Economics

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KALINGA UNIVERSITY

DEPARTMENT –ARTS AND HUMINITIES

COURSE--BA ECONOMICS (SEM-5)


SUBJECT---MONEY AND FINANCIAL MARKET
CODE--(BAGEN-505)

UNIT-4

Meaning of Trade Cycle:


A trade cycle refers to fluctuations in economic activities specially in employment, output
and income, prices, profits etc. It has been defined differently by different economists.
According to Mitchell, “Business cycles are of fluctuations in the economic activities of
organized communities. The adjective ‘businesses restrict the concept of fluctuations in
activities which are systematically conducted on commercial basis.

The noun ‘cycle’ bars out fluctuations which do not occur with a measure of regularity”.
According to Keynes, “A trade cycle is composed of periods of good trade characterised by
rising prices and low unemployment percentages altering with periods of bad trade
characterised by falling prices and high unemployment percentages”.

Features of a Trade Cycle:


1. A business cycle is synchronic. When cyclical fluctuations start in one sector it spreads to
other sectors.

2. In a trade cycle, a period of prosperity is followed by a period of depression. Hence trade


cycle is a wave like movement.

3. Business cycle is recurrent and rhythmic; prosperity is followed by depression and vice
versa.

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4. A trade cycle is cumulative and self-reinforcing. Each phase feeds on itself and creates
further movement in the same direction.

5. A trade cycle is asymmetrical. The prosperity phase is slow and gradual and the phase of
depression is rapid.

6. The business cycle is not periodical. Some trade cycles last for three or four years, while
others last for six or eight or even more years.

7. The impact of a trade cycle is differential. It affects different industries in different ways.

8. A trade cycle is international in character. Through international trade, booms and


depressions in one country are passed to other countries.

Characteristics of Trade Cycles:


(i) Industrialised capitalistic economies witness cyclical movements in economic activities. A
socialist economy is free from such disturbances.

(ii) It exhibits a wave-like movement having a regularity and recognised patterns. That is to
say, it is repetitive in character.

(iii) Almost all sectors of the economy are affected by the cyclical movements. Most of the
sectors move together in the same direction. During prosperity, most of the sectors or
industries experience an increase in output and during recession they experience a fall in
output.

(iv) Not all the industries are affected uniformly. Some are hit badly during depression while
others are not affected seriously.

Investment goods industries fluctuate more than the consumer goods industries. Further,
industries producing consumer durable goods generally experience greater fluctuations than
sectors producing nondurable goods. Further, fluctuations in the service sector are
insignificant in comparison with both capital goods and consumer goods industries.

(v) One also observes the tendency for consumer goods output to lead investment goods
output in the cycle. During recovery, increase in output of consumer goods usually precedes
that of investment goods. Thus, the recovery of consumer goods industries from recessionary
tendencies is quicker than that of investment goods industries.

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(vi) Just as outputs move together in the same direction, so do the prices of various goods and
services, though prices lag behind output. Fluctuations in the prices of agricultural products
are more marked than those of prices of manufactured articles.

(vii) Profits tend to be highly variable and pro-cyclical. Usually, profits decline in recession
and rise in boom. On the other hand, wages are more or less sticky though they tend to rise
during boom.

(viii) Trade cycles are ‘international’ in character in the sense that fluctuations in one country
get transmitted to other countries. This is because, in this age of globalisation, dependence of
one country on other countries is great.

(ix) Periodicity of a trade cycle is not uniform, though fluctuations are something in the range
of five to ten years from peak to peak. Every cycle exhibits similarities in its nature and
direction though no two cycles are exactly the same. In the words of Samuelson: “No two
business cycles are quite the same. Yet they have much in common. Though not identical
twins, they are recognisable as belonging to the same family.”

(x) Every cycle has four distinct phases: (a) depression, (b) revival, (c) prosperity or boom,
and (d) recession.

Phases of a Trade Cycle:


A typical business cycle has two phases expansion phase or upswing or peak and contraction
phase or downswing or trough. The upswing or expansion phase exhibits a more rapid growth
of GNP than the long run trend growth rate. At some point, GNP reaches its upper turning
point and the downswing of the cycle begins. In the contraction phase, GNP declines.

At some time, GNP reaches its lower turning point and expansion begins. Starting from a
lower turning point, a cycle experiences the phase of recovery and after some time it reaches
the upper turning point the peak. But, continuous prosperity can never occur and the process
of downhill starts. In this contraction phase, a cycle exhibits first a recession and then finally
reaches the bottom—the depression.

Thus, a trade cycle has four phases:


(i) depression,

(ii) revival,

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(iii) boom, and

(iv) recession.

These phases of a trade cycle are illustrated in Fig. 2.7. In this figure, the secular growth path
or trend growth rate of GNP has been labelled as EG. Now we briefly describe the essential
characteristics of these phases of an idealised cycle.

1. Depression or Trough:
The depression or trough is the bottom of a cycle where economic activity remains at a highly
low level. Income, employment, output, price level, etc. go down. A depression is generally
characterised by high unemployment of labour and capital and a low level of consumer
demand in relation to the economy’s capacity to produce. This deficiency in demand forces
firms to cut back production and lay-off workers.

Thus, there develops a substantial amount of unused productive capacity in the economy.
Even by lowering down the interest rates, financial institutions do not find enough borrowers.
Profits may even become negative. Firms become hesitant in making fresh investments.
Thus, an air of pessimism engulfs the entire economy and the economy lands into the phase
of depression. However, the seeds of recovery of the economy lie dormant in this phase.

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2. Recovery:
Since trough is not a permanent phenomenon, a capitalistic economy experiences expansion
and, therefore, the process of recovery starts.

During depression some machines wear out completely and ultimately become useless. For
their survival, businessmen replace old and worn-out machinery. Thus, spending spree starts,
of course, hesitantly. This gives an optimistic signal to the economy. Industries begin to rise
and expectations tend to become more favourable. Pessimism that once prevailed in the
economy now makes room for optimism. Investment becomes no longer risky. Additional
and fresh investment leads to a rise in production.

