ECONOMICS ASSIGNMENT

TOPIC- BUSINESS CYCLES & MONETARY

THEORY OF BUSINESS CYCLES
BY- MANJARI SIROHI
B.COM (HONS) - 3RD YEAR
ACCF AMITY UNIVERSITY

SUBMITTED TO-

MS. MANASVI KAPOOR

INTODUCTION

The term business cycle (or economic cycle) refers to economy-wide fluctuations in
production or economic activity over several months or years. These fluctuations occur
around a long-term growth trend, and typically involve shifts over time between periods
of relatively rapid economic growth (an expansion or boom), and periods of relative
stagnation or decline (a contraction or recession).[1]

Business cycles are usually measured by considering the growth rate of real gross
domestic product. Despite being termed cycles, these fluctuations in economic activity do
not follow a mechanical or predictable periodic pattern.

History
Theory

The first systematic exposition of periodic economic crises, in opposition to the existing
theory of economic equilibrium, was the 1819 Nouveaux Principes d'économie politique
by Jean Charles Léonard de Sismondi.[2] Prior to that point classical economics had either
denied the existence of business cycles[citation needed], blamed them on external factors,
notably war,[citation needed] or only studied the long term. Sismondi found vindication in the
Panic of 1825, which was the first unarguably internal economic crisis, occurring in
peacetime. Sismondi and his contemporary Robert Owen, who expressed similar but less
systematic thoughts in 1817 Report to the Committee of the Association for the Relief of
the Manufacturing Poor, both identified the cause of economic cycles as overproduction
and underconsumption, caused in particular by wealth inequality. They advocated
government intervention and socialism, respectively, as the solution. This work did not
generate interest among classical economists, though underconsumption theory
developed as a heterodox branch in economics until being systematized in Keynesian
economics in the 1930s.

Sismondi's theory of periodic crises was developed into a theory of alternating cycles by
Charles Dunoyer,[3] and similar theories, showing signs of influence by Sismondi, were
developed by Johann Karl Rodbertus. Periodic crises in capitalism formed the basis of the
theory of Karl Marx, who further claimed that these crises were increasing in severity and
predicted communist revolution; he devoted hundreds of pages of Das Kapital to crises.
Classification by periods

In 1860, French economist Clement Juglar Economic Waves series

identified the presence of economic cycles 8 to
11 years long, although he was cautious not to (see Business cycles)
claim any rigid regularity.[4] Later, Austrian Cycle/Wave Name Years
economist Joseph Schumpeter argued that a Kitchin inventory 3–5
Juglar cycle has four stages: (i) expansion Juglar fixed investment 7–11
(increase in production and prices, low Kuznets infrastructural investment 15–25
interests rates); (ii) crisis (stock exchanges Kondratiev wave 45–60
crash and multiple bankruptcies of firms
occur); (iii) recession (drops in prices and in output, high interests rates); (iv) recovery
(stocks recover because of the fall in prices and incomes). In this model, recovery and
prosperity are associated with increases in productivity, consumer confidence, aggregate
demand, and prices.

In the mid-20th century, Schumpeter and others proposed a typology of business cycles
according to their periodicity, so that a number of particular cycles were named after their
discoverers or proposers:[5]

• the Kitchin inventory cycle of 3–5 years (after Joseph Kitchin);[6]

• the Juglar fixed investment cycle of 7–11 years (often identified as 'the' business
cycle);
• the Kuznets infrastructural investment cycle of 15–25 years (after Simon
Kuznets);
• the Kondratiev wave or long technological cycle of 45–60 years (after Nikolai
Kondratiev).[7]

Interest in these different typologies of cycles has waned since the development of
modern macroeconomics, which gives little support to the idea of regular periodic
cycles[citation needed].
Occurrence

There were frequent crises in Europe and America in the 19th and first half of the 20th
century, specifically the period 1815–1939, starting from the end of the Napoleonic wars
in 1815, which was immediately followed by the Post-Napoleonic depression in the
United Kingdom (1815–30), and culminating in the Great Depression of 1929–39, which
lead into World War II. See Financial crisis: 19th century for listing and details. The first
of these crises not associated with a war was the Panic of 1825.

Business cycles in the OECD after World War II were generally more restrained than the
earlier business cycles, particularly during the Golden Age of Capitalism (1945/50–
1970s), and the period 1945–2008 did not experience a global downturn until the Late-
2000s recession. Economic stabilization policy using fiscal policy and monetary policy
appeared to have dampened the worst excesses of business cycles, and automatic
stabilization due to the aspects of the government's budget also helped mitigate the cycle
even without conscious action by policy-makers.

