As time passes, existing machinery becomes worn out and has to be replaced. 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. According to Hawtrey, “Increased activity means increased demand, and increased demand means increased activity. A long lag may mean a larger damping of disturbances than a short lag. According to Keynes, effective demand is composed of consumption and investment expenditure. The earlier economists considered the changes in the amount of credit given by banking system to be responsible for cyclical fluctuations. Introduction If general acceptance by the economics profession were the criterion for success or failure of a theory, the theory of the trade cycle attributed to F. A. Hayek would have to be declared a failure. On the other hand, with increase in the prices of consumer goods, their producers earn more profits. He explained his theory on the basis of Wicksell’s distinction between the natural interest rate and the market interest rate. But in mild depressions, there has been a reduction in the growth rate of the money stock rather than any actual fall. He does not provide funds but directs their use. Firstly, according to Keynes the main cause for trade cycle is the fluctuations in MEC. The recession of 1953-54 in America was not caused by shortage of resources. Then fall in employment leads to fall in income, expenditure, prices and profits. This leads to depression. There are many other causes which have not been analysed by Schumpter. According to Keynes, the carrying cost of surplus stocks during the depression is seldom less than 10 per cent per annum. Demand for commodities go up. Further innovation is usually financed by the promoters and not by banks. These innovations may reduce the cost of production and may shift the demand curve. Thus the entire process becomes cumulative and the economy is forced into depression. But, during this period, rate of interest is very low. The natural rate of interest is that rate at which the demand for loanable funds equals the supply of voluntary savings. If the accelerator worked continuously, output would plunge downward below the equilibrium level EE, and because of explosive tendencies, to a greater extent than it rose above it.” The fall in output in this case might be a steep one, as shown by P2 P3 Q. 1. Thus revival starts, becomes cumulative and leads to boom. Investment plays a leading role based on formula rather than on judgement. (3) Traders do not depend Only on Bank Credit: Hamberg has criticised Hawtrey for the role assigned to wholesalers in his analysis. These cycles are mostly monetary in origin. It comes to an end when banks stop credit expansion. (2) The saving and investment coefficients are disturbed overtime in such a way that an upward displacement from equilibrium path leads to a lagged movement away from equilibrium. 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. By innovation Schumpeter means “such changes in the production of goods as cannot be affected by infinitesimal steps or variations on the margin.”. According to him non-monetary factors like wars, strike, floods, drought may cause only temporary depression. Exogenous fluctuations in the money stock will lead to fluctuations in the demand for goods and services. Full Employment level not Independent of Output Path: Another criticism levelled against Hicks’s model is that the full employment ceiling. Induced by high profits, they try to produce more. In recent years, all firms resort to plough back of profits for expansion. On the other hand, if the spot did not appear on the sun, rainfall is good leading to prosperity. Prof. Hawtrey considers trade cycle to be a purely monetary phenomenon. During the downturn, investment falls due to a fall in the MEC and rise in the rate of interest. Credit is expanded or reduced by the banking system by lowering or raising the rate of interest or by purchasing or selling securities to merchants. Because of the low prices of goods, producers are not willing to expand production. (5) It ignores the effects of monetary changes upon business cycles. States that product life cycle theory has been applied to many industries and has proved successful in identifying future product and service strategies. “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. Image Guidelines 4. Some trade cycles last for three or four years, while others last for six or eight or even more years. Uploader Agreement. But it is not free from certain criticisms. This is unrealistic because financial crisis in a slump may reduce autonomous investment below its normal level. 8. 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.”. Suppose, at the full employment level, an innovation in the form of a new product has been introduced. As the cumulative process of expansion continues, producers quote higher and higher prices. This cumulative process of rising investment, income and employment continues till the boom is reached. The consumption function takes the form Ct= aYt-1 . This theory is not free from criticism. 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. International product cycle theory ignored FDI in Asian countries. It depends on factors which bring about the recovery of the MEC. Welcome to EconomicsDiscussion.net! During this phase, there will be pessimism leading to closing down of business firms. It has neglected other factors determining investment. There will be competition for factors of production between capital goods and consumption good industries. Schumpeter’s approach involves the development of his model into two stages. (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. If equilibrium rate of interest is higher than market rate of interest there will be prosperity and vice versa. 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. If there is a lag in the adjustment of real money balances to the new price level, the initial portfolio adjustment will tend to overshoot. Higher prices induce traders to borrow more in order to hold still larger stocks of goods so as to earn more profits. According to Pigou, the main cause for trade cycle is optimism and pessimism among business people and bankers. 