Increased production leads to an increase in demand for inputs. Employment of more labour
and capital causes GNP to rise. Further, low interest rates charged by banks in the early years
of recovery phase act as an incentive to producers to borrow money. Thus, investment rises.
Now plants get utilised in a better way. General price level starts rising. The recovery phase,
however, gets gradually cumulative and income, employment, profit, price, etc., start
increasing.

3. Prosperity:
Once the forces of revival get strengthened the level of economic activity tends to reach the
highest point—the peak. A peak is the top .of a cycle. The peak is characterised by an
allround optimism in the economy—income, employment, output, and price level tend to rise.
Meanwhile, a rise in aggregate demand and cost leads to a rise in both investment and price
level. But once the economy reaches the level of full employment, additional investment will
not cause GNP to rise.

On the other hand, demand, price level, and cost of production will rise. During prosperity,
existing capacity of plants is overutilised. Labour and raw material shortages develop.
Scarcity of resources leads to rising cost. Aggregate demand now outstrips aggregate supply.
Businessmen now come to learn that they have overstepped the limit. High optimism now
gives birth to pessimism. This ultimately slows down the economic expansion and paves the
way for contraction.

4. Recession:
Like depression, prosperity or pea, can never be long-lasting. Actually speaking, the bubble
of prosperity gradually dies down. A recession begins when the economy reaches a peak of
activity and ends when the economy reaches its trough or depression. Between trough and
peak, the economy grows or expands. A recession is a significant decline in economic

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activity spread across the economy lasting more then a few months, normally visible in
production, employment, real income and other indications.

During this phase, the demand of firms and households for goods and services start to fall. No
new industries are set up. Sometimes, existing industries are wound up. Unsold goods pile up
because of low household demand. Profits of business firms dwindle. Output and
employment levels are reduced. Eventually, this contracting economy hits the slump again. A
recession that is deep and long-lasting is called a depression and, thus, the whole process
restarts.

The four-phased trade cycle has the following attributes:


(i) Depression lasts longer than prosperity,

(ii) The process of revival starts gradually,

(iii) Prosperity phase is characterised by extreme activity in the business world,

(iv) The phase of prosperity comes to an end abruptly.

The period of a cycle, i.e., the length of time required for the completion of one complete
cycle, is measured from peak to peak (P to P’) and from trough to trough (from D to D’). The
shortest of the cycle is called ‘seasonal cycle’.

Purely Monetary Theory of Trade Cycle: by R.G. Hawtrey


The Pure Monetary Theory was proposed by Hawtrey, according to him the changes in
the money flows in the economy cause the fluctuations in the level of economic activities.
Thus, this theory posits that the business cycle is caused due to the fluctuations in
the monetary and credit markets.

R.G. Hawtrey describes the trade cycle as a purely monetary phenomenon, in this sense that

all changes in the level of economic activity are nothing but reflections of changes in the flow

of money.

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Thus, he holds firmly to the view that the causes of cyclical fluctuations were to be found

only in those factors that produce expansions and contractions in the flow of money —

money supply. Hence, the ultimate cause of economic fluctuations lies in the monetary

system.

According to Hawtrey, the main factor affecting the flow of money — money supply — is

the credit creation by the banking system. To him, changes in income and spending are

caused by changes in the volume of bank credit. The real causes of the trade cycle can be

traced to variations in effective demand which occur due to changes in bank credit.

Therefore, “the trade cycle is a monetary phenomenon, because general demand is itself a

monetary phenomenon.”

He points out that it is the rate of progress of credit development that determines the extent

and duration of the cycle, thus, “when credit movements are accelerated, the period of the

cycle is shortened.” This implies that if credit facilities do not exist, fluctuation does not

occur. So, by controlling credit, one can control fluctuations in the economic activity.

He further maintains that although the rate of progress of cycles may be influenced by non-

monetary causes, these factors operate indirectly and through the medium of the credit

movement. For example, a non-monetary factor such as optimism in a particular industry can

affect activity directly, but it cannot exert a general influence on industry unless optimism is

allowed to reflect itself through monetary changes, i.e., through increased borrowing. On

these grounds, Hawtrey regarded trade cycle as a purely monetary phenomenon.

The gist of Hawtrey’s theory is that the inherent instability in bank credit causes changes in

the flow of money which in effect leads to cyclical variations. An economic expansion is

caused by the expansion of bank credit and the economic crisis occurs no sooner the credit

creation is stopped by the banking system; thus, a contraction of credit leads to a depression.

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The Monetary Sequence of a Trade Cycle:

Basically, Hawtrey’s theory dwells upon the following postulates:

1. The consumers’ income is the aggregate of money income=national income or

community’s income in general.

2. The consumers’ outlay is the aggregate of money spendings on consumption and

investment.

3. The consumers’ total outlay constitutes community’s aggregate effective demand for real

goods and services. Thus, general demand is a monetary demand.

4. The wholesalers or traders have strategic position in the economy. They are extremely

sensitive in their stock hoarding business to the changes in the rate of interest.

5. The changes in the flow of money are usually caused by the unstable nature of bank credit.

Hence, bank credit has a unique significance in Hawtrey’s cyclical model.

According to Hawtrey, changes in business activity are due primarily to variations in

effective demand or consumers’ outlay. It is the total money income that determines

consumers’ outlay. The stability of the whole economic system follows from the

establishment of monetary equilibrium.

Under monetary equilibrium:

(i) Consumers’ outlay = consumers’ income;

(ii) Consumption = production;

(iii) Cash balances of consumers and traders remain unchanged;

(iv) Bank credit flow is steady;

(v) Market rate of interest = the profit rate;

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(vi) Wages (as money costs) and prices on the whole are equal (this means normal profit

margin and the normal rate of productive activity); and

(vii) There is no net export or import of gold.