In this period the economic cycle – at least the problem of depressions – was twice
declared dead; first in the late 1960s, when Phillips curve was seen as being able to steer
the economy – which was followed by stagflation in the 1970s, which discredited the
theory, secondly in the early 2000s, following the stability and growth in the 1980s and
1990s in what came to be known as The Great Moderation – which was followed by the
Late-2000s recession. Notably, in 2003, Robert Lucas, in his presidential address to the
American Economic Association, declared that the "central problem of depression-
prevention [has] been solved, for all practical purposes."

Note however that various regions have experienced prolonged depressions, most
dramatically the economic crisis in former Eastern Bloc countries following the end of
the Soviet Union in 1991; for several of these countries the period 1989–2010 has been
an ongoing depression, with real income still lower than in 1989.
Identifying

Economic activity in the US 1954–2005

Deviations from the long term growth trend US 1954–2005

In 1946, economists Arthur F. Burns and Wesley C. Mitchell provided the now standard
definition of business cycles in their book Measuring Business Cycles:[8]

Business cycles are a type of fluctuation found in the aggregate economic activity of
nations that organize their work mainly in business enterprises: a cycle consists of
expansions occurring at about the same time in many economic activities, followed by
similarly general recessions, contractions, and revivals which merge into the expansion
phase of the next cycle; in duration, business cycles vary from more than one year to ten
or twelve years; they are not divisible into shorter cycles of similar characteristics with
amplitudes approximating their own.

According to A. F. Burns:[9]

Business cycles are not merely fluctuations in aggregate economic activity. The critical
feature that distinguishes them from the commercial convulsions of earlier centuries or
from the seasonal and other short term variations of our own age is that the fluctuations
are widely diffused over the economy--its industry, its commercial dealings, and its
tangles of finance. The economy of the western world is a system of closely interrelated
parts. He who would understand business cycles must master the workings of an
economic system organized largely in a network of free enterprises searching for profit.
The problem of how business cycles come about is therefore inseparable from the
problem of how a capitalist economy functions.

In the United States, it is generally accepted that the National Bureau of Economic
Research (NBER) is the final arbiter of the dates of the peaks and troughs of the business
cycle. An expansion is the period from a trough to a peak, and a recession as the period
from a peak to a trough. The NBER identifies a recession as "a significant decline in
economic activity spread across the economy, lasting more than a few months, normally
visible in real GDP, real income, employment, industrial production".[10]

Spectral analysis of business cycles

Recent research employing spectral analysis has confirmed the presence of Kondratiev
waves in the world GDP dynamics at an acceptable level of statistical significance.[11][12]
Korotayev et al. also detected shorter business cycles, dating the Kuznets to about 17
years and calling it the third harmonic of the Kondratiev, meaning that there are three
Kuznets cycles per Kondratiev.

Cycles or fluctuations?

In recent years economic theory has moved towards the study of economic fluctuation
rather than a 'business cycle'[citation needed] - though some economists use the phrase 'business
cycle' as a convenient shorthand. For Milton Friedman calling the business cycle a
"cycle" is a misnomer, because of its non-cyclical nature. Friedman believed that for the
most part, excluding very large supply shocks, business declines are more of a monetary
phenomenon.[13]

Rational expectations theory leads to the efficient-market hypothesis, which states that no
deterministic cycle can persist because it would consistently create arbitrage
opportunities.[citation needed] Much economic theory also holds that the economy is usually at
or close to equilibrium.[citation needed] These views led to the formulation of the idea that
observed economic fluctuations can be modeled as shocks to a system.

In the tradition of Slutsky, business cycles can be viewed as the result of stochastic
shocks that on aggregate form a moving average series. However, the recent research
employing spectral analysis has confirmed the presence of business (Juglar) cycles in the
world GDP dynamics at an acceptable level of statictical significance.[11]
Explaining
The explanation of fluctuations in aggregate economic activity is one of the primary
concerns of macroeconomics. The main framework for explaining such fluctuations is
Keynesian economics. In the Keynesian view, business cycles reflect the possibility that
the economy may reach short-run equilibrium at levels below or above full employment.
If the economy is operating with less than full employment, i.e., with high
unemployment, Keynesian theory states that monetary policy and fiscal policy can have a
positive role to play in smoothing the fluctuations of the business cycle.

