Explore the main theories of the trade cycle, from classical to Keynesian to Austrian, and learn how economists interpret the fluctuations in economic activity.Several theories of trade cycles have been put forward from time to time. We shall say here a word about some well known theories.
Theories of Trade Cycle
Climatic Theory:
It is said that there are cycles of climate. For some years the climate is favourable and then comes an unfavourable turn. Changes in climate bring about changes in agricultural production. Thus, there are bumper crops of some years followed by failure of crops. The cycle of agricultural production results in a cycle of industrial activity, for industry is deeply affected by the state of agricultural production.
Sunspot Theory: According to Stanley Jevons, spots appear on the face of the sun at regular intervals. These spots affect the emission of heat from the sun, which in turn, conditions the degree of rainfall. The rain affects agriculture, which, in turn, affects trade and industry. That is how trade cycles are caused.
Comments: Modern economists do not place much reliance on climate theories. Nobody can say with certainty about the nature of the sun – spots and the degree to which they affect rain. There is no doubt that climate affects agricultural production. But the climate theory does not adequately explain periodicity of the trade cycle.
Psychological Theory:
Attempts are made by ^ome economists to explain trade cycle in terms of psychology. There are moods of optimism alternating with moods of pessimism, without there being any tangible basis for the same. At some stage, people just think that trade is good and that it is going to remain good. Business activity is intensified and becomes feverish. Then, all of sudden, people start thinking that the period of prosperity has lasted long enough and adversity is round the corner. Thus, although there was no valid reason for depression to come about, but it is brought about by the people themselves.
Comments: The psychological theory lacks any sound basis. There is conjectural element in it. There is no doubt that industrial fluctuations are affected by the waves of optimism and pessimism and are intensified by them. But they do not explain the course of the trade cycles or their periodicity aspects.
Under Consumption Theory:
According to under – consumption theory, there is too much of saving during a boom and further additions to savings reduce the level of consumption, in the face of increasing productive capacity must sooner or later lead to the collapse of the boom. This theory is associated with the names of J.A Hobson and Major Douglas.
But why does over saving or under – consumption take place? This is because during the boom, though prices rise wages lag behind, so that profit margins are progressively increased. There takes place a shift in the distribution of incomes in favour of profits and against the wage earners. The saving propensit6y of the rich is greater than that of the poor, so that a shift in income distribution in favour of the rich leads to an increase in the volume of saving. This process goes on till prices kfeep on rising and wages lag behind. However, one result of such a state of affairs is that the demand for consumption goods gets steadily reduced. This leads to contraction in their output which precipitates the crisis.
Comments: The under – consumption or over – saving theory contains an element of truth. But it cannot be the sole or adequate explanation. For example, if the under – consumption theory were to be exclusively relied on. We should expect the consumption goods industries to fluctuate more than investment goods industries. But exactly reverse is the case in real life during a trade cycle.
Monetary Theory:
R.G. Hawtrey was a firm believer in the monetary • theory. According to him variations in flows of money are the sole and sufficient determinants of business activity and account of alternating phases of prosperity and depression. Non – monetary causes like drought, floods, earthquakes, wars, strikes, unbalanced development of certain industries, etc., can a best cause a partial as distinguished from general depression.
The argument is something like this: Most of the business is done with borrowed money. When business prospects are good, the banks freely extend credit facilities. Assured of cheap and easy credit facilities, the businessmen go on expanding their business, entering into further and further commitments. A huge superstructure of credit is built up.
This superstructure can be maintained by the continuance of cheap money conditions if not their further extension. But a point is reached when banks think that they have gone a bit too far in the matter of advances. Probably their reserves ratio has fallen dangerously low. In self – defence, they apply the brake, curb further expansion of credit and begin to recall advances. This sudden suspension of credit facilities proves a bomb – shell to the business community.
Businessmen have been counting on the renewal of overdrafts and cash credit facilities. But contrary to their expectation, moneys are being called in. They have to sell off their stocks in order to repay. This general desire for liquidity depresses the market, for the stocks Matf^eing unloaded all round. Some firms, weaker links of the cfiain, fail to meet their obligations and bring to grief those whom they could not pay. Very solvent firms may fail, simply because they do not receive timely financial assistance from the banks.
Thus, the monetary phenomena of hoarding and dishoarding, credit expansion and credit contract have a lot to do with business cycles, since they represent a succession of inflationary and deflationary processes.
Comments: No doubt banking institutions play an important part in building up trade activity. But it is a bit unkind to say that they cause a crisis. The most that we can say is that they aggravate matters. They prop up a boom by an over – issue of credit and they accentuate a depression by its suspension. But neither the boom nor the depression originates with them. Secondly, a world phenomenon like a modern slump cannot be attributed to the isolated action of banks in one country. A trade cycle cannot therefore be
Some writers attribute the boom to excessive investment apd regard the slump as the necessary corrective for the imbalances created during the boom. That investment becomes excessive during the boom is borne out by the fact that investment goods industries expand faster than consumption goods industries during the upward phase of the cycle. During the depression, investment goods industries suffer more than consumption goods industries.