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. This is not correct because the former is not the cause of the latter. Unable to repay bank loans, some firms go into liquidation, thus forcing banks to contract credit further. The dynamic process of transition from one equilibrium path to another involves a cyclical adjustment process. Therefore, it may be stated that banking system cannot originate a trade cycle. Every firm is in equilibrium and producing efficiently with its costs equal to its receipts. According to Keynes, the marginal productivity of capital increases with the increase in profits of consumer goods. During this period of recession, credit, prices and interest rate decline but total output is likely to average larger than in the preceding prosperity. Thus consumption lags behind income, and the multiplier is treated as a lagged relation. Employment, output and income fall resulting in depression. According to this theory, the spot that appears on the sun influences the climatic conditions. At … John Maynard Keynes, one of the most influential economists of the 20th century, never worked out a pure theory of trade cycles, though he made significant contributions to the trade cycle theory.Keynes states, “The trade cycle can be described and analyzed in terms of the fluctuations of the marginal efficiency of capital relatively to the rate of interest.” It is based on Say’s law of markets. There is also much evidence that during business cycles the money stock plays largely an independent role. On the other hand, in deep depression cycles, there has been a greater fall in money stock. 4. Wages also go down. In this article we will discuss about Trade Cycle:- 1. There are bottlenecks and shortages. Hayek has suggested that the volume of money supply should be kept neutral to solve the problem of cyclical fluctuations. A high rate of interest will not prevent the people to borrow. However, these boom conditions cannot last long because the forces of expansion are very weak. 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. The theories are: 1. Profits and interest rates are zero. Useful Notes on Product Life-Cycle Theory of International Trade. 3. In a trade cycle, a period of prosperity is followed by a period of depression. Raymond Vernon, a Harvard Business School professor, developed the product life cycle theory A modern, firm-based international trade theory that states that a product life cycle has three distinct stages: (1) new product, (2) maturing product, and (3) standardized product. According to Friedman, the lag plays an important role in business cycles. A vicious circle is set up, a cumulative expansion of productive activity.”. This is not correct because besides changes in the rate of interest, the expectations of profit, innovation, invention, etc. These are unrealistic assumptions because the capital-output ratio is itself subject to change due to technological factors, the nature and composition of investment, the gestation period of capital goods, etc. Suppose, there is over production and excess supply in one sector, that will result in fall in price and income of the people employed in that sector. It is effective demand which determines the level of income and employment. 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. The lags in economic activity behind peaks and troughs in the rate of change of the money stock are not uniform. Trade cycles are periodic fluctuations of income, output and employment. Equilibrium rate of interest is one at which savings are equal to investment. 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. Account Disable 12. International investment and international trade in the product cycle, Vernon, R. (1992). This theory does not explain all the phases of trade cycle. According to this theory, trade cycle is result of the interaction between multiplier and accelerator. Further, it is also possible, as pointed out by Schumpeter, that autonomous investment may itself be subject to fluctuations due to a technological innovation. Over investment is due to indivisibility of investment and excess supply of bank credit. Its first impact is on the financial markets where first bonds, then equities and only later on payments for real resources will be affected. In actuality, traders do not depend exclusively on bank credit but they finance business through their own accumulated funds and borrowing from private sources. Such persons were to be found in the 18th and 19th centuries who made innovations. Consequently, the production of consumer goods falls, their prices increase and their consumption decreases. 6. Consequently, output, employment and income increase. Cost of production increases. During the downswing, “the multiplier-accelerator mechanism sets in reverse, falling investment reducing income, reduced income reducing investment, and so on, progressively. Secondly, innovation is not the only cause of business cycle. This is shown as the “Secondary Wave” in Figure 2. Thus the cycles are inherently explosive but are contained by ceilings and floors of the economy. Entrepreneurs become pessimistic and reduce their investment and production. Recession: When the entrepreneurs realize their mistakes, they reduce investment, employment and production. Below is a more detailed description of each stage in the business cycle: Another factor is the export of gold to other countries when imports exceed exports as a result of high prices of domestic goods. Firms incurring losses will go out of business. Further, price of the product falls due to abundant supply leading to a decline in profits. Prices rise further. 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. He gives the example of a railway company which lays down one more track to avoid traffic congestion. Friedman’s Theory 6. The warranted rate of growth is the rate which will sustain itself. 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. In a period of recession and depression, according to Keynes, rate of interest should be high due to strong liquidity preference. Therefore, banks will lend at a low rate of interest which makes the entrepreneurs to borrow more. This will lead to rise in market rate of interest above the equilibrium rate of interest. The demand for capital goods will increase leading to a rise in price of these goods. (5) Full Employment Assumption Unrealistic: Schumpeter’s analysis is based on the unrealistic assumption of full employment of resources to begin with. Rate of interest does not determine the level of borrowing and investment. According to Hayek, so long as the natural rate of interest equals the market rate of interest, the economy remains in the state of equilibrium and full employment. Thus the period of contraction starts making the producers reduce their output. The induced investment, on the other hand, is dependent on changes in the level of output. At Q2, the slump reaches the bottom or floor provided by the LL line. These encourage borrowings on the part of merchants and producers. 