There are a number of alternative heterodox economic theories of business cycles, largely
associated with particular schools or theorists. There are also some divisions and
alternative theories within mainstream economics, notably real business cycle theory and
credit-based explanations such as debt deflation and the financial instability hypothesis.

Exogenous vs. endogenous

Within mainstream economics, the debate over external (exogenous) versus internal
(endogenous) causes of the economic cycle is centuries long,[vague] with the classical
school (now neo-classical) arguing for exogenous causes and the underconsumptionist
(now Keynesian) school arguing for endogenous causes. These may also broadly be
classed as "supply-side" and "demand-side" explanations: supply-side explanations may
be styled, following Say's law, as arguing that "supply creates its own demand", while
demand-side explanations argue that effective demand may fall short of supply, yielding
a recession or depression.

This debate has important policy consequences: proponents of exogenous causes of crises
such as neoclassicals largely argue for minimal government policy or regulation (laissez
faire), as absent these external shocks, the market functions, while proponents of
endogenous causes of crises such as Keynesians largely argue for larger government
policy and regulation, as absent regulation, the market will move from crisis to crisis.
This division is not absolute – some classicals (including Say) argued for government
policy to mitigate the damage of economic cycles, despite believing in external causes,
while Austrian School economists argue against government involvement as only
worsening crises, despite believing in internal causes.

The view of the economic cycle as caused exogenously dates to Say's law, and much
debate on endogeneity or exogeneity of causes of the economic cycle is framed in terms
of refuting or supporting Say's law; this is also referred to as the "general glut" debate.
Until the Keynesian revolution in mainstream economics in the wake of the Great
Depression, classical and neoclassical explanations (exogenous causes) were the
mainstream explanation of economic cycles; following the Keynesian revolution,
neoclassical macroeconomics was largely rejected. There has been some resurgence of
neoclassical approaches in the form of real business cycle (RBC) theory. The debate
between Keynesians and neo-classical advocates was rewakened following the recession
of 2007.

Mainstream economists working in the neoclassical tradition, as opposed to the

Keynesian tradition, have usually viewed the departures of the harmonic working of the
market economy as due to exogenous influences, such as the State or its regulations,
labor unions, business monopolies, or shocks due to technology or natural causes (e.g.
sunspots for William Stanley Jevons, planet Venus movements for Henry Ludwell
Moore).

Contrarily, in the heterodox tradition of Jean Charles Léonard de Sismondi, Clement

Juglar, and Marx the recurrent upturns and downturns of the market system are an
endogenous characteristic of it.[14]

The 19th century school of Underconsumptionism also posited endogenous causes for the
business cycle, notably the paradox of thrift, and today this previously heterodox school
has entered the mainstream in the form of Keynesian economics via the Keynesian
revolution.

Keynesian

According to Keynesian economics, fluctuations in aggregate demand cause the economy

to come to short run equilibrium at levels that are different from the full employment rate
of output. These fluctuations express themselves as the observed business cycles.
Keynesian models do not necessarily imply periodic business cycles. However, simple
Keynesian models involving the interaction of the Keynesian multiplier and accelerator
give rise to cyclical responses to initial shocks. Paul Samuelson's "oscillator model"[15] is
supposed to account for business cycles thanks to the multiplier and the accelerator. The
amplitude of the variations in economic output depends on the level of the investment,
for investment determines the level of aggregate output (multiplier), and is determined by
aggregate demand (accelerator).

In the Keynesian tradition, Richard Goodwin[citation needed] accounts for cycles in output by
the distribution of income between business profits and workers wages. The fluctuations
in wages are almost the same as in the level of employment (wage cycle lags one period
behind the employment cycle), for when the economy is at high employment, workers are
able to demand rises in wages, whereas in periods of high unemployment, wages tend to
fall. According to Goodwin, when unemployment and business profits rise, the output
rises.
Credit/debt cycle

One alternative theory is that the primary cause of economic cycles is due to the credit
cycle: the net expansion of credit (increase in private credit, equivalently debt, as a
percentage of GDP) yields economic expansions, while the net contraction causes
recessions, and if it persists, depressions. In particular, the bursting of speculative bubbles
is seen as the proximate cause of depressions, and this theory places finance and banks at
the center of the business cycle.

A primary theory in this vein is the debt deflation theory of Irving Fisher, which he
proposed to explain the Great Depression. A more recent complementary theory is the
Financial Instability Hypothesis of Hyman Minsky, and the credit theory of economic
cycles is often associated with Post-Keynesian economics such as Steve Keen.