Hawtrey contends that such a monetary equilibrium situation is one of extremely delicate

balance, which can be easily dislocated by any number of causes and when disturbed, tends

to move into a transitional period of cumulative disequilibrium.

He emphasised that primarily it is the unstable nature of the credit system in the economy that

causes changes in the flow of money and disturbs the monetary equilibrium. In this

connection he feels that the discount rate or interest rate exerts a great influence.

The Expansion Phase:

A typical expansion phase, according to Hawtrey, might proceed along the following lines.

The expansion phase of the trade cycle is brought about by an increase of credit and lasts so

long as the credit expansion goes on. A credit expansion is brought about by banks through

the easing of lending conditions along with a reduction in the discount rate, thereby reducing

the costs of credit.

By lowering their lending rates, banks stimulate borrowing. Such a reduction in the interest

rate is a great stimulus to wholesalers (or traders). According to Hawtrey, traders are in a

strategic position as they tend to carry their large stocks primarily with borrowed money.

Moreover, traders usually mark their profits as fraction of the value of a large turnover of

goods. Hence, a small change in the interest rate affects their profits to a disproportionately

large extent. Thus, they are very sensitive to change in the rate of interest.

Traders are induced to increase their stocks — inventories— when the interest rate falls.

Hence, they give large order to the producers; the increased orders of traders cause the

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producers to raise their level of production and employment. This in turn leads to an increase

in income and monetary demand.

“Thus the whole amount of the funds created by the bank is received as income, whether

profits, wages, rents, salaries, or interest, by those engaged in producing the commodities.”

Evidently, the increased production leads to an expansion of consumers’ income and outlay.

This means increased demand for goods in general, and traders find their stocks diminishing.

These result in further orders to producers, a further increase in productive activity, in

consumers’ income and outlay, and in demand, and a further depletion of stocks. Increased
activity means increased demand, and increased demand means increased activity.” This

leads to a cumulative expansion, set up, fed and propelled by the continuous expansion of

bank credit.

Hawtrey further states: “Productive activity cannot grow without limit. As the cumulative

process carries one industry after another to the limit of productive capacity, producers begin

to quote higher and higher prices.” Thus, when prices rise, traders have a further incentive to

borrow and hold more stocks in view of the rising profits.

The rising prices operate in the same way as falling interest rates and the spiral of cumulative

expansion is accelerated further. This means that there are three important factors which

influence credit expansion by banks. These are:

(i) the rate of interest charged by the banks

(ii) traders’ expectations about the price behaviour

(iii) the actual magnitude of their sales

The rate of interest is determined by the banks. Traders’ expectations depend on general

business conditions and their psychology. Actual magnitude of sales depends on the net effect

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of the first two upon the consumers’ outlay. In short, “Optimism encourages borrowing,

borrowing accelerates sales, and sales accelerate optimism.”

Financial Crisis (Recession):

According to Hawtrey, prosperity comes to an end when credit expansion ends.

As banks go on increasing credit, their cash funds deplete and they are forced to curtail credit

and raise interest rates in order to discourage the demand for new loans. Due to the shortage

of gold reserves, the central bank — as lender of the last resort — has to set a limit on the

accommodation to commercial banks.

Eventually, the central bank will start contracting credit by raising the bank rate. Thus, the

drain of cash from the banking system ultimately results in an acute shortage of bank

‘reserve’, so that the banks not only refuse to lend any more, but actually are compelled to

contract.

It is interesting to note that in Hawtrey’s view a drain upon the cash reserves of the banking

system is caused by the public. For a rise in consumers’ income generally would lead to an

increase in the cash holding (unspent margins) by the public.

This happens when the wages rise and consequently wage-earners’ demand for cash rises.

Thus, what ultimately limits the expansion of credit is the absorption of money in circulation,

mainly by wage earning classes.

Moreover, under the international gold standard, if expansion is taking place rapidly in a

country, it will lose gold to other countries due to excessive imports. Eventually, the central

bank will have to adopt a restrictive policy.

Contraction Phase (Depression):

The recessionary phase merges with depression due to the growing shortages of credit. The

contraction of credit exerts a deflationary pressure on prices and profits and on consumers’

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income and outlay. High rate of interest charged by banks discourages traders to hold large

stocks and their demand for credit decreases. Prices start falling, profits also drop.

Accordingly, traders further reduce stocks and stop ordering goods. Producers in turn will

curtail output and employment. The income of the factors of production will decline. When

consumers’ income and outlay decrease, effective demand decreases, stocks and output

decrease, prices fall, profits fall and so on — a cumulative downswing develops.

In a nutshell, it is the contraction of effective demand reflected in reduced outlay by

consumers and increased holding of cash balances in view of a large credit curb that causes a
vicious circle of deflation leading to severe depression.

Recovery:

During a depression, as traders experience slackening in the demand for their goods, they will

try to dispose of goods at whatever low price they get and repay bank’s loans. When loans are

liquidated, money gradually flows from circulation into the reserves of bank. As depression

continues, banks will have more and more idle funds.

The credit creating capacity of banks increases and in order to stimulate borrowing, banks

lower the interest rate. Traders will now be stimulated to increase their inventories and the

whole process of expansion will be once again set in motion.

The central bank now helps by lowering the bank rate and adopts open market purchases of

securities so that cash is pumped into banks improving their lendable resources. And when

the purchase of securities is carried far enough, the new money will find an outlet. Hawtrey

believes that the ordinary measures of monetary instruments such as bank rate policy and

open market operations may help in bringing about a revival.

In Hawtrey’s view, this cyclical behaviour is fundamentally a monetary phenomenon. He

does not deny that non-monetary causes (such as invention, discovery, bumper crops, etc.)

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may affect productive activity but he feels that their effects will be synchronised only with

monetary effects. Non-monetary causes have no periodicity; the periodicity that appears in

trade cycles is due to monetary effects, and it can be surmounted by an appropriate banking

policy.