1. The process of contraction becomes cumulative leading to depression. A rise in consumer and business confidence 2. Trade cycles are the outcome of economic development in a capitalist society. Therefore, consumption will not increase. (7) Does not Explain Periodicity of Cycle: The theory also fails to explain the periodicity of the cycle. (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. As the process continues, the initial impacts will spread throughout the economy. (2) Innovations not the Only Cause of Cycles: Schumpeter’s contention that cyclical fluctuations are due to innovations is not correct. This state of recession ends in depression. Mere contraction of bank credit will not lead to depression if marginal efficiency of capital is high. Real income production, employment, prices, profit etc. At best, it can create conditions for that. Even then, it fails to bring a revival. The rise in prices may induce the entrepreneurs to increase their investments leading to over-investment. The kingpin in Hawtrey’s theory is the trader or the wholesaler who gets credit from banks and starts the upturn or vice-versa. On the other hand, if traders finance their stocks with their own funds, interest rate changes will have little effect on their purchases. Content Filtration 6. Each long wave upswing is brought about by an innovation which leads to abundance of goods for the masses. This theory assumes that the amount saved would be automatically invested. It has been defined differently by different economists. (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. But this is not true. In this phase, there is a slow rise in output, employment, income and price. This is because they are very sensitive to changes in the rate of interest. Since income at this level is decreasing relative to the previous stage of the cycle, there is a decreased amount of investment. In such a situation, there is no need of transferring resources from one sector to the other. Suppose the central bank increases the stock of money in the market by open market operations by purchasing securities. The Austrian business cycle theory (ABCT) is an economic theory developed by the Austrian School of economics about how business cycles occur. As the boom progresses, there is a tendency for the MEC to fall due to two reasons. This deadlock can be broken by following a cheap money policy by the central bank which will ultimately bring about recovery in the economy. 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. The rate of decrease in the accelerator is limited by the rate of depreciation in the downswing. Next, Friedman and Schwartz explain the mechanism which brings about monetary changes leading to the business cycles. But the term marginal efficiency of capital is vague. This website includes study notes, research papers, essays, articles and other allied information submitted by visitors like YOU. Prosperity: It is a state of affairs in which real income and employment are high. According to Keynes, the principal cause of depression and unemployment is the lack of aggregate demand. are falling. Thus Schumpeter’s theory is not a correct explanation of trade cycles. Revival can be brought about by raising aggregate demand which, in turn, can be raised by increasing consumption and/or investment. But Keynes gives more importance to fluctuations in the MEC as the principal cause of cyclical fluctuations. Substantial contractions in the quantity of money over shorter periods have been a major factor in producing severe economic contractions. Further, as admitted by Hicks himself, depression may start even before reaching the full employment ceiling due to monetary factors. On the contrary, when the market interest rate is more than the natural rate, the economy is in depression. Since the supply price of capital assets is stable in the short-run, the MEC is determined by the prospective yield of capital assets, which, in turn, depends on business expectations. As the process of expansion continues, cost of production increases, due to scarcity of factors of production. (3) Hicks assumes constant values for the multiplier and the accelerator. So when credit becomes cheap, they borrow from banks in order to increase their stocks or inventories. A trade cycle is international in character. But Hawtrey believes that an expansion of credit leads to a boom. Privacy Policy3. Market rate of interest is one at which demand for and supply of money are equal. The rate of decrease in investment is limited by the rate of depreciation. But full employment is an unrealistic assumption, as no country in the world has achieved full employment. Hayek formulated his monetary over-investment theory of trade cycle. During depression, the level of economic activity is extremely low. The business cycle is not periodical. Here he seems to follow Keynes blindly regarding the stable consumption function. Increase in the supply of goods and decline in the demand create under consumption and hence over production. This is because the theory is based on the multiplier-accelerator interaction in rigid form, according to Kaldor and Duesenberry. But the actual behaviour of the postwar cycles has shown that the expansionary phase of the business cycle is much longer than the contractionary phase. Hayek’s theory is incomplete because it does not explain the various phases of trade cycle. 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. The following points highlight the top eight theories of business cycle. 