Post-Keynesian economist Hyman Minsky has proposed a explanation of cycles founded

on fluctuations in credit, interest rates and financial frailty, called the Financial Instability
Hypothesis. In an expansion period, interest rates are low and companies easily borrow
money from banks to invest. Banks are not reluctant to grant them loans, because
expanding economic activity allows business increasing cash flows and therefore they
will be able to easily pay back the loans. This process leads to firms becoming
excessively indebted, so that they stop investing, and the economy goes into recession.

While credit causes have not been a primary theory of the economic cycle within the
mainstream, they have gained occasional mention, such as (Eckstein & Sinai 1986), cited
approvingly by (Summers 1986).

Real business cycle theory

Within mainstream economics, Keynesian views have been challenged by real business
cycle models in which fluctuations are due to technology shocks. This theory is most
associated with Finn E. Kydland and Edward C. Prescott, and more generally the Chicago
school of economics (freshwater economics). They consider that economic crisis and
fluctuations cannot stem from a monetary shock, only from an external shock, such as an
innovation.

There were great increases in productivity, industrial production and real per capita
product throughout period from 1870-1890 that included the Long Depression and two
other recessions.[16][17] See:Long depression#A profit depression with real growth There
were also significant increases in productivity in the years leading up to the Great
Depression. Both the Long and Great Depressions were characterized by overcapacity
and market saturation.[18][19]

Over the period since the Industrial Revolution, technological progress has had a much
larger effect on the economy than any fluctuations in credit or debt, the primary
exception being the Great Depression, which caused a multi-year steep economic decline.
The effect of technological progress can be seen by the purchasing power of an average
hour's work, which has grown from $3 in 1900 to $22 in 1990, measured in 2010 dollars.
[20]
There were similar increases in real wages during the 19th century. See: Productivity
improving technologies (historical) A table of innovations and long cycles can be seen at:
Kondratiev wave#Modern modifications of Kondratiev theory

Carlota Perez blames "financial capital" for excess speculation, which she claims is likely
to occur in the "frenzy" stage of a new technology, such as the 1998-2000 computer,
internet, dot.com mania and bust. Perez also says excess speculation is likely to occur in
the mature phase of a technological age.[21]

RBC theory has been categorically rejected by a number of mainstream economists in the
Keynesian tradition, such as (Summers 1986) and Paul Krugman.

Alternative hypotheses

Politically-based business cycle

Another set of models tries to derive the business cycle from political decisions. The
partisan business cycle suggests that cycles result from the successive elections of
administrations with different policy regimes. Regime A adopts expansionary policies,
resulting in growth and inflation, but is voted out of office when inflation becomes
unacceptably high. The replacement, Regime B, adopts contractionary policies reducing
inflation and growth, and the downwards swing of the cycle. It is voted out of office
when unemployment is too high, being replaced by Party A.

The political business cycle is an alternative theory stating that when an administration of
any hue is elected, it initially adopts a contractionary policy to reduce inflation and gain a
reputation for economic competence. It then adopts an expansionary policy in the lead up
to the next election, hoping to achieve simultaneously low inflation and unemployment
on election day.[22]

The political business cycle theory is strongly linked to the name of Michał Kalecki[23]
who argued that no democratic government under capitalism would allow the persistence
of full employment [This sentence is confusing, and the reference given does not support
this statement. Please clarify and correct the reference], so that recessions would be
caused by political decisions. Persistent full employment would mean increasing workers'
bargaining power to raise wages and to avoid doing unpaid labor, potentially hurting
profitability. (He did not see this theory as applying under fascism, which would use
direct force to destroy labor's power.) In recent years, proponents of the "electoral
business cycle" theory have argued that incumbent politicians encourage prosperity
before elections in order to ensure re-election—and make the citizens pay for it with
recessions afterwards.
Marxist economics

For Marx the economy based on production of commodities to be sold in the market is
intrinsically prone to crisis. In the heterodox Marxian view profit is the major engine of
the market economy, but business (capital) profitability has a tendency to fall that
recurrently creates crises, in which mass unemployment occurs, businesses fail,
remaining capital is centralized and concentrated and profitability is recovered. In the
long run these crises tend to be more severe and the system will eventually fail.[24] Some
Marxist authors such as Rosa Luxemburg viewed the lack of purchasing power of
workers as a cause of a tendency of supply to be larger than demand, creating crisis, in a
model that has similarities with the Keynesian one. Indeed a number of modern authors
have tried to combine Marx's and Keynes's views. Others have contrarily emphasized
basic differences between the Marxian and the Keynesian perspective: while Keynes saw
capitalism as a system worth maintaining and susceptible to efficient regulation, Marx
viewed capitalism as a historically doomed system that cannot be put under societal
control.[25]

