Ralph G. Hawtrey presented his explanation of “business cycles” in 1926. According to him, changes in money supply are the major source of fluctuations in the business activity. Due to this reason his theory of business cycles is termed as the monetary theory.” Non-monetary factors such as floods, drought, earthquake, wars, strikes etc., can cause partial depression, but the general depression can only be caused by contraction of money supply. In Hawtrey’s opinion, the most distinguishing feature of trade cycle is periodicity. Period of good trade is followed by period of bad trade. They occur alternatively and duration of the cycle is from seven to eleven years. Money and banking system are the sole source of business cycles. Hawtrey based his theory on Say’s law of markets and believes in classical assumption of full employment. Below is given a description of the factors causing the up-swing and the down-swing, which result in large fluctuations in the economic activities.
When traders decide to increase their stocks, they borrow from banks. Credit is created and this leads to an increase in effective demand. Incomes of those who participate in the production process increase. So there will be an overall expansion in the economy. The expansion is in terms of output, employment, money supply and, prices.
The demand and hence the production will keep on rising till the level of maximum capacity is achieved. Further increase in demand will cause price level to go up. Prices will also rise due to an increase in money supply in the economy. Increase in price level further increases the demand for credit. But the banks can provide loans only up to a specific limit. Eventually interest rate is raised and the banks ask for the repayment of the previous loans. Tight credit policy will be followed. Firms in order to return the loans will stop further investment. Projects will stop and raw materials and intermediate goods will be sold at reduced prices. Overall price level will fall. This will discourage new investment and the economy will be in depression.
When the banks get their money back. They start lending the money on easy terms and conditions. With this the process of upswing starts again, and this is how the business cycles originate.
In the above discussion, it has been observed that changes in supply of money are responsible for economic fluctuations. Business cycles are associated with credit expansion and contraction which in turn results in inflation and deflation in the economy, respectively.
Hawtrey’s theory has been criticized on the basis of following points.
1. It has been argued that changes in money supply might play a role in fluctuations in economic activity, but they do not cause business cycles.
2. The role of banks and businessmen is over exaggerated.
3. The theory wilt not works, if people invest their own money and do not borrow from banks.
4. The theory fails in the situation of liquidity trap.
5. The theory does not take into account the non-monetary factors such as innovations, multiplier, accelerator etc.
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