When the market interest rate is less than the natural rate, there is prosperity in the economy. 1. So for a few years, disinvestment in stocks will continue till the surplus stocks are exhausted. 1. In such a situation, the demand for investment funds is more than the supply of available savings. According to him, Keynes makes no attempt to test any of his deductions with facts. ADVERTISEMENTS: … (2) The introduction of a new method of production; (4) The conquest of a new source of raw materials or semi-manufactured goods; and. Consequently, the natural interest rate falls. Next, Friedman and Schwartz explain the mechanism which brings about monetary changes leading to the business cycles. But empirical evidence shows that the response of investment to a change in output (v) is spread over many periods. Each long wave upswing is brought about by an innovation which leads to abundance of goods for the masses. According to Schumpeter, a reservoir of untapped technical knowledge exists in a capitalist society which he can make use of. According to Prof. Smithies, the source of growth should he within the system. According to Hicks, it is the multiplier-accelerator interaction which weaves the path of economic fluctuations around the warranted growth rate. Simultaneously, banks impose restrictions on giving loans to them. Consequently, supply exceeds demand. Thus “the full employment ceiling” acts as a direct restraint on the upward expansion of the economy. (iii) Changes in the stock of money have been attributed to a specific variety of exogenous factors rather than to changes in economic activity. But now all innovations form part of the functions of joint stock companies. On the contrary, when the market interest rate is more than the natural rate, the economy is in depression. 8. may at best cause a partial depression, but not a general depression. Low interest rate induces producers to get more loans from banks. Profits increase and old industries expand by borrowing from the banks. Hayek’s theory is incomplete because it does not explain the various phases of trade cycle. Theory of under … Consequently, output, employment and income increase. According to Schumpeter, innovations in the structure of an economy are the source of economic fluctuations. Depression may retard rather than encourage autonomous investment. 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. Thus explosive cycles are inherent in his model. Bank credit may be important in the short run when industrial concerns get credit facilities from banks. Exogenous fluctuations in the money stock will lead to fluctuations in the demand for goods and services. A general trade cycle consists of: Pre-Sales: Finding a supplier and … 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. 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. According to Hicks, it is autonomous investment that brings a gradual movement towards the floor and it is again increase in autonomous investment at the bottom that leads to the lower turning point. 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. 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. The new innovation starts producing goods and there is an increased flow of goods in the economy. The economy does not turn upward immediately from Q2 but will move along the slump equilibrium line to Q3 because of the existence of excess capacity in the economy. (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. According to Hart, Keynes relied on “convention” for forecasting changes in business expectations. Revival has started. The trade cycle simply means the whole course of trade or business activity which passes through all phases of prosperity and adversity. Prices and cost of production of goods start declining until recession sets in. 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.”. But this does not happen because of the upper limit or ceiling set by the full employment level FF. 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. In reality, there is no full employment of resources. During the downturn, investment falls due to a fall in the MEC and rise in the rate of interest. 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. Fig 1 shows a very strong cyclical upswing and then downswing, with very large output gaps in the boom and recession stages. In such a situation, there is no need of transferring resources from one sector to the other. Thus optimism encourages borrowing borrowing increases sales, and sales raise optimism. This is based on the Keynesian stable consumption function. One cannot therefore separate the long-run full employment trend from what happens during a cycle.”. “Interest rates and asset prices may simply be conduit through which monetary change is transmitted to expenditures without being altered at all, just as a greater inflow into a tank may, after an interval, simply increase the rate of outflow without altering the level of the tank itself.” All these forces operate simultaneously and there are cyclical fluctuations. The higher economic growth increases incomes and causes more demand for housing 4. The increased demand for assets will spread sooner or later affecting equities, houses, durable producer goods, durable consumer goods, etc. On … These show that the stock of money has displayed a systematic cyclical pattern over the decades. These, in turn, lead to reduction in the demand for factors of production. According to Keynes, the principal cause of depression and unemployment is the lack of aggregate demand. (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 encourages investment and the process of revival begins in the economy. On the other hand, in deep depression cycles, there has been a greater fall in money stock. Further, Hicks’s contention that revival would start with the exhaustion of excess capacity has not been proved by empirical evidence. With the increase in the purchasing power of consumers, the demand for the products of old industries increases in relation to supply. (5) The carrying out of the new organisations of an industry. Schumpeter’s Innovations Theory 4. Industrial disputes could lead to wage increases and cost push inflation, and vice versa. In one of his earlier writings, Friedman emphasises that the concept of lag is related to the business cycle. (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. To perform his economic function, the entrepreneur requires two things: first, the existence of technical knowledge in order to produce new products, and second, the power of disposal over the factors of production in the form of bank credit. 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