Keynes Theory of Trade cycle8th February 2020
Keynes did not build up his own exclusive theory of the trade cycle. But he made such important contributions to the analysis of depressions and inflation that his disciples could give a systematic account of the upturn and the downturn in economic activity. In his General Theory, Keynes thought it sufficient to add “Notes on the Trade Cycle.”
These notes did not comprise a complete theory of the trade cycle because no attempt was made here to give a detailed account of the various phases of the trade cycle. Keynes did not examine closely the empirical data of cyclical fluctuations. All the same, Keynes provided the analytical tools for the purpose of building a complete theory.
According to Keynes, business cycle is caused by variations in the rate of investment caused by fluctuations in the Marginal Efficiency of Capital. The term ‘marginal efficiency of capital’ means the expected profits from new investments. Entrepreneurial activity depends upon profit expectations. In his business cycle theory, Keynes assigns the major role to expectations.
Business cycles are periodic fluctuations of employment, income and output. According to Keynes, income and output depend upon the volume of employment. The volume of employment is determined by three variables: the marginal efficiency of capital, the rate of interest and the propensity to consume.
In the short period the rate of interest and the propensity to consume are more or less stable. Therefore, fluctuations in the volume of employment are caused by fluctuations in the marginal efficiency of capital.
The Keynesian theory of trade cycle is summarised below:
- Crucial Role of Investment
Keynes maintained that trade cycles are essentially caused by variations in the rate of investment due to the fluctuations in the marginal efficiency of capital. The changes in investment are made worse by the changes induced by the cycle itself in propensity to consume and the state can be described and analyzed in terms of the fluctuations of the marginal efficiency of capital relatively to the rate of interest.” Thus fluctuations in MEC were considered by Keynes to be the root cause of the trade cycle.
In Keynes’ view, the marginal efficiency of capital depends mainly upon two factors:
- The series of prospective yields from investment in the new capital assets, and
- The supply price (replacement cost) of the new capital assets.
These two factors are based upon the psychology of the investors. Therefore, they can change at any time and very rapidly. MEC is based on expectations of the businessmen. At one time, there can be wave of optimism which pushes up the MEC. At another time, there can be a pessimistic mood in the market for new capital assets which depresses the MEC considerably.
In Keynes’ view, introduction of the sudden changes in MEC and hence of investment was the key to the understanding of business cycles. Both the downturn and the upturn in economic activity are the result of sudden and substantial changes in investment.
- The Upswing in Economic Activity
During the expansion phase of the trade cycles, the investors have an optimistic outlook. They have a firm confidence of the high profitability of the investment in new capital assets. They have a multiplier effect. Income rises much faster than the rise in investment. In a period of rising income, output and employment, the optimism of the investor gets further support. Therefore, expansion of economic activity goes on automatically till full employment of resources is reached.
The movement of the economy towards full employment is called a boom. The rate of interest rises fast during the boom phase. But the exclusive optimism on the part of investors’ does not allow the rate of interest to act as a brake on rising investment. If investment were to be done on the basis of cold calculations, new investments would not take place once the rate of interest gets equaled with the MEC.
As the boom proceeds, the profitability of investment must fall owing to three factors:
(i) The tendency towards diminishing marginal return due to the growing supply of capital assets;
(ii) The rising cost of production of capital assets; and
(iii) Rise in the rate of interest.
But businessmen tend to ignore the fall in MEC because of over-optimism on their part. To quote Keynes, “A boom is a situation in which over-optimism triumphs over a rate of interest which, in a cooler light, would be seen to be excessive.”
- Recession and Depression
The continued rise in investment approaches progressively a point where the additional capital goods would not be demanded. It is a point of saturation of demand for capital goods. Rising cost of production of capital assets, the declining prospective yields, appearance of shortages and bottlenecks in production, excessive competition and the abundance of manufactured goods are unmistakable signs of the impending recession. Consequently, the over-optimism of the boom condition is followed by pessimism.
