Let us make an in-depth study of the Hawtrey’s pure monetary theory of the trade cycle.

According to Hawtrey, “The trade cycle is a purely monetary phenomenon because general demand is itself a monetary phenomenon.”

Hawtery was of opinion that in every deep depression, monetary factors play a critical role.

He made the classical quantity theory of money the basis of his theory of the trade cycle. In his view, changes in flow of money are the sole and sufficient cause of changes in economic activity.


His argument can be put down briefly as follows:

The flow of money approximately equals consumer outlay which can be written as MV. where V is the income-velocity of circulation of the total money m. If the quantity of money is expanded, demand exceeds anticipated supply; stocks of goods proving insufficient, additional orders have to be placed.

This brings about a rise in output, factor incomes, costs and hence prices. In the opposite situation, a reduction in the quantity of money causes reduction in demand for goods which leads to fall in output, income, employment and price.

Hawtrey’s theory highlights the role of three monetary factors in generating up-wings and down wings in economic activity:


(а) The strategic role of merchants in determining the level of economic activity in response to changes in the discount rate.

(b) Changes in the flow of total monetary demand.

(c) The role of the so-called external drain and recall of bank reserves.

The three factors, when combined under different conditions can together cause the uprising or downturn in economic activity. Take, for example, the expansion or upswing in the economic system. It has been contended that when banks accumulate excess reserves with them, they liberalise the terms of credit.


They can do so in different ways:

(1) Banks may be less strict in insisting on the security offered.

(2) They may extend the maximum time period of lending.

(3) The banks may not discriminate among the purposes for which they lend.

(4) They may reduce the rate of discount for bills. This last factor particularly induces the merchants to borrow much more than before. The merchant group makes its profit as a small fractional mark upon the value of a large and rapidly moving stock of goods. Therefore, even a small reduction in the discount rate and consequent changes in the interest rates leads to substantial increase in their profit.

Easy bank credit leads to a process of cumulative expansion. A reduction in the rate of discount of bills by commercial banks induces the wholesalers to help bigger stocks. They give heavier orders to the manufacturers who in turn pay more to the factors of production in terms of wages, rents, interest and profit. This increases incomes and hence consumers’ outlay on goods and services. Increased expenditure on goods and services reduces the stock of merchants to a sub-normal level.

They, in turn, try to secure more credit, order more stocks and thus push up production of goods and services. Thus Hawtrey observers: “Increased activity means increased demand and increased demand means increased activity. A vicious circle is set up, a cumulative expansion of productive activity.”

Once started, the process of expansion feeds on itself. When prices rise under the pressure of demand and rising costs, dealers have a further inducement to borrow in order to meet the need for higher investments on the same stock. Further, the instability of the velocity of circulation of money raises investment demands. This also feeds the fire of expansion. A boom feeds on itself.

During the later stages of a boom, the banks come to realise that they have reduced their reserves to a dangerously low level. Further extension of credit is stopped and outstanding loans are recovered on schedule. This not only stops further expansion but also reverses the process.


A process of contraction ensues, because prices assume a downward trend. “The downward tendency of prices is sufficient to maintain the process of contraction, even though the rate of interest is no longer high according to the ordinary standards.

The process of contraction becomes cumulative owing to the restrictions on credit. The firms, in order to repay their earlier loans, are forced to sell parts of their stocks. When all the firms try to do so, the prices tend to fall further; since firms suffer losses, they curtail production and lay-off workers.

Falling factor incomes reduce consumer outlays which depress the sales and causes the stocks to accumulate. Thus, the downturn in prices plunges the economy into deep depression.

As depression sets in, loans are liquidated. Money flows back to replenish bank reserves. Soon bank reserves rise above the normal level. The rate of interest may go very low. Yet the falling prices and growing pessimism among firms detract the firms from borrowing.


Hawtrey called this state of affairs a ‘credit deadlock’. In such a situation, the central bank of a country might try to purchase securities from the commercial banks so as to pump more money into the system.

This strengthens the liquidity position of banks. So the banks might try to give liberal loans to intending borrowers. But this does not start a process of recovery, for the new credit may be utilized by the firms to pay old debts. Thus, a liberal credit policy during depression may lead only to a change in the composition of assets of banks. It often fails to encourage investments.

We can conclude Hawtrey’s theory by saying that it is based mainly on the assumptions:

(1) That changes in the rate of interest are a powerful force in directing the economic system, and


(2) That the interest rate changes influence mainly the volume of inventories, not fixed capital.

The direct policy implication of Hawtrey’s theory is that anti-depression policy must aim to stabilise, not the price level of commodities, but the prices of the factors of production. Stability of factor incomes would ensure stable consumer outlays which would stabilise the economy.