles.
KEYNES' THEORY OF BUSINESS CYCLES
J.M. Keynes in his seminal work 'General
Theory of Employment, Interest and Money
made an important contribution to the
analysis of the causes of business cycles. According to
Keynes theory, in the short run, the level of income, output or employment is determined by
tne 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.
that is, 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
they will employ a larger amount of resources, both men and materials. In short, a higher
o f aggregate demand will result in greater output, income and employment. On the other
f the level of aggregate demand is low, smaller amount of goods and services can be
0d profitably. This means, that the total quantity of national output produced will be small.
h Small output can be produced with a small amount of resources. As a result, there will
employment of resources, both labour and capital. Hence, the changes in the level of
gate effective demand will bring about flucuations in the level of income. output and
ment.Thus, according to Keynes, the fluctuations in economic activity are due to the
C Ons in aggregate effective demand. Fall in aggregate eflective demand will create the
WAlls of recession or depression. If the aggregate demand is increasing, economic expansion
will take place.
dem No the question arises What causes fluctuations in aggregate demand? The aggregate
demand is compoposed of demand for consumption goods and demand for investment goods. Thus

1.
Knut Wicksell, nterest and Prices, London: Macmillan, 1936.
 Modern Economics
386

of the consumers on consumoticn

aggregate demana depends on the total expenditure
and entrepreneurs on investment goods. Propensity to consume being more or less mahle
the fluctuations in in e
short run, fluctuationsin aggregate demand depend primarily upon
demand. Keynes shows that the fundamental
cause of fluctuations in
aggregate deTmnd
hence in fluctuations in economic activity is the fluctuations in investment demand. Inve
e
about business cycles in the econom
xtmer
demand is very unstable and volatile and brings
Let us start from the phase of economic expansion to explain Keynes's theory of
comes to end and recese
busne
theory expansion
cycles. We first explain how in Keynesian two factors eventually work to cause ie
depression sets in. During an economic expansionincrease in demand for Invea
de.
ment to fall. First, during the expansion phase capital goods
the rise in prices of capital goods due to rising mare-
large-scale investment activity leads to
cost of their production. Higher prices
of capital goods raise the cost of investment pro
and thereby reduce marginal efficiency of capital
rate of
(that i5, expected returm). Second
demand for money increases which raises interes Tale.
income nises during expansion phase, the
unprofitable. Thus, fall in marginal eifcie
Higher interest rate makes some potential, projectsrate on the other cause decline in invesme
of on the one hand and rise
in interest
capitalDeclining
demand. trend of investment, according to Keynes, raises doubis about the prospectie

which is more factor determining marginal efficiency of capital

important
yield on capital goods of interest. When among businessmen pessimism se
than cost of investment projects and rate
stock prices umble. The crash in stock prices
in about future profitability of investment projects fall in prices of shars
investment to fall even more. Besides,
worsens the situation and causes
to Keynes, is an important factor determing
reduces wealth of households. Wealth, according
stock prices reduces autonomous consumption demand of
consumption. Thus, the decline in
investment and consumption demand aggregate demand de
households. With the fall in both
unintended inventories with the finms. This induces the
clines which result in accumulation of
firms to cut production of goods.
rise in rate of
besides the rise in cost of capital goods and
It follows from above that
interest towards the end of the expansion YA
phase, it is the fall in expected prospective
efficiency
yield that reduces the marginal demand
investment to
of capital and causes

fall. This induces a wave of pessimistic ex

businessmen and specu-
pectations among
lators. These pessimistic expectations cause

which work like

stock prices to tumble
adding fuel to the fire. They cause a further
fall in the marginal efficiency of capital.
The turning point from expansion to con
traction is thus caused by a sudden collapse lo
In termsof
in marginal efficiency of capital.
the marginal effi-
graph, a sudden fall in 0
on leftward shift in
ciency of capital causes