According to Hawtrey, it is only the inherent instability of bank credit that causes fluctuations

in business and turn them into rhythmic changes. Abolish the instability of bank credit by an

appropriate bank policy and the trade cycles will disappear.

A Critical Appraisal:
No doubt, Hawtrey’s theory is perfectly logical in its basic concept of a self-generating cycle

of cumulative process of expansion and contraction. One of the most striking features of

Hawtrey’s theory is his explanation of the period of a cycle, i.e., his explanation of the

turning points of expansion and contraction.

Hawtrey, in his analysis, however, exaggerates the significance of wholesalers, ignoring the

capital goods industries and all other sectors of the economy.

Some critics have pointed out that monetary inflation and deflation are not causes, as

Hawtrey expounds, but the result of trade cycles. In fact, credit expansion follows business

expansion, and once it takes place, it would accelerate business activity. So monetary

deflation is preceded by business contraction.

The role of bank credit in the economic system is over-emphasised by Hawtrey. It is true that

finance is the backbone of business and bank credit plays an important role in it, but it does

not mean that banks are always the leaders of economic activity.

Hawtrey asserts that changes in the flow of money are the sole and adequate cause of

economic fluctuations. But, a trade cycle, being a complex phenomenon, cannot be attributed

to a single cause. There are various nonmonetary indigenous and exogenous factors, besides

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monetary factors which influence economic activity. Thus, it is incorrect to say that trade

cycles are a purely monetary phenomenon.

Hawtrey’s theory has been criticised on many grounds:


1. Hawtrey’s theory is considered to be an incomplete theory as it does not take into account
the non-monetary factors which cause trade cycles.

2. It is wrong to say that banks alone cause business cycle. Credit expansion and contraction
do not lead to boom and depression. But they are accentuated by bank credit.

3. The theory exaggerates the importance of bank credit as a means of financing


development. In recent years, all firms resort to plough back of profits for expansion.

4. Mere contraction of bank credit will not lead to depression if marginal efficiency of capital
is high. Businessmen will undertake investment in-spite of high rate of interest if they feel
that the future prospects are bright.

5. Rate of interest does not determine the level of borrowing and investment. A high rate of
interest will not prevent the people to borrow. Therefore, it may be stated that banking system
cannot originate a trade cycle. Expansion and contraction of credit may be a supplementary
cause but not the main and sole cause of trade cycle.

Hayek’s Monetary Overinvestment Theory

Over-Investment Theory:
Prof. Von Hayek in his books on “Monetary Theory and Trade Cycle” and “Prices and
Production” has developed a theory of trade cycle. He has distinguished between equilibrium
or natural rate of interest and market rate of interest. Market rate of interest is one at which
demand for and supply of money are equal.

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Equilibrium rate of interest is one at which savings are equal to investment. If both
equilibrium rate of interest and market rate of interest are equal, there will be stability in the
economy. If equilibrium rate of interest is higher than market rate of interest there will be
prosperity and vice versa.

For instance, if the market rate of interest is lower than equilibrium rate of interest due to
increase in money supply, investment will go up. The demand for capital goods will increase
leading to a rise in price of these goods. As a result, there will be a diversion of resources
from consumption goods industries to capital goods industries. Employment and income of
the factors of production in capital goods industries will increase.

This will increase the demand for consumption goods. There will be competition for factors
of production between capital goods and consumption good industries. Factor prices go up.
Cost of production increases. At this time, banks will decide to reduce credit expansion. This
will lead to rise in market rate of interest above the equilibrium rate of interest. Investment
will fall; production declines leading to depression.

Hayek’s theory has certain weaknesses:


1. It is not easy to transfer resources from capital goods industries to consumer goods
industries and vice versa.

2. This theory does not explain all the phases of trade cycle.

3. It gives too much importance to rate of interest in determining investment. It has neglected
other factors determining investment.

4. Hayek has suggested that the volume of money supply should be kept neutral to solve the
problem of cyclical fluctuations. But this concept of neutrality of money is based on old
quantity theory of money which has lost its validity.

Hayek’s Monetary Overinvestment Theory

Hayek based his theory of the trade cycle on Wicksell’s theory of the income determination.

Wicksell had analyzed the equilibrium of the economic system with the help of a distinction
between the natural rate and money rate of interest.
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Natural rate of interest is that at which the demand for loanable funds equals the supply of
loanable funds.

Natural rate of interest shows the equilibrium state of the economy Money rate of interest, on
the other hand, is that which actually prevails in the market at a particular time. While the
natural rate is the result of operation of the long term factors, both monetary’ and real, the
money rate of interest is the result of monetary forces over a short period.

Wicksell had proposed that when the money rate diverges from the real rate of interest, there
is disequilibrium in the economic system.

The two rates must be brought into equality if equilibrium is to prevail. If the money rate is
above the natural rate of interest, there is contraction. If the money rate happens to be less
than the natural rate, there is expansion of the economic system.

Hayek’s theory is called ‘monetary’ overinvestment theory’ because it considers


‘overinvestment’ of the economy’s resources in the capital goods sector as the sole cause of
the business cycle, and the overinvestment takes place when there is too much expansion of
money; cheaper money encourages the producers to introduce more roundabout (capital-
intensive) methods of production because these have lower cost of production and hence give
a higher rate of profit to them.

If the productive structure of the economy is to be kept in balance, then there must be an
equilibrating proportion of the resources devoted between consumer goods and capital goods
production. Producers decide to invest resources in their individual capacity.

They have no regular plan at the economy level for maintaining the desired proportion. Thus
unplanned changes in the structure of production of the economy brought about by the
divergence between the money rate and the natural rate of interest are considered to be the
main cause of instability of the system.

The boom in the economy is considered in this theory to be the result of money rate being
brought substantially below the natural rate of interest through an increased supply of money.
Easier availability of credit and the low interest rate encourage the producers to introduce
more roundabout methods of production.

As a result, the process of production is considerably lengthened. This means a rise in the
prices of producer goods relative to those of consumer goods.