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”. Schumpeter’s theory has been criticised on the following grounds. Fall in income will lead to a decline in demand for goods and services produced by other sectors. There are idle resources. It affects different industries in different ways. He has distinguished between equilibrium or natural rate of interest and market rate of interest. The autonomous investment is independent of changes in the level of output. 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. Similarly, the main cause of the downturn is reduction in investment. Thus, the variations in climate are so regular that depression is followed by prosperity. According to Friedman and Schwartz, the empirical evidence justifies the generalisations noted above. He opines that non-monetary factors like strikes, floods, earthquakes, droughts, wars, etc. For example, global companies even conduct research and development in developing markets where highly skilled labor and facilities are usually cheaper. It serves especially to emphasise that in a capitalist economy characterised by substantial amounts of durable equipment, a period of contraction inevitably follows expansion. They also cancel orders with producers. This leads to further increase in productive activity, income, outlay, and demand, and a further depletion of stocks of merchants. Falling demand, prices and incomes are the signals for depression. Meaning of Trade Cycle 2. (2) The introduction of a new method of production; (4) The conquest of a new source of raw materials or semi-manufactured goods; and. It is associated with W.S.Jevons and later on developed by H.C.Moore. Joseph A. Schumpeter has developed innovation theory of trade cycles. The product life cycle theory is used to comprehend and analyze various maturity stages of products and industries. LL is the lower equilibrium path of output representing the floor or ‘slump equilibrium line’. So entrepreneurs undertake new investment. Given constant values of the multiplier and the accelerator, it is the ‘leverage effect’ that is responsible for economic fluctuations. In the circular flow, the same products are produced every year in the same manner. Surplus stocks of goods are exhausted. But in reality, business cycles are the result of the other exogenous factors like innovations. 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. The reliance on the conventional hypothesis makes Keynes’ concept of expectations superfluous and unrealistic. Monetarists like Friedman have supported Hawtrey’s theory. 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. Vernon believes that there are four stages of production cycle: innovation, growth, Major US historical economic fluctuations include inflationary and deep depression cycles. The product life-cycle theory was developed by Raymond Vernon in the mid-1960s. If resources remain unutilized, the expansion of both the capital goods sector and consumer goods sector may occur simultaneously. This sudden disposal of goods leads to fall in prices and liquidation of marginal firms. (3) Bank Credit not the Only Source of Funds: Schumpeter gives too much importance to bank credit in his theory. Ultimately, the natural forces of recovery bring about a revival. Share Your PPT File, Top 7 Theories of Interest (With Criticisms). Banks may stop their loans. Since consumption is stable during the short-run, revival is possible by increasing investment. Consequently, money incomes and prices rise and help to create a cumulative expansion throughout the economy. According to Hawtrey, prosperity cannot continue limitlessly. Each phase feeds on itself and creates further movement in the same direction. 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. Pessimism gives way to optimism. 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”. It induces a secondary wave of credit inflation which is superimposed on the primary wave of innovation. As the innovators start repaying bank loans out of profits, the quantity of money is decreased and prices tend to fall. So for a few years, disinvestment in stocks will continue till the surplus stocks are exhausted. According to him, Keynes makes no attempt to test any of his deductions with facts. At this time, banks will decide to reduce credit expansion. Explanation of Floor and Lower Turning Point not Convincing: Hicks’s explanation of the floor and of the lower turning point is not convincing. Ultimately, expenditures rise on all directions without any change in interest rates at all. Producers transfer the factors from the production of capital goods to that of consumer goods. Cyclical variations in the quantity of money may well be an important element in the ordinary mild business cycle. The latter curtail their productive activities due to fall in demand. The shorter the length of life of durable assets, the shorter the depression. Google Scholar Lundberg (E.) (1937): Studies in the Theory of Economic Expansion (King, 1937), Chapter IX. A trade cycle is asymmetrical. The prosperity phase is slow and gradual and the phase of depression is rapid. The demand for investment funds is met by the increase in the supply of money. 3. Business cycle is recurrent and rhythmic; prosperity is followed by depression and vice versa. So watch this video till end. There is a general uptrend in business community. There being full employment in the economy, they transfer factors of the production from consumer goods sector to capital goods sector. (4) The economy cannot expand beyond the full employment level of output. It may at best check growth and not cause a depression. 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. Thirdly, Keynes does not explain periodicity of trade cycle. Their prices fall. There is rise in wages, prices, profits and interest. Hicks’s Theory. Content Guidelines 2. Line FF is the full employment ceiling level above the equilibrium path EE and is growing at the constant rate of autonomous investment. This will tend to raise service prices. When the market interest rate is less than the natural rate, there is prosperity in the economy. These show that the stock of money has displayed a systematic cyclical pattern over the decades. Many economists do not know what the theory is, and many are sure that the theory is fundamentally wrong-headed. 