Read this article to learn about the concept and monetary theory of trade cycles.

Concept of Business Cycle:

Broadly speaking, business cycles are a kind of fluctuations which occur in business activity with a certain degree of regularity and periodicity.

Business cycles are wavelike movements found in the aggregate economic activity of a notion.

According to Keynes, a business cycle is characterized by alternating expansionary and contractionary fluctuations in business activity. There is always some measure of regularity in respect of the duration and the time sequence of the upward and downward movements of the business cycle.


According to Schumpeter, the business cycle represents wavelike fluctuations in the level of business activity from the equilibrium or trend line. It is clear from the evidence, statistics and business history that the economic activities of a country are subject to a great variety of fluctuations. Seasonal variations, business cycles, commercial or inter-crisis cycles, possibly long waves, and secular trends are acceptable and popular forms of business fluctuations.

Business fluctuations do not have a fixed rhythm, but are characterized by alternating waves of expansion and contraction—they are cyclical in the sense that the phases of contraction and expansion recur frequently and in a fairly uniform patterns. These business cycle fluctuations may be distinguished from seasonal and other types of fluctuations by the nature of their rhythm.

Our primary task so far has been the development and the analysis of the determination of income and output. The theory basically attempts to do no more than to explain how investment, saving and consumption interact to determine the income level. But a more comprehensive and ambitious theory must attempt to analyze the dynamics of income movements—which in a free market economy pass through alternating periods of expansion and contraction—that we call business cycles.

A theory capable of doing this goes beyond the static theory of income determination—it must answer questions that arise on account of the behaviour of the economy during business cycles like: why expansion comes to an end? Why economy moves downward? How much the economy will go down during depression? Why and how does a slump comes to an end? How a recovery begins and gives rise to prosperity?


Historically, it is difficult to say when a systematic study of these and other questions basic to business cycles began. According to Schumpeter, Clement Juglar was the first to make a systematic study of business cycles by about 1860 onwards. However, confining our study to the last few decades in connection with the study of business cycle theories, important contributions have been made by Schumpeter, Hansen, Metzler, Harrod, Kalecki, Samuelson, Kaldor, Hicks, Goodwin, Duesenberry and many others.

According to Burns and Mitchell, a normal trade cycle consists of four closely inter-related phases: revival, expansion, recession and contraction. The peak or celling, on the one hand and trough or floor on the other hand, represents critical turning points in the trade cycle.

According to Prof. Haberler an expansion or prosperity is a state of affairs in which the real income consumed, the real income produced and the level of employment are high or rising and there are no idle resources or unemployed workers or very few either. In other words, during prosperity phase economic affairs and activities are at the optimum level and there is no wastage of resources of any kind. The level of wages and prices is also high, though wages lag behind prices.

But with the passage of time, resources which are already fully employed become scarce, output becomes less elastic, bottlenecks appear, costs rise, deliveries become difficult—all these combine to give a boost to the rising volume of money. The rise in the price level is also not uniform leading to distortions in the price structure. These lags and distortions bring about an end of cumulative expansion or prosperity phase of the cycle and the recession begins giving way to contraction, depression or regular slump.


Recession though spread over a short span of time marks the turning point during which the forces that make for regular slump or depression finally win over and come to prevail. Once a recession starts, it tends to feed upon itself, like wild fire in a forest. The recession generates such complex forces as lead the entire system to a headlong crash. Its outward signs are the decline in prices, liquidation of stock market, strain in banking system, increase in unemployment, liquidation of bank loans, decline in orders, construction activities, etc.

A cumulative wave of liquidation that sets in the stock market and money market passes on to the commodity market and other markets turning into a regular depression. It gives rise to panic and collapse of confidence. The distortions appear in contraction as they appear in expansion. Imbalances appear in price structures and cost structures. Thus, the circle of cumulative trouble is complete. The collapse of confidence and weakening of expectations which pave the way for recession brings about a fall in prices, reduction in output, fall in profits, fall in employment, fall in bank credit.