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The increased purchasing power in the hands of the producers enables them to attract
productive resources away from the consumer goods sector to the production of capital
goods. If full-employment of resources already prevailed in the economy, additional
resources into the producer-goods industries can come only from reduced supplies of the
resources to consumer-goods industries.

Thus, the output of producer goods would increase at the expense of the output of consumer
goods. Reduced output of consumer goods would raise the prices of these goods and
discourage consumption. A cut in consumption means forced saving.

This forced saving serves to expand the producer goods output. In addition to this, forced
saving is the extra saving of the class of persons having contractual incomes like rents and
salaries. These savings also go into the production-goods sector. Thus, the boom is fed by
monetary overinvestment of resources in the production of capital goods.

How does the boom end into a collapse of the system? Hayek argues that as the capital-goods
output expands, consumer goods become scarce and their prices start rising fast. Profit-
margins in the production of consumer-goods go up.

Therefore, entrepreneurs in the consumer-goods sector also try to bid for resources in
competition to the producer-goods sector. This raises costs of production and reduces profit-
margin in the producer-goods sector.

The process of rise in costs and reduction of profit in this sector will continue all the normal
and natural ratio of consumer goods to producer’s goods prevails in the economy. But the
process of contraction in the producer-goods sector becomes cumulative because of the slump
in the natural rate of interest.

At the same time, banking system may also clamp restriction on the flow of credit to the
producer-goods industries. Falling profit margins and shortage of credit would compel the
firms to switch back to the less roundabout processes of production which employ less capital
and more labour. New projects would not be executed and old ones may be abandoned.

Since the demand for producer goods of a roundabout nature falls, their prices crash and the
firms having such stocks suffer losses. This is the onset of recession. How does the recession
lead to a depression? The answer is fall of the natural rate of interest below the money rate of
interest as a result of the shortening of the processes of production both in the capital-goods
sector and the consumer-goods sector.

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Since consumers are able to revert to their level of consumption they had before the boom
started, the prices of consumer goods do not fall as much as the prices of producer goods.
Producers try to shift resources from producer-goods to consumer-goods production but the
process of shifting is painfully slow.

This is because the rate of absorption of labour and materials by consumer-goods industries is
much lower than the rate at which these are released by the producer-goods sector. The result
is a rising number of the un-employers.

Under the pressure exerted by unemployment, low wages, reduced profit margins in the
capital goods industries and restricted credit facilities, less roundabout methods of production
are used in the production of consumer goods.

Since the producers become pessimistic in the process of restructuring production, the system
contracts even beyond the level at which the natural rate of interest would be the same as the
market or money rate. As a consequence, the depression becomes unnecessarily prolonged
and recovery much more difficult.

How does the recovery ultimately come about? During depression, commodity prices
typically fall faster than money wages. The rising level of real wages during the slump phase
brings about a revival of investment. This revival occurs through what has been called
‘capital deepening’.

Since real wages tend to rise during the slump, producers have a tendency to adopt more
durable machines which are supposed to replace labour by capital. The rising demand for
capital goods for capital deepening begins to offset the decline in induced investment. Thus,
recovery starts which eventually leads to an upswing and so on.

From the analysis of the upswing and the downswing of economic activity given by Hayek
and described above, we can easily say that it was an effort at combining Hawtrey’s monetary
theory with the Austrian theory of capital to explain more convincingly the phenomenon of
the trade cycle.

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Keynes’ Theory of Business Cycles

The below mentioned article provides notes on Keynes’ theory of business cycle.
Explanation to the Theory:
J.M. Keynes in his seminal work ‘General Theory of Employment, Interest and Money’ made
an important contribution to the analysis of the causes of business cycles.

According to Keynes theory, in the short run, the level of income, output or employment is
determined by the level of aggregate effective demand.

In a free private enterprise, the entrepreneurs will produce that much of goods as can be sold
profitably. Now, if the aggregate demand is large, that is, if the expenditure on goods and
services is large, the entrepreneurs will be able to sell profitably a large quantity of goods and
therefore they will produce more. In order to produce more they will employ a larger amount
of resources, both men and materials. In short, a higher level of aggregate demand will result
in greater output, income and employment.

On the other hand, if the level of aggregate demand is low, smaller amount of goods and
services can be sold profitably. This means that the total quantity of national output produced
will be small. And a small output can be produced with a small amount of resources. As a
result, there will be unemployment of resources, both labour and capital.

Hence, the changes in the level of aggregate effective demand will bring about fluctuations in
the level of income, output and employment. Thus, according to Keynes, the fluctuations in
economic activity are due to the fluctuations in aggregate effective demand. Fall in aggregate
effective demand will create the conditions of recession or depression. If the aggregate
demand is increasing, economic expansion will take place.

Now the question arises:


What causes fluctuations in aggregate demand? The aggregate demand is composed of
demand for consumption goods and demand for investment goods. Thus aggregate demand
depends on the total expenditure of the consumers on consumption goods and entrepreneurs
on investment goods.

Propensity to consume being more or less stable in the short run, fluctuations in aggregate
demand depend primarily upon the fluctuations in investment demand. Keynes shows that the
fundamental cause of fluctuations in aggregate demand and hence in fluctuations in economic
activity is the fluctuations in investment demand. Investment demand is very unstable and
volatile and brings about business cycles in the economy.

19
Let us start from the phase of economic expansion to explain Keynes’ theory of business
cycles. We first explain how in Keynesian theory expansion comes to end and recession or
depression sets in. During an economic expansion two factors eventually work to cause
investment to fall.

First, during the expansion phase increase in demand for capital goods due to large-scale
investment activity leads to the rise in prices of capital goods due to rising marginal cost of
their production. Higher prices of capital goods raise the cost of investment projects and
thereby reduce marginal efficiency of capital (that is, expected rate of return).

Secondly, as income rises during expansion phase, the demand for money increases which
raises interest rate. Higher interest rate makes some potential projects unprofitable. Thus, fall
in marginal efficiency of capital on the one hand and rise in interest rate on the other cause
decline in investment demand.

