KEYNESIAN THEORY OF BUSINESS CYCLES
Keynes response to classical theory of trade cycle. The keynes theory of business fluctuations was developed during the Great Depression of the 1930 s It was in response to the classical theory that the economy is self correcting. The classical economists were of the view that if at any time excessive unemployment occurs in the economy market forces automatically restore the economy to its full employment level in the long run.
Keynes theory of trade cycles
J. M. Keynes, however, disagreed with the above view He presented a new theory which is based on a demand side explanation of business cycles.
According to keynes in the short run, the level of income, output and employment is determined by the level of aggregate effective demand. Aggregate demand is composed of demand for consumption goods and demand for investment goods. If the expenditure on goods and services and investment is large, then greater quantity of goods will be produced. This will create more employment and income if the aggregate demand is low then smaller amount of goods and services will be produced. A lower level of aggregate, demand thus results in smaller output, income and employment. J.M. Keynes is of the view that it is the changes in the level of aggregate demand which bring about fluctuations in the level of income output and employment. Now what causes changes in aggregate demand?
The fluctuation in economic activity says Keynes is due to fluctuations in investment demand. The investment demand is determined by expected rate of profit from the investment on the one hand and the rate of interest on the other hand.
Lord Keynes defines marginal efficiency of capital as the expected rate of profit between the prospective yield of that type of capital and the cost of producing that unit If the prospective rate of return of capital used in the business is higher than the current rate of interest the entrepreneurs are encouraged to increase investment spending on construction, equipment, and inventories. Marginal efficiency of capital depends upon two factors: (1) Expected return from capital assets and (2) The supply price or replacement cost of the assets. Marginal efficiency of capital is raised by opening of a new investment a new product a new method of production a major change in the organization of business and by the expectation of rising prices It is lowered by failing prices rising costs productive difficulties and a decline in investment. A rise in the marginal efficiency of capital relatively to the current rate of interest leads to a burst in investment. The volume of employment and income increases. The demand for consumer goods goes up which leads to further increase in investment goods industries.
Expansion phase of the business cycle
During the expansion of trade cycle the investors have an optimistic outlook. They in enthusiasm over estimate the expected rate of return from the investment projects. The expansion of the economy goes on automatically till full employment of resources is reached. The movement of the economy towards full employment is called a boom fl the boom phase the investors ignore the fail in the marginal efficiency of capital. The rate of interest also does not act as a brake on rising investment. The over investment n the economy raises the cost of production of goods and begins to reduce profits on investment.
Recession and depression
The contraction phase of the business cycle is brought about by a fall in the marginal efficiency of capital relatively to the prevailing rate of interest when all the remunerative channels for investment are fully utilized then the scope for further investment declines. Due to excessive demand for loanable funds, the reserves of the banks get depleted. The market rate of interest goes up. The higher rate of interest induces people to save more money. The higher liquidity preference or the increasing demand for money to hold reduces the demand for consumer goods. When the business prospects appear bleak the investors are then not prepared to renew or extend their capital equipment. Due to excess of savings over-investment the income and employment decline We are then in a phase of recession which finally results in depression.
It may be remembered here that J M Keynes has used three psychological propensities in formulating his theory of business cycle. They are (i) propensity to consume (ii) propensity to save and (iii) the marginal efficiency of capital Lord Keynes also introduced the concept of multiplier in order to show the effect of increase in total income due to increase in investment. Keynes is of the view that upswing of business cycle is caused by a rise in the marginal efficiency of capital. When the entrepreneurs find that the opportunities for profitable investment exist they repair the existing plants and install the new ones. The money spent by the investors goes into the pockets of wage earners. They then increase their orders of consumption goods. The total receipts of the entrepreneurs goes up. They being encouraged to high profits place more orders for consumption and capital goods industries. The volume of employment and income increases. The multiplier is then at work.
Recovery is a slow process
According to Keynes the recovery after depression is a slow process. How much time the economy takes to recovery depends upon three factors:
i) Rate of growth of the economy.
ii) Time period of the wearing out of the capital goods.
iii) Time taken to dispose of the stocks of the boom period.
Keynes theory dominated economic thinking from late 1930’s to early 1970’S. Criticism of Keynes Theory of Trade Cycle.
The Keynesian theory of business cycle is criticized on the following grounds:
(i) It offers half explanation Keynes theory offers half explanation of the business cycle. It fails to explain the periodicity of the trade cycles.
(ii) Neglect of the role of accelerator J M Keynes explained the process of downswing and upswing of trade cycle through the concept of investment multiplier. The fact however is that multiplier alone does not offer satisfactory explanation of the business fluctuations. It is the multiplier acceleration interaction which brings about expansion or contraction of the economic activity.
(iii) Psychological theory Keynes theory of trade cycle is very near to the psychological theory of the Classical economists. It does not explain the real factors which cause changes in business expectations. Conclusion. J. M. Keynes did not build up an exclusive theory of the trade cycle. He simply gave a systematic account of the upturn and the down turn in economic activity.
Keynes provided analytical tools for the purpose of building a theory of trade cycle. On the foundations laid down by J.M. Keynes, Hicks, Goodwin and Molthews propounded the modern theories of the trade cycle.
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