Austrian school

Main article: Austrian business cycle theory

Economists of the heterodox Austrian school argue that business cycles are primarily
caused by excessive creation of bank credit - or fiduciary media - which is encouraged by
central banks when they set interest rates too low, especially when combined with the
practice of fractional reserve banking. The expansion of the money supply causes a
"boom" in which resources are misallocated due to falsified interest rate signals, which
then leads to the "bust" as the market self-corrects, the malinvestments are liquidated, and
the money supply contracts.

One of the primary critiques of Austrian business cycle theory is the observation that the
United States suffered recurrent economic crises in the 19th century, most notably the
Long Depression following the Panic of 1873, prior to the establishment of a U.S. central
bank in 1913. Adherents, such as the historian Thomas Woods argue that these earlier
financial crises were prompted by government and bankers' efforts to expand credit
despite restraints imposed by the prevailing gold standard, and are thus consistent with
Austrian Business Cycle Theory.

Henry George

Henry George's theory identifies land price fluctuations as the primary cause of most
business cycles.[26] The theory is generally ignored in most of today's discussions of the
subject[27] despite the fact that the two great economic contractions of the last 100 years
(1929–1933 and 2008-??) both involved speculative real estate bubbles.

George observed that one of the factors that is absolutely necessary for all production —
land — has an inherent tendency to rise in price on an exponential basis as the economy
grows. The reason for this is that the quantity of land (the stock of locations and natural
resources) is fixed, while its quality is improved due to improvements such as
transportation infrastructures and economic development of the surroundings. Investors
see this tendency as the economy grows and they buy land ahead of the boom areas,
withholding it from use in order to take advantage of its increased value in the future. In
every booming economy prices of land, housing and rents increase far more rapidly than
the overall rate of inflation.[citation needed] Speculation in land concentrates profits in
landholders and diverts economic resources to speculation in land, squeezing profits
away from production that has to occur on this land.[citation needed]

In effect, land speculation creates a built-in supply shock, that squeezes the economy just
as economic output increases. This is a systemic retardation of the economy, placing a
sharp brake on further economic expansion. This shock to the economy occurs as long as
there is land speculation, creating an underlying tendency toward inflation and recession
late in the growth phase of the business cycle. Land speculation, according to George, is
always the cause of economic downturns. There are any number of contributing causes;
things like oil price shocks, consumer confidence crises, international trade fluctuations,
natural disasters — but none of these things creates the underlying weakness.

Land speculation slows the economy in two ways. It increases production costs by
making land in general more expensive (shifting the AS curve upward) as well as
decreasing productivity by denying access to the best locations, shifting the AS curve to
the left and lowering "potential output".[28]

The recent housing bubble offers some validation to George's theory and has created
great distortions around the world. In the U.S. the bubble caused extreme regional
differences in land prices, creating uncompetitive business conditions due to higher
wages and taxes. State (CA, IL) and local governments in many of these high cost areas
are suffering large budget shortfalls as businesses close or relocate to low cost areas such
as the Atlanta, GA region, which has low land prices and was a leader in economic
growth for the last several decades.

The Wisconsin Business School publishes an on line database with building cost and land
values for 46 U.S. metro areas.[29]
Mitigating
Most social indicators (mental health, crimes, suicides) worsen during economic
recessions. As periods of economic stagnation are painful for the many who lose their
jobs, there is often political pressure for governments to mitigate recessions. Since the
1940s, following the Keynesian revolution, most governments of developed nations have
seen the mitigation of the business cycle as part of the responsibility of government,
under the rubric of stabilization policy.

Since in the Keynesian view, recessions are caused by inadequate aggregate demand,
when a recession occurs the government should increase the amount of aggregate demand
and bring the economy back into equilibrium. This the government can do in two ways,
firstly by increasing the money supply (expansionary monetary policy) and secondly by
increasing government spending or cutting taxes (expansionary fiscal policy).

By contrast, some economists, notably New classical economist Robert Lucas, argue that
the welfare cost of business cycles are very small to negligible, and that governments
should focus on long-term growth instead of stabilization.