It is the cumulation of these forces that makes the recession so dangerous and a depression so severe. The difference between a recession and depression is one of degree only and not of kind. The recession when carried to extremes gives rise to depression— the symptoms are the same. But there is an end to the downward trend because the forces do crop up that restore price and cost relations so badly distorted during depression. Prices stop falling, inventories are exhausted and sold out, supplies ultimately reach scarcity levels.

While this goes on, the cost price relations tend to become more favourable and start staging a comeback. The costs which pinch profits begin to fall and changes in efficiency appear. Not only the less efficient workers but also less efficient plants and managements are dropped, thereby lowering the average cost of production. These forces of revival manifest themselves first in the level of stock exchange prices, construction activities and equipment industries. This, in turn, leads to the revival of general economic activity.

Cycles and Underdeveloped Countries:

It is interesting to note that most of the cycles arrive with the advance of modern industrialism. In advanced and developed economies, the ups and downs of business activities are common due to their nature, structure and special features.

On account of greater capital intensity, reliance on making and spending money, dependence on banking and credit—the recurrent alternations of prosperity and depression begin to appear. The result is the trade cycles. But in a society where economic life is simple and confined to family, production is for the family and not for market, where activity is guided by need and not by prices or profits, where business economy is lacking—business cycles do not appear.

Such an economy is subsistence economy and such economies do not generate cycles. In such an economy, there is no reason or force that will prompt people to vary their activities from year to year. Simple agricultural communities of backward economies, living off the soil, with the little or no surplus, would be of this sort.

Agricultural sector of such economies, in particular, is not exposed to business cycles. But when a greater part of the population starts earning a living by making money, producing goods for wider markets using credit and banking and organizing their enterprises on a large scale with many-employees—then business cycles start appearing. It is clear, therefore, that business cycles are a function of what has come to be called ‘modern capitalism’.

It is interesting to note that France and Japan which have remained to a large degree the home of small scale business and industry, have been in the past less affected by business cycles than their contemporaries like the USA, UK and West Germany. In less developed countries like China, India and South Africa—fluctuations are produced, if at all, more by non-business than by business causes like droughts, floods, epidemics, excessive rains and civil disorder, etc. Hence, the nature of business cycles in these economies is quite different from the nature of business cycles in advanced economies.

Monetary Theory of the Trade Cycle:


The best known exponent of a monetary theory of trade cycle is R.G. Hawtrey, an English economist, who set forth his view in many books and articles. The central idea of his thesis is that the changes in the flow of money changes are the sole and sufficient causes of changes in business activities. He believes business cycles cannot occur in the absence of an elastic money supply, that money supply is elastic—capable of expansion and contraction in all countries with modern banking systems.

The expansion and contraction of money lead to cumulative expansion and contraction of business and industry and are sufficient to generate business cycles. The behaviour of the bankers is such as to help the expansion and contraction of money. Hawtrey, therefore, believed that business cycles is essentially a monetary phenomenon, caused by variations in the money supply with the help of banking system of advanced industrial countries, “Variations in effective demand”, says Hawtrey, “which are the real substance of the trade cycle, must be traced to changes in bank credit”.

According to Hawtrey, in equilibrium, consumer’s outlay equals consumers’ income, consumption equals production, the cash balances of consumers and traders are being neither increased nor decreased, the banks are neither increasing nor diminishing the bank credit and there is no net export or import of gold: Hawtrey feels that this equilibrium when disturbed tends to move into a period of cumulative disequilibrium.

An expansion can start by an increase of gold, increase in stocks of goods, increase in consumers expenditures, increase in bank credit, etc. In each of these cases consumers’ expenditure is likely to go up as a result of increased income of the community, which is a source of an increase in effective demand.


This, in turn, sets up a cumulative process of expansion in which more and more cash is released by traders and by banks and more and more additions are made to consumer’s income and outlay. Traders pile up and replenish their stocks of goods by using their idle balances and arranging bank loans. This leads to a genera) rise in the level of prices.