for example Investment

the investment demand curve,
in due t
from 1o to 71 in Figure 27.3 resulting 27.3. A Decline in Imvestment Expendinure
from * to * at the Fig. Capital
decline in investment Fall in Marginal Eficiency of
given of interest. Note that decrease in
rate
decrease in
investment does not automatically
rate interest to offset the fall in the marginal
of efficiency of capital 1s e
oriing

additional factor that makes Keynes's business cycle theory potent a

However, to Keynes,
of multiplier which an
was impotant discovery of J.M. Keynes. According
 Business Cycles 387

stment xDenditure causes a decline in income which in turn reduces consumption ex

expenditu

in consumption expenditure further reduces income and this

i ni n v e s t n
on
The reduction

continues further. The total fall in income (A) due to an initial process
enditure. The
income decline
duction in
of A) will be equal to Al MPCc
in investment (A) where-1MPC is the value of multiplier.

nal propensity to consume is 0.75, the multiplier will be equal to 4. Thus, a decline in
fent by 100
100 ccrores
r o r e s will
wil lead to the decline in income by 400 crores. Note that multiplier
f m a r g i n a l

in by
vestment

reverse. Thus, the mulüplier process magnifies the effect of decline in investment
works in reverse.

expenditure on aggregate demand and income and further deepens the depression. As income
h e r e

Apenditu falling rapidly under the multiplier effect, the

output are falli employment
also goes tumbling
0Thus, the Keynes theoryot income multiplier plays a significant role in causing magnified
in income, output
and employment following a reduction in investment.
changes
tis important to note that, in Keynes's views, wages and prices are not flexible enough
c t the decline in investment expenditure and thereby restore full employment. This is in
coptrast to the classical theory where changes in wages and prices ensure continuous full
mnlovment. In Keynes model wages and prices are "sticky" downward which implies that
will
hough wages and prices do not remain constant but when demand falls wages and prices
fall but not sufficient to restore full employment in the economy.
the economy out of the
Since wage and price flexibility does not ensure the recovery of
thinks that marginal efficiency of capital must rise to stimulate
state of depression, Keynes
investment falls to a very low level, capital stock begins to wear
investment. During depression
some existing capital equipment becomes technologically
Qut and requires replacement. Further,
demand for replacement investment. A long
obsolete and has to be abandoned. This generates
goods are
period of time is necessary for existing capital to depreciate mean that capital
because most
durable as well as irreversible. By durability of capital goods
we they last for a long
be used for purposes other than those for
time and by irreversibility we mean that they cannot
which they are meant.
cause of the upper
Thus, just collapse of marginal efficiency of capital is the main
as the
from recession to recovery is due
turming point, similarly the lower turning point, ie., change rate of profit. Restoration
to the revival of the marginal efficiency of capital, that is, expected
of business confidence is the most important, yet the most
difficult factor to achieve. Even if
is because of the fact that
reduced, the investment will not increase. This
the rate of interest is
n the absence of confidence the profitability of investment may remain so low that no practi-
investment. The interval which will elapse
cable reduction in the rate of interest will stimulate is conditioned by two factors: () the
Derween the upper turming point and the start of recovery and (i) the time required to absorb
ume necessary for wearing out of durable capital assets,
De excess stocks of goods left over from the boom. Just as the expected rate of profit was
as the
ushed down by the growing abundance of capital during the period of boom, similarly
a scarcity of capital goods, then the ex-
CES of capital goods are depleted and there grows businessmen to invest more. When the level of
PCLd rate of profit rises thereby inducing the amount due to the multiplier effect. So
stment increases, income increases by a magnified
ine
cumulative process starts upward.
stock occurs without replacement and also some
etius, over time as depreciation of capital obsolete, the size of capital stock declines.
SIng capital equipment becomes technologically reduced depression level of output. Thus
nvestment must be undertaken even to produce efficiency of capital rises which boosts
with
e emergence of scarcity of capital, marginal it induces further rise
in income and consumption de-
Mand Once investment increases, works to magnify the effect of increase
irough the multiplier Now, the multiplier
in process.
The mood of bussinessmen changes
fromn pessimism
nent on raising aggregate demand. All these factors
DE

work to hft the economy out of

Sm which drives up stock prices.
388 Modern Economics

depression and puts it on the road to prosperity.