However, even according to Keynesian theory, managing economic policy to smooth out
the cycle is a difficult task in a society with a complex economy. Some theorists, notably
those who believe in Marxian economics, believe that this difficulty is insurmountable.
Karl Marx claimed that recurrent business cycle crises were an inevitable result of the
operations of the capitalistic system. In this view, all that the government can do is to
change the timing of economic crises. The crisis could also show up in a different form,
for example as severe inflation or a steadily increasing government deficit. Worse, by
delaying a crisis, government policy is seen as making it more dramatic and thus more
painful.

Additionally, since the 1960s neoclassical economists have played down the ability of
Keynesian policies to manage an economy. Since the 1960s, economists like Nobel
Laureates Milton Friedman and Edmund Phelps have made ground in their arguments
that inflationary expectations negate the Phillips curve in the long run. The stagflation of
the 1970s provided striking support for their theories, defying the simple Keynesian
prediction that recessions and inflation cannot occur together.[original research?] Friedman has
gone so far as to argue that all the central bank of a country should do is to avoid making
large mistakes, as he believes they did by contracting the money supply very rapidly in
the face of the Wall Street Crash of 1929, in which they made what would have been a
recession into the Great Depression.[citation needed]
MONETARY THEORY OF TRADE CYCLE

Money and Cycle Traditions

In business cycle theory, the Continental tradition has tended to be to emphasize that it is
"real" phenomena -- technological change in particular -- that pushes the economy out of
equilibrium and that it is the consequent unbalanced structure of the real economy that
drives the cycle. It is important to note that, for the Continental tradition, it is a
horizontal unbalancedness, i.e. disproportionalities across sectors of the economy at a
point in time, that drive the cycle In contrast, the Anglo-American tradition is to focus on
how "external" things like psychology or credit, can "unbalance" the economy and drive
the cycle. But for Anglo-Americans the unabalancedness is vertical, i.e. difficulties in
coordinating across time.

In both these theories, credit plays a role -- in particular, the starting point for all of them
is Knut Wicksell's insight on the relationship between the "natural" rate of interest and
the "money" rate of interest. But Wicksell's theory of the cumulative process was talking
about money and prices, consequently, it was natural to turn explicit attention to the
interrelationship between money, prices and the cycle. This was the main endeavour of
Ralph G. Hawtrey and Friedrich A. von Hayek in the 1920s.

When grafting a monetary theory into a cycle theory, one must already have some sort of
idea of how the cycle process works itself through. This is where the division between
the Continental and Anglo-Ameican traditions in cycle theory is useful way of dividing
the monetary cycle theories as well. Hawtrey, a Cambridge economist, naturally adopted
the Anglo-American approach for his underlying cycle, while Hayek, an Austrian
economist at the L.S.E., took adopted the Continental approach. Consequently, for
Hawtrey, the economy is a "single-sector" entity and the cycle is driven by vertical
unbalancedness -- miscoordination across time (caused by money, of course). For
Hayek, the economy is a "multi-sectoral" complex, and thus the cycle is driven by
horizontal unbalancedness -- miscoordination across sectors (caused by money as well).
Thus, Hawtrey is unconcerned with relative prices; money influences his "single-sector"
economy by affecting the absolute price level. In contrast, for Hayek's multi-sector
economy, it is how money affects relative prices that is the key to the cycle. Absolute
prices, in Hayek's view, are irrelevant.

(B) Hawtrey's Pure Money Cycles

R.G. Hawtrey has perhaps the most famous "pure money" theory which he outlined in a
barrage of articles and books (1913, 1926, 1928, 1933, 1937). His theory, as noted, is
Wicksellian in many respects. But his chief characters are wholesalers and middlemen
who rely unduly on bank credit and are thus highly sensitive to interest rates. Any slight
injection of money which lowers the money rate of interest induces these middlemen to
increase inventories. They do so by borrowing from banks increases and demanding
increases in production from firms. But because increasing production takes time, the
money supply of the economy is momentarily too large for the given amount of income
(think of a Cambridge cash-balance theory). This "unspent margin" leads to higher
demand for goods by consumers - but that extra demand will itself lower the inventories
of these middlemen. Realizing their falling inventories, they will then call again upon
firms to step up production and borrow money to do so. But again that leads to an excess
supply of money, etc.

The turning points in the Hawtrey cycle arise when production (and thus income) finally
catches up with the higher money supplies. They will catch up, Hawtrey tells us, because
banks will begin to close off credit when they see their reserves being stretched too far.
Then we jump into the recession: when banks stop lending to middlemen, these will
reduce their demands on firms. Production will slow down and so will incomes - but with
a lag again. The fall in money supply comes first and so consumers now have excess
demand for money and will thus lower their demand for goods. That leads to inventory
build up and a further demand by middlemen that production reduce further. The
downturn continues until the banks are flushed with money once again and need to lend
out.