This general rise in prices lends strength to the forces of expansion. The rigidity of wages and interest rates increases the profits of businessmen and they borrow still more from banks. But this process of expansion cannot go on indefinitely. It goes on till banks are willing to lend and expand credit. With the rising volume of monetary transactions and the increased money income and expenditure of consumers, they sets in at first slowly, then with increasing force, a drain of cash out of banks into circulation because everybody—consumers, producers, traders, want more cash to carry on the transactions.

The flow of cash out of banks at a time when their deposit liabilities are increasing endangers their conventional cash-reserve ratio—the banks thus are compelled to put brakes on borrowing, primarily by raising the rate of interest. This, in turn, sets up a drastic and cumulative chain of reactions. The contraction follows. This like the expansion is a function of-a-change in effective demand. The restrictionist policy of credit by banks and high interest rates discourage the businessmen from investment in goods, stocks and equipment’s.

The income falls and the cash starts returning to the banks due to a decline in the transactions demand for money, bringing a contraction in the economic activity. But as soon as the cash reserve ratios of the banks improve, they adopt more liberal attitude and the stage is set for revival.


This, in brief, is Hawtrey’s account of cyclical behaviour through monetary causes—this behaviour is fundamentally a monetary phenomenon. Hawtrey does not deny that non-monetary causes like inventions, inventories crops may affect business activity but non-monetary causes, such as these have no periodicity—the periodicity in trade cycles is due to monetary effects, which could be controlled through appropriate banking policy. It may be said that amongst the modern writers, Hawtrey finds maximum support from the writings of Milton Friedman who shares with Hawtrey the efficacy of cheap money policy—that in deep depression monetary factors play a crucial role. But Hawtrey’s theory has not gone unchallenged.

It has many limitations. These limitations and considerations suggest that monetary theory alone is not sufficient to explain the emergence of business cycles and other explanations will have to be given due consideration. It has been pointed out that trade cycles is not purely a monetary phenomenon. Hawtrey unduly exaggerated the role of wholesalers and their sensitiveness to the changes in the rate of interest, etc. Empirical evidence goes to show that bank credit, after all, is not the sole destabilizing factor.

Monetary Overinvestment Theory:

The best known exponent of this theory is A.F. Hayek. He objects to the purely monetary theory of the trade cycle developed by Hawtrey because it does not explain the distortions in the structure of production, that is, the variations in the production of capital goods and consumer goods. Others who subscribe to this theory are F. Machlup, L. Mises and the English economist L. Robins. According to Hayek, the chief cause of disturbance lies in the elasticity of bank credit.

The power of the banks to expand money by easing credit is the chief cause first of booms and then depressions. But Hayek’s contribution lies in trying to trace the connection of the behaviour that follows the expansion of money supply and the distortions in the structure of production comprising chiefly of two classes of goods.

Hayek begins his analysis by assuming that the economic system is in equilibrium. He regards the business cycle as a disturbance of the equilibrium and the different phases (expansion, recession, contraction, revival) as departures from the equilibrium position.

In equilibrium the rate of interest is such that savings find their way to equal investments, the structure of production is adjusted in right proportions in which income is divided between spending and saving, there are no unemployed resources, there is enough effective demand, etc. Suppose now an expansion of bank credit takes place causing the market rate of interest to diverge from the natural or the equilibrium rate of interest.


As long as the market rate of interest is below the natural rate, it pays the businessmen to borrow and invest and expand business activity. The expansion in bank credit is treated like additions in voluntary savings which are invested for enlarging the means of production.

There is a rise in the price of producers’ goods relative to consumption goods. In other words, there is a tendency to transfer mobile resources to the higher stages of production by undertaking projects of a more roundabout nature. There are more plants, more durable means of production, a flow of labour and materials. In short, the fall in the rate of interest brought about by an increase in the bank credit has the same results as when additional savings lower the rate of interest, that is, a change in the structure of production.