However. it is notewonthy that the recovery process from depression takes a very lon
long
time. Keynes argued that Government should not wait for long for the natural recovery to occu
This is because persistence of depression creates a lot of human sufferings. He, therefore, ad.
VOcated for the active intervention by the Government to raise aggregate through fiscal policv
that is, stepping up its expenditure or reducing taxes. Thus, he argued for the adoption of polic
of deficit budget to boost aggregate demand so that economy 1s ited out of depression.

It may be noted that Keynes' business cycle theory is sclf-generating. In it the econom
passes through a long phase of expansion. But eventually some forces automatically work fr
example. the growing abundance of capital stock, which reduces marginal efficiency of caital
Pessimisin overtakes businessmen. This causes reduction in investment which is responsible for
bringing about downswing in the economy. The idea that it is the fluctuations in investment
that bring about the fluctuations in the level of economic
activity is an important
contribution
made by Keynes. Of course, even before Keynes, it was believed that the fluctuations inthe
investment demand have something to do with the business
cycles, but a systematic exposition
was
lacking. Keynes propounded a definite relationship between a change in investment and
the resulting
change in income and employment. This relationship is embodied in his famous
theory of multiplier.
The Critical Appraisal of Keynes' Theory
J.M. Keynes has made three
important contributions to the business cycle theory. First, it
is fluctuations in investment that cause
in economic activity (i.e.,
changes in aggregate demand which bring about changes
income, output, and employment). Secondly, fluctuations in investment
demand are caused by
changes in expectations of businessmen regarding making of profits (that
is, marginal efficiency of
capital). Thirdly,
which tells us how changes in investment Keynes put
forward an important theory of
multiplier
and employemnt.
bring about magnified changes in the level of income
But the Keynesian
theory of multiplier alone does not offer a full and
nation of the trade cycles. A basic satisfactory expla-
feature of the trade cycle is its cumulative
on the
upswing as well as on the character both
it downswing i.e., once economicactivity starts rising or tallhng
gathersmomentum and for a time feeds on
itself. Thus, what we have to
cumulative character of economic fluctuations. The explain is the
adequate for this task. For example, suppose that investmenttheory of multiplier alone does not prove
rises by 100 rupees and that e
magnitude of mulüplier is 4. From the theory of
rise by 400 and if multiplier we know
multiplier is the only force at work, that will be thethat national income wt w
the economy reaching a new stable end of the matter,
real life this is not likely to be so, forequilibrium
a rise in
at a higher level of
national income. Bu
will have further income produced by a
repercussions in the economy. This reaction is described given rise in investnc
the accelerator. According to the in the principie
tend to induce changes in the rate ofprinciple
of acceleration, a wll
investment. change in national
income
While
as a resuli of
change in investment, the acceleration multiplier refers to the change n ome
a
change in investment as a resuli of principle describes the relationship berw
In the above change in income.
example, when income has risen
has risen by an
equivalent amount. This will induce by 400 rupees, people's
services. When the demand for them to spend more on
spendiu d
goods rises, s the
existing plant and machinery. All this leads initially this will be met by overwork
to an
businessmen will be induced to expand their productive increase in profits with the result ha
capacity and will instal nehuced th

i.e., they will invest more than before, plants

increase in investment. The Thus, a rise in income leads to a
and the resulting increase in accelerator
inveslment.describes this relation
Thus, Samuelson combined the acceleratofurtnecoe
Phca
Inco
with the multiplier and showed that
between an inerease priuiple
the interaction
between the two can bring
a