Declining trend of investment, according to Keynes, raises doubts about the prospective yield
on capital goods which is more important factor determining marginal efficiency of capital
than cost of investment projects and rate of interest. When among businessmen pessimism
sets in about future profitability of investment projects stock prices tumble.

The crash in stock prices worsens the situation and causes investment to fall even more.
Besides, fall in prices of shares reduces wealth of households. Wealth, according to Keynes,
is an important factor determining consumption. Thus, the decline in stock prices reduces
autonomous consumption demand of households.

With the fall in both investment and consumption demand aggregate demand declines which
results in accumulation of unintended inventories with the firms. This induces the firms to cut
production of goods.

It follows from above that besides the rise in cost of capital goods and rise in rate of interest
towards the end of the expansion phase, it is the fall in expected prospective yield that
reduces the marginal efficiency of capital and causes investment demand to fall. This induces
a wave of pessimistic expectations among businessmen and speculators.

These pessimistic expectations cause stock prices to tumble which work like adding fuel to
the fire. They cause a further fall in the marginal efficiency of capital. The turning point from
expansion to contraction is thus caused by a sudden collapse in marginal efficiency of capital.

20
In terms of graph, a sudden fall in the marginal efficiency of capital causes leftward shift in
the investment demand curve, for example from I 0I0 to I1I1 in Figure 13.3 resulting in decline
in investment from I0* to I1* at the given rate of interest. Note that decrease in investment
does not automatically decrease in rate of interest to offset the fall in the marginal efficiency
of capital.

However, an additional factor that makes Keynes’ business cycle theory potent is the working
of multiplier which was an important discovery of J.M. Keynes. According to Keynes, a
decrease in investment expenditure causes a decline in income which in turn reduces
consumption expenditure. The reduction in consumption expenditure further reduces income
and this process of reduction in income continues further. The total fall in income (∆Y) due
to an initial decline in investment (∆I) will be equal to ∆I x 1/1 – MPC where 1/1 – MPC is
the value of multiplier.

If marginal propensity to consume is 0.75, the multiplier will be equal to 4. Thus, a decline in
investment by 100 crores will lead to the decline in income by 400 crores. Note that
multiplier here works in reverse. Thus, the multiplier process magnifies the effect of decline
in investment expenditure on aggregate demand and income and further deepens the
depression.

21
As income and output are falling rapidly under the multiplier effect, the employment also
goes tumbling down. Thus, the Keynes theory of income multiplier plays a significant role in
causing magnified changes in income, output and employment following a reduction in
investment.

It is important to note that, in Keynes’ views, wages and prices are not flexible enough to
offset the decline in investment expenditure and thereby restore full employment. This is in
sharp contrast to the classical theory where changes in wages and prices ensure continuous
full employment.

In Keynes’ model wages and prices are “sticky” downward which implies that though wages
and prices do not remain constant but when demand falls wages and prices will fall but not
sufficient to restore full employment in the economy.

Since wage and price flexibility does not ensure the recovery of the economy out of the state
of depression, Keynes thinks that marginal efficiency of capital must rise to stimulate
investment. During depression investment falls to a very low level, capital stock begins to
wear out and requires replacement.

Further, some existing capital equipment become technologically obsolete and have to be
abandoned. This generates demand for replacement investment. A long period of time is
necessary for existing capital to depreciate because most capital goods are durable as well as
irreversible. By durability of capital goods we mean that they last for a long time and by
irreversibility we mean that they cannot be used for purposes other than those for which they
are meant.

Thus, just as the collapse of marginal efficiency of capital is the main cause of the upper
turning point, similarly the lower turning point, i.e., change from recession to recovery, is due
to the revival of the marginal efficiency of capital, that is, expected rate of profit. Restoration
of business confidence is the most important, yet the most difficult factor to achieve.

Even if the rate of interest is reduced, the investment will not increase. This is because of the
fact that in the absence of confidence the profitability of investment may remain so low that
no practicable reduction in the rate of interest will stimulate investment.

The interval which will elapse between the upper turning point and the start of recovery is
conditioned by two factors:
(i) The time necessary for wearing out of durable capital assets, and

22
(ii) The time required to absorb the excess stocks of goods left over from the boom.

Just as the expected rate of profit was pushed down by the growing abundance of capital
during the period of boom, similarly as the stocks of capital goods are depleted and there
grows a scarcity of capital goods, then the expected rate of profit rises thereby inducing the
businessmen to invest more. When the level of investment increases, income increases by a
magnified amount due to the multiplier effect. So the cumulative process starts upward.

Thus, over time as depreciation of capital stock occurs without replacement and also some
existing capital equipment become technologically obsolete, the size of capital stock declines.
New investment must be undertaken even to produce reduced depression level of output.
Thus with the emergence of scarcity of capital, marginal efficiency of capital rises which
boosts investment.

Once investment increases, it induces further rise in income and consumption demand
through the multiplier process. Now, the multiplier works to magnify the effect of increase in
investment on raising aggregate demand. The mood of businessmen changes from pessimism
to optimism which drives up stock prices. All these factors work to lift the economy out of
depression and puts it on the road to prosperity.

However, it is noteworthy that the recovery process from depression takes a very long time.
Keynes argued that Government should not wait for long for the natural recovery to occur.
This is because persistence of depression creates a lot of human sufferings.

He, therefore, advocated for the active intervention by the Government to raise aggregate
demand through fiscal policy, that is, stepping up its expenditure or reducing taxes. Thus, he
argued for the adoption of policy of deficit budget to boost aggregate demand so that
economy is lifted out of depression.

It may be noted that Keynes’ business cycle theory is self-generating. In it the economy
passes through a long phase of expansion. But eventually some forces automatically work,
for example, the growing abundance of capital stock, which reduces marginal efficiency of
capital. Pessimism overtakes businessmen. This causes reduction in investment which is
responsible for bringing about downswing in the economy.

