Hicks Theory of Trade Cycle

08/02/2020 0 By indiafreenotes

Hicks put forward a complete theory of business cycles based on the interaction between the multiplier and accelerator by choosing certain values of marginal propensity to consume (c) and capital- output ratio (v) which he thinks are representative of the real world situation.

According to Hicks, the values of marginal propensity to consume and capital-output ratio fall in either region C or D of Fig. 1.

As seen above, in case values of these parameters lie in the region C, they produce cyclical movements (i.e., oscillations) whose amplitude increases overtime and if they fall in region D1 they produce an explosive upward movement of income or output without oscillations. To explain business cycles of the real world which do not tend to explode, Hicks has incorporated in his analysis the role of buffers.

On the one hand, he introduces output ceiling when all the given resources are fully employed and prevent income and output to go beyond it, and, on the other hand, he visualizes a floor or the lower limit below which income and output cannot go because some autonomous investment is always taking place.

Another important features of Hicks’ theory is that business cycles in the economy occur in the background of economic growth (i.e., the rising trend of real income of output over time). In other words, cyclical fluctuations in real output of goods and services take place above and below this rising line of trend or growth of income and output. Thus in his theory he explains business cycles along with an equilibrium rate of growth.

In Hicks’ theory of long-run equilibrium growth that is determined by rate of increase of autonomous investment over time and, therefore, long-run equilibrium growth of income is determined by the autonomous investment and the magnitudes of multiplier and accelerator. Hicks assumes that autonomous investment, depending as it is on technological progress, innovations and population growth, grows at a constant rate.

With further assumptions of stable multiplier and accelerator, equilibrium income will grow at the same rate as autonomous investment. It follows therefore that the failure of actual output to increase along the equilibrium growth path, sometimes to move above it and sometimes to move below it, determines the business cycles.

Hicks’ theory of business cycles has been explained with the help of Fig. 13.7. In this figure, AA line represents autonomous investment. Autonomous investment is that investment which is not induced by changes in income and is made by entrepreneur as a result of technological progress or innovations or population growth. Hicks assumes that autonomous investment grows annually at a constant rate given by the slope of the line AA.

Given the marginal propensity to consume, the simple multiplier is determined. Then the magnitude of multiplier and autonomous investment together determine the equilibrium path of income shown by the line LL. Hicks calls this the floor line as this sets the lower limits below which income (output) cannot fall because of a given rate of growth of autonomous investment and the given size of the multiplier. But induced investment has not yet been taken into account.

If national income grows from one year to the next, as it would move along the line LL, there is some amount of induced investment via accelerator. The line EE shows the equilibrium growth path of national income determined by autonomous investment and the combined effect of the multiplier and accelerator. FF is the full employment ceiling. It is a line that shows the maximum national output at any period of time when all the available resources of the economy are fully employed.

Given the constant growth of autonomous investment, the magnitude of multiplier and the induced investment determined by the accelerator, the economy will be moving along the equilibrium growth path line EE. Thus starting from point E, the economy will be in equilibrium moving along the path EE determined by the combined effect of multiplier and accelerator and the growing level of the autonomous investment.

Suppose when the economy reaches point P0 along the path EE, there is an external shock—say an outburst of investment due to certain innovation or jump in governmental investment. When the economy experiences such an outburst of autonomous investment it pushes the economy above the equilibrium growth path EE after point P0.

The rise in autonomous investment due to external shock causes national income to increase at a greater rate than that shown by the slope of EE. This greater increase in national income will cause further increase in induced investment through acceleration effect. This increase in induced investment causes national income to increase by a magnified amount through multiplier.

So under the combined effect of multiplier and accelerator, national income or output will rapidly expand along the path from P0 to P1. Movement from PQ to P1 represents the upswing or expansion phase of the business cycle. But this expansion must stop at P1 because this is the full employment output ceiling. The limited human and material resources of the economy do not permit a greater expansion of national income than shown by the ceiling line CC.

Therefore, when point P1 is reached the rapid growth of national income must come to an end. Prof. Hicks assumes that the full employment ceiling grows at the same rate as autonomous investment. Therefore, CC slopes gently unlike the very steep slope of the line from P0 to P1. When point P1 is reached the economy must grow at the same rate as the usual growth in autonomous investment.

For a short time the economy may crawl along the full employment ceiling CC. But because national income has ceased to increase at the rapid rate, the induced investment via accelerator falls off to the level consistent with the modest rate of growth determined by the constant rate of growth of autonomous investment. But the economy cannot crawl along its full employment ceiling for a long time.

The sharp decline in growth of income and consumption when the economy strikes the ceiling causes a sharp decline in induced investment. Thus with the sharp decline in induced investment when national income and hence consumption ceases to increase rapidly, the contraction in the level of the income and business actually must begin.

Once the downswing starts, the accelerator works in the reverse direction. That is, since the change in income is now negative the inducement to invest must begin to decrease. Thus there is slackening off at point P2 and national income starts moving toward equilibrium growth path EE. This movement from P2 downward therefore represents the downswing or contraction phase of the business cycle.

In this downswing investment falls off rapidly and therefore multiplier works in the reverse direction. The fall in national income and output resulting from the sharp fall in induced investment will not stop on touching the level EE but will go further down. The economy must consequently move all the way down from point P2 to point Q1. But at point Q1 the floor has been reached.

Whereas the upswing was limited by the output ceiling set by the full employment of available resources, in the downswing the national income cannot fall below the level of output represented by the floor. This is because the floor level is determined by simple multiplier and autonomous investment growing at constant rate, while during the downswing after a point accelerator ceases to operate.

It may be noted that during downswing the limit to negative investment (disinvestment) and therefore the limit to the contraction of output is set by the depreciation of capital stock. There is no way for the businessmen to make disinvestment at a desired rate higher than the depreciation.

When during downswing such conditions arise, accelerator becomes inoperative. After hitting the floor the economy may for some time crawl along the floor through the path Q1 to Q2. In doing so, there is some growth in the level of national income. This rate of growth as before induces investment and both the multiplier and accelerator come into operation and the economy will move towards Q3 and the full employment ceiling CC. This is how the upswing of cyclical movement again starts.

Assumptions of Hicks Theory of Trade Cycle

The following assumptions were made to develop his theory of the trade cycle:

(i) In Hicksian analysis, a progressive economy is assumed in which autonomous investment is increasing at a regular rate, so that system is such which could remain in progressive equilibrium.

(ii) The saving and investment coefficients are such that an upward displacement from the equilibrium path will tend to cause a movement away from equilibrium, though this movement may be lagged.

(iii) There is no direct restraint upon upward expansion in the form of a scarcity of employable resources provided by the full employment ceiling i.e., it is impossible for the output to expand beyond full employment level.

(iv) Though there is no direct constraint on the contraction yet the transformation of accelerator in the downswing (i.e., disinvestment cannot exceed depreciation) provides an indirect constraint.

(v) There are fixed values of the multiplier and accelerator throughout the different phases of a cycle, i.e., consumption function and investment function are both assumed to be constant.

(vi) However, in Hicksian analysis both the multiplier and accelerator are treated with a lag. He treats multiplier as a lagged relation, so that consumption in period t is regarded as a function of income of the previous period t – 1 and not of current period t. He also uses accelerator with a time lag i.e., induced investment in present period also responds to output changes in the previous period.