6. also affect trade cycles. Profits decline. There is unemployment. In the diagram above, the straight line in the middle is the steady growth line. With economic growth, banks are more willing to lend, increasing investment. The new innovation starts producing goods and there is an increased flow of goods in the economy. Hawtrey’s theory is incomplete because it emphasises only monetary factors and totally ignores such non-monetary factors as innovations, capital stock, multiplier-accelerator interaction, etc. They are business expectations, price changes, cost of storage, etc. Since full employment is an exception rather than the rule. During the expansion phase, the MEC is high. Report a Violation 11. Depression sets in, and the painful process of readjustment to the “point of previous neighbourhood of equilibrium” begins. Thus Schumpeter’s first approximation consists of a two-phase cycle. Trade Cycle Theory: Goodwin, Kalecki and Phillips. There is no wastage of materials. Product Life Cycle Theory. According to Hayek, when the fall in prices comes to an end during depression, banks begin to raise the supply of money which reduces the market interest rate below the natural interest rate. With low profits and reduction in loans, producers reduce the production of capital goods and adopt labour-intensive production processes. It is also possible that part of a particular investment may be autonomous and a part induced, as in the case of machinery. In reality, there is no full employment of resources. On the other hand, an increase in the rate of interest will lead to reduction in borrowing, investment, prices and business activity and hence depression. 4. And fluctuations in the rate of investment are caused mainly by fluctuations in the marginal efficiency of capital.”. They adopt capital-intensive methods for producing more of capital goods. These factors force the banks to raise interest rates and refuse to lend. Bank credit plays an important role in business activity. There is optimism everywhere. According to Hawtrey, the process of recovery is very slow and halting. Disclaimer 8. When there is crop failure, that will result in depression. Schumpeter assigns the role of an innovator not to the capitalist but to an entrepreneur. Second, on the reaction mechanism of the economic system to the disturbances. Despite these criticisms, it cannot be denied that one of the important causes of business cycles is “a dance of the dollar.”. The first approximation starts with the economic system in equilibrium with every factor fully employed. Thus in the Keynesian explanation of the trade cycle, “the cycle consists primarily of fluctuations in the rate of investment. This is not correct. The result will be a damped cycle. Low interest rate induces producers to get more loans from banks. Lundberg, therefore, suggests that the assumption of constancy in accelerator should be abandoned for a realistic approach to the understanding of trade cycles. MEC is rapidly increasing and rate of interest is sticky. (1) Innovator not Necessary for Innovations: Schumpeter’s analysis is based on the innovator. Before uploading and sharing your knowledge on this site, please read the following pages: 1. Phases 4. 10. This increases or decreases the flow of money in the economy and thus brings about prosperity or depression. Critics have pointed out the weakness of Keynes’ theory. Business expands; factors of production are fully employed; price increases further, resulting in boom conditions. Boom. Demand for bank loans increases. This extension of cycle is followed by a period of revival which continues till the equilibrium level is reached. This encourages investment and the process of revival begins in the economy. Thus the phase of expansion starts. In fact, causation also has run in other direction. Secondly, Keynes assumes that rate of interest is stable. 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. 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. Momentum effect. 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.”. According to Mitchell, “Business cycles are of fluctuations in the economic activities of organized communities. 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. Similarly, it reaches its trough before the ‘reference’ trough. The business cycle moves about the line. 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. The demand for the old products is decreased. This is what has happened historically. If this theory is correct, then industrialised countries should be free from cyclical fluctuations. Second, this is true both for long secular changes and also for changes over periods roughly the length of business cycles. Share Your Word File This will lead to a fall in MEC. Monetary changes may be one among other factors, and not the only factor. This theory has been formulated by Malthus, Marx and Hobson. Hence they save and invest which results in an increase in the volume of goods. Theories of Trade Cycle: Many theories have been put forward from time to time to explain the phenomenon of trade cycles. Hence, due to competition for factors of production costs may go up, leading to an increase in price. Thus innovations may bring about changes in economic conditions. The process of expansion goes on till the boom is reached. Businessmen will undertake investment in-spite of high rate of interest if they feel that the future prospects are bright. Mercantilism. There are no idle resources. 41 Downloads; Abstract. 5.Distinction Between Autonomous and Induced Investment not Feasible: Critics like Duesenberry and Lundberg point out that Hicks’s distinction between autonomous and induced investment is not feasible in practice. During the period of expansion businessmen are optimistic. A trade cycle is cumulative and self-reinforcing. Friedman concludes on the basis of empirical evidence that lags involving changes in the rate of the money stock that affect the level of economic activity are both long and variable. 5. 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. Further, the fall in the MEC may shift the consumption function downward thereby hastening the depression. It is wrong to say that banks alone cause business cycle. The innovating entrepreneur is financed by expansion of bank credit. Line AA shows the path of autonomous investment growing at a constant rate. All these will bid up the prices of assets and of both producer and consumer goods. Banks reduce their loans and advances. 