The idea that it is the fluctuations in investment that bring about the fluctuations in the level
of economic activity is an important contribution made by Keynes. Of course, even before

23
Keynes, it was believed that the fluctuations in the investment demand have something to do
with the business cycles, but a systematic exposition was lacking.

Keynes propounded a definite relationship between a change in investment and the resulting
change in income and employment. This relationship is embodied in his famous theory of
multiplier.

The Critical Appraisal of Keynes’ Theory:


J.M. Keynes has made three important contributions to the business cycle theory:
First, it is fluctuations in investment that cause changes in aggregate demand which brings
about changes in economic activity (i.e., income, output, and employment).

Secondly, fluctuations in investment demand are caused by changes in expectations of


businessmen regarding making of profits (that is, marginal efficiency of capital).

Thirdly, Keynes put forward an important theory of multiplier which tells us how changes in
investment bring about magnified changes in the level of income and employment.

But the Keynesian theory of multiplier alone does not offer a full and satisfactory explanation
of the trade cycles. A basic feature of the trade cycle is its cumulative character both on the
upswing as well as on the downswing, i.e., once economic activity starts rising or falling, it
gathers momentum and for a time feeds on itself. Thus, what we have to explain is the
cumulative character of economic fluctuations.

The theory of multiplier alone does not prove adequate for this task. For example, suppose
that investment rises by 100 rupees and that the magnitude of multiplier is 4. From the theory
of multiplier we know that national income will rise by 400 and if multiplier is the only force
at work, that will be the end of the matter, with the economy reaching a new stable
equilibrium at a higher level of national income.

But in real life this is not likely to be so, for a rise in income produced by a given rise in
investment will have further repercussions in the economy. This reaction is described in the
principle of the accelerator. According to the principle of acceleration, a change in national
income will tend to induce changes in the rate of investment.

While multiplier refers to the change in income as a result of change in investment, the
acceleration principle describes the relationship between a change in investment as a result of
change in income.

24
In the above example, when income has risen by 400 rupees, people’s spending power has
risen by an equivalent amount. This will induce them to spend more on goods and services.
When the demand for goods rises, initially this will be met by overworking the existing plant
and machinery.

All this leads to an increase in profits with the result that businessmen will be induced to
expand their productive capacity and will install new plants, i.e., they will invest more than
before. Thus, a rise in income leads to a further induced increase in investment.

The accelerator describes this relation between an increase in income and the resulting
increase in investment. Thus, Samuelson combined the accelerator principle with the
multiplier and showed that the interaction between the two can bring about cyclical
fluctuations in economic activity.

Principle of Acceleration:
Keynes’ concept of multiplier is inadequate to account for the total national income induced
by the original money spent. It explains the effect of initial investment on consumption and
hence on income, but ignores the effect of induced consumption or income on
investment. The latter effect is known as acceleration effect. To know the total effect of
initial money spent on total income, multiplier effect and the acceleration effect should be
combined.
The principle of acceleration was first introduced by J.M. Clark in 1917. Later on the
economists like, Hicks, Samuelson and Harrod, further developed this principle to explain the
business cycles. The principle of acceleration is based on the fact that the demand for capital
goods is derived from the demand for consumer goods.
The acceleration principle explains the process by which a change in demand for
consumption goods leads to a change in investment on capital goods. According to Kurihara,
“The accelerator coefficient is the ratio between induced investment and an initial change in
consumption.”
Symbolically, the coefficient of acceleration is expressed as- v = ∆I/∆C or ∆I = v∆C, where v
is the acceleration coefficient, AI is net change in investment and AC is the net change in
consumption expenditure. Hicks has broadly interpreted the concept of acceleration as the
ratio of induced investment (∆I) to change in income or output (∆Y).
Thus, the accelerator v = ∆I/∆Y (or the capital-output ratio). This implies that the demand for
capital goods is not derived from consumer goods alone, but from any demand for output.
Now it has become customary to explain the principle of acceleration in terms of final output
(Y).

25
The production of any given demand for final output generally requires for technical reasons
an amount of capital several times larger than the output produced with it. Therefore, an
increase in the demand for final output will give rise to an additional demand for capital
goods several times larger than the new demand for output.
If, for example, a machine worth Rs. 3 lakh produces output worth Rs. 1 lakh, then the
accelerator v will be 3 (v = ∆I/∆Y = 3 lakh/I lakh = 3).

Equational Model:
The principle of acceleration can be expressed in the form of equational model given
below:

Thus, it is clear from Equations (1) and (2) that gross investment in the economy is equal to
net investment plus replacement investment. Assuming replacement investment to be
constant, gross investment varies with the level of net investment at each level of output.

Working of Acceleration Principle:


The working of acceleration principle can be explained with the help of an example given in
Table-3.

26
(i) Column (1) indicates a series of time periods.
(ii) Column (2) gives the assumed level of income and output in each period.
(iii) Assuming a constant capital-output ratio or the value of accelerator, v = 2, the required
stock of capital in each period is two times the corresponding output of that period, as shown
in Column (3).
(iv) The replacement investment in each period is assumed to be equal to 10% of the capital
stock in period zero. Thus, it is 20 in each period, (i.e., 10% of 200= 20) as shown in Column
(4).
(v) Net investment in any period as shown in Column (5) equals v times the change in output
between that period and the preceding period. For example, net investment in period 3= v
(Yt3 – Yt2) = 2(115-105) = 20. This means that given the accelerator v = 2, an increase in the
demand for final output of 10 leads to an increase of capital goods of 20.
(vi) Total demand for capital goods {Column (6)} is equal to the net investment plus
replacement investment { (i.e.. Column (4) + Column (5) } in each period. For example, total
investment in period 3 = 20+ 20 = 40.
(vii) Thus it is clear that, given the value of accelerator, total demand for capital goods
depends upon the change in the total output. As long as the demand for final goods rises {i.e.,
Y increases upto period 6 in Column (2)}, net investment is positive {(i.e., upto period 6 in
Column (5)}. After period 6, demand for final goods [Column (2)] falls and the net
investment [Column (5)] is negative.
(viii) Total output [(Column (2)] increases at an increasing rate from period 1 to period 4 and
net investment increases {Column (5)}. Then output increases at a decreasing rate from
period 5 to 6 and the net investment declines. From period 7 to 9, total output falls, and the
net investment becomes negative.
(ix) The behaviour of gross investment is similar to the net investment. The only difference is
that the gross investment is not negative and once it becomes zero in period 8, it starts rising.
The reason for this is that despite the net investment becoming negative, the replacement
investment continues at the constant rate.