However, as these changes go on their emerges a growing scarcity of consumer goods because it is not possible to have simultaneous expansion in all fields on account of the scarcity of resources. People would be almost forced to reduce their consumption and save the money or income which they would have otherwise spent on consumer goods, had they been available. But this forced saving due to credit inflation and high prices and non-availability of goods is quite different from voluntary savings.

The transfer of income away from a group of the economy with a low saving rate (mps) to one with a high saving rate by means of inflation is called forced savings. Hayek distinguishes it with voluntary savings—it is that level of savings which the community will deposit in banks, as determined by the propensity to save, whereas forced saving results when banks artificially ease credit, making it possible for businessmen to overinvest, which results in rising prices—lowering real income and consumption, with the result that the community is forced to save more than usual.

But this situation cannot last long because people would not like to reduce their consumption but for the compulsion of high prices. As soon as their incomes increase they will revert back to their earlier levels of consumption and expenditure. The result is a further rise in the prices of consumer goods (because their production has already fallen due to expansion in producers’ goods sector). In other words, it means that consumers do not support the changes in the structure of production brought about by businessmen due to easy credit.

The ultimate result would be a transfer of mobile capital and labour from higher to the lower stages, a reduction in the production of capital goods relative to consumer goods and even an abandonment of some projects altogether. It is, therefore, clear that the fundamental cause of fluctuations has been an overinvestment brought about by forced saving. Voluntary saving brings about a change in the structure of production that is permanent, while forced saving brings about a similar change that cannot be permanent. Hayek’s findings are thus quite opposite to those who hold that excessive saving is the cause of our distresses.


What really happens, according to him, is the excessive investment due to elastic bank credit and not excessive saving. The bank credit is like a subsidy for the producers of capital goods—but a subsidy that is bound to be withdrawn when it is needed most. In Hayek’s theory, the depression may be defined as the period during which the structure of production is being shortened to its appropriate length. This shortening process is painful and serious, when it takes place more and more labour-intensive methods are employed.

Shortening of the structure of production with losses in producers’ goods sector, forced saving, restriction of credit cause downturn of the system resulting in depression. Hayek says the best way and solution to eliminate cycles is to do away with bank credit—which is the ultimate source of all troubles. Forced saving must disappear. Money should be kept neutral (a fixed money supply) subject only to such variations which will neutralize changes in the velocity of circulation and in the coefficient of monetary transactions.

It is, therefore clear that, as against Hawtrey’s overemphasis on the role of money and bank credit Hayek is concerned with monetary overinvestment and its actual relationship with production processes. Hayek’s analysis correctly points to the maladjustments and distortions in the production processes which will result from over-investment.

He, however, started by assuming full employment of resources, but even at the peak of economic activity it is not to be found. Moreover, the relationship between capital goods and consumer goods is complimentary rather than competitive. He has given undue importance to the changes in the rate of interest not warranted by facts.

It has been seen that even if the rate of interest were to remain constant throughout the cycle, variations in production will still occur—this time via high profits. Doubts have also been cast on the generation of forced saving. Hayek’s theory does not explain the turning points and his suggestion of neutral money policy is also less realistic. Milton Friedmar, in 1960s has, no doubt, documented a monetary theory of business cycles (for USA). Its main thesis is that rapid changes in the rate of growth of money supply induce cyclical changes in income. He argues that a reversion to monetary rules would be desirable whereby the rate of growth of the money supply is set at some stable level.

Thus right from Hawtrey, Hayek to Milton Friedman a change in the policy of the central bank or in the behaviour of money holders or financial intermediaries has a direct effect on the aggregate level of income and the cyclical activity of the economy and the multiplier or the accelerator or the interaction between the two is not the only influence on business activities. In fact, the advocates of this theory believe that no cycle can be explained or no cause can assert itself unless it takes into account the monetary factors.