7. Trade Cycle in Just Inflation and Deflation Hawtrey argues that the trade cycle is nothing but small-scale replica of an outright money inflation and deflation. 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. Harrod doubts the contention that autonomous investment would be increasing at the bottom of the depression. For this, they pay higher remuneration to factors of production in comparison with the producers of capital goods. Hicks assumes that autonomous investment continues throughout the different phases of the cycle at a steady pace. This is shown as the “Primary Wave” in Figure 2. Investment depends on rate of interest and marginal efficiency of capital. Keynes regards the trade cycle as mainly due to “a cyclical change in the marginal efficiency of capital, though complicated and often aggravated by associated changes in the other significant short-period variables of the economic system.”. In order to repay bank loans, businessmen start selling their stocks. Disclaimer Copyright, Share Your Knowledge (2) Monetary Changes not the Main Cause of Business Cycles: According to this theory, monetary changes are the main cause of business 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. This leads to a cumulative decline in employment and income via the reverse operation of the multiplier. This causes an increase in money supply and rise in price leading to expansion. Hence investments are increased beyond limits and there is over production, which results in losses. The Samuelson-Hicks theory of Chapter 7 is an example of the treatment of oscillations in macro-economic quantities in period terms. This leads to increase in their production. Hence this distinction between autonomous and induced investment is of doubtful validity in practice. As a result, production costs fall and profits increase. According to Prof. Smithies, the source of growth should he within the system. Hawtrey’s theory is considered to be an incomplete theory as it does not take into account the non-monetary factors which cause trade cycles. These theories can be classified into non-monetary and monetary theories. above video is explains you trade cycle. If the banking system places more money in the hands of entrepreneurs, prices will increase. 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. First, as more capital goods are being produced steadily, the current yield on them declines. But fluctuations in inventory investment can at best produce minor cycles which are not cycles in the true sense of the term. Money incomes increase. When the net trade days are positive, the company needs to funds those days with net income or a line of credit.When the net trade cycle is negative, the firm is being paid for the service or product before the firm pays its vendor AP.While a negative net trade cycle can be very advantageous to a business, it only holds true when a business is increasing the revenues. According to Dernburg and McDougall, the full employment level depends on the magnitude of the resources that are available to the country. In addition, there may be an endogenous cycle. (5) The working of the accelerator in the downswing provides an indirect restraint on the downward movement of the economy. Innovations are not inventions. Simultaneously, banks impose restrictions on giving loans to them. During the period of good trade, entrepreneurs become optimistic which would lead to increase in production. One cannot therefore separate the long-run full employment trend from what happens during a cycle.”. Thus the total amount of investment in the economy is equal to autonomous investment minus the constant rate of depreciation. Accelerator theory of investment. The oldest of all international trade theories, Mercantilism, dates back to 1630. This will bid up prices of such assets. Schumpeter’s treatment of the different phases and turning points of the cycle is novel and different from all other economists. Depression may retard rather than encourage autonomous investment. 2. 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 revival and recovery becomes cumulative and leads to prosperity. Rising asset prices such as houses; this causes a rise in wealth and consumer spending. The product life cycle theory has been less able to explain current trade patterns where innovation and manufacturing occur around the world. When the new product becomes successful, other entrepreneurs will also produce similar products. It is consistent with saving-investment equilibrium. Roger W. Garrison* I. The merit of Keynes’ theory lies in explaining the turning points-the lower and upper turning points of a trade cycle. Thus, with the continuous reduction in the prices of goods and factors in the economy, a long period of depression and unemployment begins. MEC depends on the expectations of the entrepreneur about future. 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. 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. “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. This is because the equilibrium may deviate due to both internal and external reasons. 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. Thus the competitive impact of an innovation would not increase costs and prices. But the fact is that at the time of revival, the resources are unemployed. To explain the course of the Keynesian cycle, we start with the expansion phase. To conclude with Dernburg and McDougall, “The Hicks’s model serves as a useful framework of analysis which, with modification, yields a fairly good picture of cyclical fluctuation within a framework of growth. Thus the introduction of an innovation may not lead to the withdrawal of labour and other resources from old industries. When the economy is at the level of depression, banks have excess reserves. Prof. Strigl has criticised this theory for giving undue importance to forced savings. Rich people have large income but their marginal propensity to consume is less. Terms of Service 7. The lag of economic activity appears to be greater for peaks than for troughs. 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. 4. A reduction of rate of interest by the banking institutions would enthuse the businessmen to borrow more and more and ex… Bank credit is the principal means of payment in the present times. If both equilibrium rate of interest and market rate of interest are equal, there will be stability in the economy. Plagiarism Prevention 5. Thus changes in the money stock are a consequence as well as independent cause of changes in economic activity. 