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 course of a business cycle, according to the Keynesian theory, runs as follows. During the period of expansion the marginal efficiency of capital is high. Businessmen are optimistic; investment goes on at a rapid pace; employment is high; and incomes are rising, each increment of investment causing a multiple increase of income.
Towards the end of the period, the high marginal efficiency of capital receives a setback from two directions:
(i) The cost of production of new capital assets increases as shortages and bottlenecks of materials and of labour arise, and
(ii) Owing to the abundance of output, profits are lowered below expectation.
Soon business optimism gives way to scepticism and then to pessimism. The marginal efficiency of capital collapses with catastrophic suddenness. When businessmen find the investment expected to yield 10% yield only 3%, reducing incomes still further.
The downward movement proceeds cumulatively, because every decrement of investment causes a multiple decrement in income. The economy proceeds towards a crisis and depression. Recovery begins when confidence revives, that is, when the marginal efficiency of capital again increases.
This will happen after the period of time necessary for (i) the wearing out and obsolescence of part of the durable capital and (ii) the exhaustion of excess stock of consumer goods accumulated during the depression. Gradually the growing scarcity of capital goods and consumer goods increases profits and expectation of profits.
The marginal efficiency of capital revives and expansion commences. The time period of a cycle is fairly regular because the average time required for the wearing out, obsolescence and exhaustion of capital and consumer goods is more or less the same in every epoch.
However, Keynes’ theory is not free from defects. Its main weaknesses are listed below:
1. Keynes based his theory only on internal causes of a trade cycle. Moreover, he has developed his explanation with the help of multiplier principle alone. He has ignored induced investment and the acceleration effect. A complete explanation of a trade cycle must consider external causes of a trade cycle and the role of the accelerator in causing investment and income fluctuations.
2. Keynes has not explained clearly the determinants of ‘marginal efficiency of capital’ which influence the investment decisions of entrepreneurs.
3. Keynes does not attach due importance to the rate of interest. He considers the rate of interest only as an item of the cost of production of goods. He, on the other hand, holds that rate of interest does not exercise any influence on investment decisions.
4. The periodical aspect or the phases of the business cycle is left in darkness in Keynes’ theory. Keynes has mainly discussed the problems of economic depression, with which he was primarily concerned.