(C) Hayek's Monetary Theory

Hawtrey's theory is interesting, but, as noted, is very "vertical". The cycle theory of
Friedrich Hayek (1929, 1931) is concentrated on "horizontal" aspects and thus closer in
spirit to the Continental tradition of Spiethoff and Cassel. Hayek's theory combins
Wicksellian themes with the concept of changing factor proportions - namely, what he
calls "lengthening" and "shortening" of the "period of production", Austrian concepts we
may interpret loosely as "increasing" and "decreasing" the production of capital goods
relative to consumer goods.

F.A.Hayek's theory of business cycles starts on a Wicksellian footing: a credit expansion

at the trough because the accumulation of loanable funds has led the "natural" rate of
interest to fall below the "real" rate of interest. An investment expansion ensues and thus
capital goods are demanded.

However, the initial raise in the demand for capital goods, by itself, essentially means
that the aggregate demand in an economy is greater than aggregate supply. Assuming the
economy to be resource constrained, this implies that firms must decide whether to
simply not respond to the higher capital demand and keep on producing the same
consumer goods as before or else to respond and thus produce more capital goods and
reduce the production of consumer goods. Hayek argued the latter would happen - and
thus the proportion of capital to consumer goods would rise.

But when we keep aggregate supply fixed, that means consumer income is kept fixed -
thus consumer demand for consumer goods has not dropped. But the supply of consumer
goods has dropped. Thus, there will be what Hayek called "forced savings": consumers
are forced to save simply because there are no more consumer goods to buy. This
increase in savings, we must note, will fund the initial expansion in credit.

But then our story would end without fluctuations in output. Let us then follow Hayek
and argue that aggregate supply is not completely fixed and that new resources are
brought into use. Then capital goods and consumer goods production will both rise. This
is a general expansion of output. But expansion of output in general means higher income
and higher income in general and thus higher consumer demand. As a result, consumers
demand more consumer goods and place pressure on the consumer goods industry to
produce more.

This can continue until the full employment level is reached. Then the aggregate supply
constraint we spoke of comes in force. Assuming proportions are not changing, the rising
demand for consumer goods leads to rising prices in the consumer goods industry relative
to capital goods. This is merely the expression of forced savings again. But what effect
will this have? The rising prices of consumer goods make the consumer goods industry
more profitable relative to the capital goods industry. They can thus begin to outcompete
the capital goods industry on the (now very tight) factor markets: i.e. consumer goods
industries will start getting the labor and capital that the capital goods industry used to
command. This bidding war leads to a rise in factor costs overall - rises in wages and
rises in the money loan rate. This is the peak of the cycle.

What happens then? Hayek suggested the rising costs in the economy and the relatively
poorer position of the capital goods industry will lead make them less profitable to begin
with; furthermore, the rising loan rate will only lead to a decrease in investment and thus
a decrease in demand for their products. In short, faced with lower profit and lower
demand, the capital goods industry will shrink in size relative to the consumer goods
industry. The downswing is on.

During the downsing, as the capital-goods industry shrinks, people who were employed
by that sector will be laid off. That will lead to a decline in the demand for consumer
goods, which now will lead to a shrinkage in the consumer goods industry. But the
shrinkage in the consumer goods indutry means that now investment demand will drop
even further (as consumer goods firms also demand capital). That will lead to a further
shrinkage of capital goods production and so on. As a result of the general collapse in
output and collapse in investment demand, loanable funds will again start piling up
unused at the banks and there thus money (loan) rate will start falling. A point will come,
argued Hayek, when the loan rate will collapse below the natural rate and investment
picks up again. This way, the trough is reached and the capital goods industry begins
producing again - and thus expansion arises.

The main points to note about Hayek's theory are these: if there was no banking system
providing credit, there would be no cycle because everything would have to be in
equilibrium. It is money (or, more precisely, the supply of credit by banks at a rate below
the real rate of interest) which is disequilibrating demand and supply for capital goods
and consumer goods. During the expansion there is a "lengthening of the period of
production", i.e. an rise in capital goods production relative to consumer goods, but both
sectors are increasing output. During the contraction, there is a "shortening of the period
of production", i.e. fall in the amount of capital goods produced relative to consumer
goods, but both sectors are decreasing output. This "lengthening"/"shortening" during the
expansion/contraction is what earned it the name of "Concertina Effect".