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. According to Hayek, when the prices of factors are rising continuously, the rise in production costs bring fall in profits of producers. As a result, investment in capital goods also increases and does not fall. In such a situation, the demand for investment funds is more than the supply of available savings. Keynes considers the trade cycle as mainly due to fluctuations in the MEC. Second, it implies that monetary change has been an exogenous variable and that causation runs only from monetary change to economic change. 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. Finally, when all excess capacity is exhausted, autonomous investment will cause income to rise which will in turn lead to an increase in induced investment so that the accelerator is triggered off which along with the multiplier moves the economy toward the ceiling again. The innovations theory of trade cycles is associated with the name of Joseph Schumpeter. Hence it is not related to the growth of the economy. Prohibited Content 3. This leads to the atmosphere of prosperity in the country and monetary over-investment on factors spreads the boom. Article shared by. Similarly, contraction of credit cannot bring about a depression. Many theories have been put forward from time to time to explain the phenomenon of trade cycles. Thus it is a mechanical sort of explanation in which human judgement, business expectations and decisions play little or no part. 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. Hence it is a function of the growth rate of the economy. Keynes’s Theory 5. Incomes fall. 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. (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. But they are accentuated by bank credit. Though there is an element of truth in this theory, this theory is unable to explain the occurrence of boom and starting of revival. Schumpeter’s Innovations Theory: The innovations theory of trade cycles is associated with the … Fluctuations in the rate of investment are also caused by fluctuations in the rate of interest. (4) Traders do not react to changes in Interest Rates: Further, Hamberg also does not agree with Hawtrey that traders react to changes in interest rates. Before publishing your Articles on this site, please read the following pages: 1. Theories. Economics, Monetary Economics, Capitalism, Trade Cycle, Theories, Theories of Trade Cycle. But now all innovations form part of the functions of joint stock companies. 7. Similarly during boom, rate of interest should be low because of weak liquidity preference; but actually the rate of interest is high. The MEC increases. A rise in demand raises prices. 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. According to Prof. R.G. In imputing growth to an unexplained extraneous factor, Hicks has failed to provide a complete explanation of the cycle. It is not easy to transfer resources from capital goods industries to consumer goods industries and vice versa. Since rate of interest is more or less stable, marginal efficiency of capital determines investment. This theory was developed by A.C. Pigou. Schumpeter’s Innovations Theory 4. F.A. 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. People will tend to consume more services, such as renting houses rather than purchasing them. Privacy Policy 9. At this time, the banks call off loans from the borrowers. He has ignored real factors. Expansion and contraction of credit may be a supplementary cause but not the main and sole cause of trade cycle. Expanding trade cycle theory beyond that purpose and function was, he believed, fallacious. 4. Keynes doesn’t develop a complete and pure theory of trade cycles. The economy will move along the ceiling from P1 to P2 depending upon the time period of the investment lag. Howtrey’s Monetary Theory Of Trade Cycle: Prof. Hawtrey regards business cycle as purely a monetary phenomenon. (6) The relation between the multiplier and accelerator is treated in a lagged manner, since consumption and induced investment are assumed to operate with a time lag. These conditions lead to recession. This will create over production in other sectors. Hawtrey’s Monetary Theory 2. The entrepreneur is not a man of ordinary ability but one who introduces something entirely new. At the same time, as majority of the people are poor, they have low propensity to consume. On the other hand, the market rate of interest is the money rate which prevails in the market and is determined by the demand and supply of money. Trade cycle is a complex phenomenon and it cannot be associated with climatic conditions. 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. 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. When the capital stock is increasing during any period, the ceiling is raised. 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. But this does not happen because of the upper limit or ceiling set by the full employment level FF. 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. But it has failed to explain revival. 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. For this, they place larger orders with producers who, in turn, employ more factors of production to meet the increasing demand. Published originally in 1929, Monetary Theory and the Trade Cycle is the first essay Friedrich A. Hayek wrote. If the slump is severe, induced investment will quickly fall to zero and the value of the accelerator becomes zero. According to Schumpeter, innovations in the structure of an economy are the source of economic fluctuations. As defined by Hicks, it is independent of the path of output. Every increase in investment leads to a multiple increase in income via the multiplier effect. It is in this way that the cyclical process will be repeated in the economy. Schumpeter accepts Juglar’s statement that “the cause of depression is prosperity,” and then gives his own view about the originating cause of the cycle. #Trade_Cycle_theory_by_Samuelson, व्यापार चक्रो का सिद्धांत:सेम्यूल्सन, Samuelson Trade Cycle theory - Duration: 17:19. 