The wave of pessimism spreads fast. In this situation, the marginal efficiency of capital collapses with a suddenness which is catastrophic. Share markets often collapse. Investors lose confidence, output falls, unemployment increases. There seems to be glut of capital goods in the market. Thus, the contraction phase sets in.
Economic contraction proceeds at a rapid pace because the multiplier operates in the reverse direction and reduces income much faster than the decline in investment. Another force which speeds up the contraction is the rapid rise in the rate of interests after the collapse of investment markets. The relatively faster rise in the rate of interest during the contraction phase is due to the sudden increase in liquidity preference of the people during a period of falling prices.
Keynes attributed sudden rise in liquidity preference to the following three factors which operate in depression:
(a) People expect the security prices to fall further which leads the owners of securities to sell them before they suffer a further capital loss. Since there are few buyers of securities, their prices fall and the rate of interest rises to the extent the security prices fall.
(b) When the general price level is falling, consumers continue to postpone their purchases and hold on to cash. As the value of money increases, the demand for cash jumps up.
(c) The producers are forced to liquidate their inventories to meet their contractual obligations in the form of rents and salaries to permanent staff. They try to raise loans for the purpose which further adds to the demand for cash.
All these three factors raise the liquidity preference of the people and hence the rate of interest. While the rate of interest thus rises, the MEC continues to fall. This dampens investment activity further. The business world is overtaken by depression. Actually, the situation should not be as bad as it looks, but investors become over- pessimistic. It is very difficult for the government to revive their confidence in the investment market.
This is because the government can try to reduce the rate of interest through increased money supply. The governments cannot guarantee profitability of investment. Banks may offer loans at concessional rates but investors may not avail of these loans. Thus, monetary policy alone fails to revive economic activity in a depression. The low rate of investment generates a low level of equilibrium income in the economy. This is what Keynes called ‘Under-employment Equilibrium’. This equilibrium tends to be stable for some time.
Recovery of the economy from the state of depression necessitates the use of fiscal policy. Tax concessions and other incentives for investment activity along with public investment alone take the economy out of the depths of depression.
- Recovery is a Slow and Halting Process
The process of expansion of economic activity is slow after depression.
The time taken by the economy to recover depends among others upon the following three factors:
One, the normal rate of growth of the economy. This may be relatively high or relatively low. A high normal rate of growth hastens recovery a low rate of growth retards it.
Two, the time period of obsolescence/wearing out of the capital goods. The longer the life of capital goods, the longer it takes the economy to recover and vice-versa. Shorter life-spans of the capital goods require investments at an early date for replacement of these goods. This reduces the time for recovery.
Three, the time taken to dispose of accumulated stocks from the boom period. If the entrepreneurs happen to have already sold off the stocks of semi-finished and finished goods during the recession phase of the cycle, even a slight improvement in the climate of investment facilitates recovery. On the opposite, revival of economic activity shall be delayed to the extent producers have unsold stocks. Till old stocks get exhausted, new investments cannot be made.
The recovery is thereby slowed down. Generally it takes 3 to 5 years to absorb the stocks of the firms which they accumulate from the boom phase. Therefore, this is the minimum time for a depression to last. The maximum time of a depression depends upon the other factors, most important of which is the level of consumption of the people during depression.
We are now in a position to summarise the distinct contributions Keynes made to the explanation of trade cycles. Firstly, Keynes made it clear that trade cycles are fluctuations of economic activity around an equilibrium level. The equilibrium level of economic activity is determined mainly by non-induced (autonomous) investment.
Secondly, Keynes could provide, for the first time, a convincing explanation of the turning points of the trade cycle. This he could successfully do with the help of his theory of the consumption function. The collapse in the investment market is caused by excessive investment as compared to real savings under the consumption function of the people.
The lower turning point is marked where income becomes equal to consumption and there is no net saving or investment Thirdly, Keynes could show why the downturn of the economy is sudden while the recovery process is generally slow. Thirdly, the cumulative nature of the upswing and downswing was explained by Keynes with the help of his concept of the investment multiplier. The multiplier works in the upswing to raise income fast while it works in the backward direction to reduce income fast in the downswing.