Most importantly, the turning point of the cycle is caused by consumers demand too
much. Thus excess consumer demand is the direct cause of recessions (the indirect cause
is the earlier overinvestment or, more precisely, the banking sector's cheap lending
policies which started the whole thing.)

Hayek's ex-student (but now turned Keynesian), Nicholas Kaldor (1939) disagreed with
his old master at L.S.E.. He proposed that the proportion of capital goods to consumer
goods should actually fall rather than rise during the expansion. According to Kaldor, at
the trough, firms as a whole are operating with excess capacity. In other words, there is a
fixed stock of capital, part of which is not being used (by which we mean, labor is not
being applied). Consequently, as the upswing begins, it would be madness if the first
thing entrepreneurs did was go build more machines and raise capacity even more.
Rather, Kaldor argued, during the initial stages of the upswing, more labor will get hired,
but no new capital will be demanded. Thus consumer demand rises first, and thus
consumer industries' profitability rises - and thus loanable funds are allocated to these.
Thus, consumer goods industries should rise in proportion to the capital goods industry
during the expansion. When firms reach their existing capacity, Kaldor went on, then
they will begin to demand capital. Only then will demand for capital goods rise.

In the downswing, Kaldor (1939) argued, the reverse happens: as the peak begins to
disappear, entrepreneurs cannot "fire" machines in the short run in order to cut back
output - rather, they will lay off workers. But that precipitates a collapse in consumer
demand and thus that related industry. Thus, the relative size of the capital goods industry
rises even though output as a whole falls.

Hayek absorbed these lessons from his old student and in subsequent work (Hayek, 1939,
1941), he reversed his earlier argument completely around. In essence, Hayek proposed
that the expansion of credit (at the trough), will expand the demand for consumer goods.
This, in turn, would raise profits in the consumer goods industries and their prices. As
consumer goods prices rise, real wages fall - thereby increasing profits. As profits
increase, it may seem reasonable for entrepreneurs to invest for greater production.
However, this new investment will be directed towards methods of production which are
labor-intensive given that real wages have collapsed. This latter part is what Hayek
referred to as the "Ricardo Effect".

In essence, the first investment effect would raise demand for capital goods whereas the
second "Ricardo effect" should decrease it. Since Hayek assumes that the Ricardo effect
eventually outweighs the investment effect, investment demand falls and the capital
goods industries collapse in relative size.
The argument for why the collapse in real wages outweighs the profit-driven investment
is understandable. As consumer demand expands and profits keep on rising, investment
demand for capital- widening (i.e. applying machinery in order to keep up with greater
employment of labor) will increase. However, as the real wages keep falling, capital-
widening investment will become less tenable so that capital-"shallowing" (i.e. more
labor-intensive techniques) is called for. Note that if investment rises, profits rise further
and, the greater the rise in profits, the greater the fall in wages. In time then, the falling
wages will outweigh the extra profits from capital-widening and actually result in capital-
lessening which, in turn, prompt a collapse in investment demand and hence, a recession.

Hayek's new theory, however, depended too much on changes of technique as the
dampener of business cycles. In addition, note that, unlike Keynes, Hayek proposed that
overconsumption (thus higher prices and falling real wages) cause the upswing to slow
down and eventually reverse itself. Excess demand causes recessions not excess supply.

Characteristically, Kaldor (1942) could not leave this alone. Why, he asked, did high
profits imply lower investment? After all, in most theories, if the productivity of capital
(read profits) rises above interest, investment should increase, "under no circumstances
can total investment demand become smaller in consequence of a rise in the rate of
profit" (Kaldor, 1942). Investment could ostensibly fall if, and only if, the rate of interest
rises. If such happened, then we should not be surprised to see investment collapse. The
Concertina effect, he noted: "as a phenomenon of the trade cycle is non-existent or
insignificant while the supposition that a scarcity of savings causes booms to collapse is
fallacious." (Kaldor, 1942)

Despite Hayek's (1942) attempted restatement of the Ricardo effect, the verdict of the age
was clear. In both his 1931 attempt and in his 1939 rectification, he attempted to
demonstrate that overconsumption was the chief cause of depressions. However, Kaldor
succesfully picked away at his first theory and then showed that his Ricardo Effect was
only possible under some very special circumstances and hence, highly unlikely. Kaldor,
in effect, sustained the flag of underconsumption and overproduction as the chief
evildoers.