5. But for Keynes, the change in consumption function with its effect on MEC is responsible for trade cycle. 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. 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. This explanation of the transmission mechanism fits with the empirical observations of business cycles. Hicks assumes in his model that the average capital-output ratio (v) is greater than unity for a time lag of one year or less. When rate of interest is reduced by banks, entrepreneurs will borrow more and invest. According to Hicks, this upswing phase relates to the standard cycle which will lead to an explosive situation because of the given values of the multiplier and the accelerator. With the increase in the purchasing power of consumers, the demand for the products of old industries increases in relation to supply. But critics point out that the direction of causation is just the opposite of it. The adjective ‘business’ restricts the concept of fluctuations in activities which are systematically conducted on commercial basis. The non-bank sellers and commercial banks will try to readjust their portfolios. Friedman and Schwartz have argued on the basis of US historical data that business cycles are mostly monetary in origin. Rather, they ask the business community to repay their loans. He emphasized the role of psychological factor in the generation of trade cycles. When cyclical fluctuations start in one sector it spreads to other sectors. Thus the value of the multiplier changes with different phases of the cycle. These theories can be classified into non-monetary and monetary theories. 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. Credit expansion and contraction do not lead to boom and depression. This is based on the Keynesian stable consumption function. Our mission is to provide an online platform to help students to discuss anything and everything about Economics. All the sections of the people suffer. The amplitude of economic fluctuations depends: First, on the amplitude, time pattern, number and independence of the disturbances affecting the economic system. In this sense, it is similar to that of Pigou’s psychological theory. It is the introduction of a new product and the continual improvements in the existing ones that are the principal causes of business cycles. There is less investment in capital goods. In the Hicksian theory, the accelerator is based on induced investment which along with the multiplier brings about an upturn. An increase in money supply will lead to boom and vice versa, a decrease in money supply will result in depression. Profits increase and old industries expand by borrowing from the banks. Fresh investment starts taking place. According to Schumpeter, there is nothing that can explain that inventions occur in a cyclical manner. However, this theory is not accepted today. The second approximation of Schumpeter follows through the reaction of the impact of original innovation. Prof. Culbertson regards this evidence as faulty for two reasons: First, it relates turning points in one series in the money stock to turning points in economic activity. Recovery: In the early period of recovery, entrepreneurs increase the level of investment which in … Firstly, Schumpter’s theory is based on two assumptions viz., full employment and that innovation is being financed by banks. Merchants place more orders which induce the entrepreneurs to increase production by employing more labourers. Businessmen are optimistic. Further, Hicks’s contention that revival would start with the exhaustion of excess capacity has not been proved by empirical evidence. Some of the points of criticism are discussed below: None can deny that expansion of credit leads to the expansion of business activity. On the other hand, a decline in MEC leads to unemployment and fall in income and output. This causes a general glut in the market. Spiethoff has pointed out that over investment is the cause for trade cycle. Looks at how this theory can be applied to international trade especially with regard to competition in the form of … Innovations are regarded as the routine of industrial concerns and do not require an innovator as such. Sunspot Theory or Climatic Theory: It is the oldest theory of trade cycle. Mechanical Explanation of Trade Cycle: Another serious limitation of the theory is that it presents a mechanical explanation of the trade cycle. Content Guidelines 2. It is the oldest theory of trade cycle. (7) It is assumed that the average capital-output ratio (v) is greater than unity and that gross investment does not fall below zero. This theory is realistic in the sense that it considers over investment as the cause of trade cycle. But rate of interest does play an important role in decision making process of entrepreneurs. Forced savings increase with the fall in consumption which are invested for the production of capital goods. 2. TOS4. According to Hart, Keynes relied on “convention” for forecasting changes in business expectations. 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. The lag may be long because the effects of monetary disturbances are distributed over an extended period. Some of the characteristics of a boom include: A fast growth of consumption helped by rising real incomes, strong confidence and a surge in house prices and share prices; A pick up in demand for capital goods as businesses invest in extra capacity to meet strong demand and to make higher profits 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 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. Innovation is financed by bank loans. 11. Thus it can be said in Fisher’s words that the cycle is largely a “dance of the dollar”. But in the downswing, the accelerator does not work so swiftly as in the upswing. Hence trade cycle is a wave like movement. Product prices are equal to both average and marginal costs. Optimism gives way to pessimism. Product innovation and diffusion influence long-term patterns of international trade. After a period of gestation, the new products start appearing in the market displacing the old products and enforcing a process of liquidation, readjustment and absorption. Hicks’ theory of trade cycle: Prof Hicks explains the phenomenon of trade cycles by combining the … This leads to fall in the prices of factors and resources become unemployed.