27
Assumptions and Limitations of Acceleration Principle:
The acceleration principle is based on a number of assumptions which are difficult to be
found in the actual world.
The important assumptions and limitations of the principle of acceleration are as
follows:
i. Constant Capital-Output Ratio:
The acceleration principle is based on the assumption of constant capital-output ratio. It
means that the units of capital required to produce one unit of output remain constant. In the
dynamic world, the capital-output ratio changes and therefore the acceleration effect also
varies.
ii. No Excess Capacity:
The acceleration principle assumes that there should be no excess capacity in the capital
goods industries. If excess capacity exists, an increase in the demand for consumer goods will
not lead to any induced investment because the increased demand will be met from the
existing capital and machinery.
iii. Permanent Change in Consumption Demand:
The principle of acceleration will operate it the increase in consumption demand is
permanent. A purely temporary change in consumption demand will not induce the
entrepreneurs to invest in the production of additional capital goods.
iv. Availability of Resources:
The acceleration principle assumes the availability of resources. The supply of resources
should be elastic so that the investment in capital goods industries can be increased easily. If
tire economy is at the full employment, the capital goods industries will fail to expand
because of non-availability of required reserves.
v. Elastic Supply of Funds:
The acceleration principle assumes elastic supply of cheap credit so that sufficient funds for
induced investment are available. If there is shortage of credit, the rate of interest will be high
and the investment in capital goods will be low.
vi. Absence of Time Lags:
The acceleration principle assumes that increased output leads to a simultaneous rise in
investment. But, in reality, a rise in demand takes a long time to produce its impact on
investment level.
vii. Neglect of Expectations:
The acceleration principle neglects the role of expectations on the decision-making behaviour
of entrepreneur. Inducement to invest is not influenced by demand alone. It is also affected
by future anticipations about stock market changes, political changes, international events,
etc.
viii. Neglect of Technological Changes:
The acceleration principle also ignores the role of technological changes on investment.
Some technological changes may take the form of capital-saving (or labour-saving) and thus
may reduce (or increase) the volume of investment.

Importance of Acceleration Principle:


In spite of certain limitations, the principle of acceleration occupies a significant place in the
macro-economic analysis.
The main points of importance are given below:

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(i) The principle of acceleration, along with the principle of multiplier, helps to understand
the process of income generation more clearly and comprehensively. The concept of
multiplier provides only a partial explanation of the income generation process.
(ii) The principle of acceleration explains why the fluctuations in income and employment
occur so violently.
(iii) It demonstrates that capital goods industries fluctuate more than the consumer goods
industries.
(iv) It is more useful in explaining the upper turning point of the business cycle because what
is responsible for a fall in the induced investment is not any absolute fall in the demand for
consumer goods but only a decline in its rate of increase.
(v) Harrod has used the coefficient of acceleration in the growth model to show that the
economic growth in an economy depends upon the size of accelerator; higher the size of
accelerator, higher the growth rate and vice versa.
In the words of Shapiro, “The acceleration principle, however inadequate by itself, clearly
emerges us one of a number of major factors that are needed in combination with the
multiplier to explain the fluctuations observed in the world of investment spending.”

Concept of Multiplier:
The concept of multiplier is an integral part of Keynes’ theory of employment. It is an
important tool of income propagation and business cycle analysis. Keynes believed that an
initial increment in investment increases the final income by many times. To this relationship
between an initial increase in investment and the final increase in total income, Keynes gave
the name of ‘investment multiplier,’ which is also known as ‘income multiplier’ or simply
‘multiplier’.

According to Keynes, “Investment multiplier tells us that when there is an increment of


aggregate investment; income will increase by an amount which is K times the increment of
investment.” Similarly, according to Kurihara, “The multiplier is the ratio of change in
income to the change in investment.” In the words of Dillard, “Investment multiplier is the
ratio of an increase of income to given increase in investment”

In short, the multiplier tells us how many times the income increases as a result of an initial
increase in investment. Given the marginal propensity to consume (MPC), the multiplier
establishes a quantitative relationship between aggregate income (or employment) and the
investment. The multiplier is expressed as-

where K denotes the multiplier, ∆Y the change in income and ∆I the change in investment.

29
The basic idea behind the theory of multiplier is that of the induced consumption as a result
of increased investment. Whenever an investment is made, the effect is to increase income
not only by the amount of original investment but by a multiple of it.

The initial effect of an increase in investment expenditure is the increase in income by the
same amount. But as income increases, consumption also increases. Consumption
expenditure, in turn, becomes additional income of those employed in the consumer goods
industries. Thus, there is a further increase in income due to induced consumption and so on.
To sum up, the investment does not increase income in the industries where investment is
originally made, but also in other industries whose products are demanded by the men
employed in the investment industries.

Relation between MPC and Multiplier:


The size of marginal propensity to consume (MPC) is a key to the size of the multiplier. The
value of multiplier is in fact determined by the MPC.
The formula of the multiplier which highlights the close relationship between the MPC
and the size of the multiplier can be derived in the following manner:

30
It is clear from Table-1 that greater the MPC, higher the size of the multiplier and lesser the
MPC, lower the size of the multiplier. Since, according to the psychological law of
consumption, the value of the MPC lies between zero and one, i.e., 0 < MPC < 1, it follow
that the size of the multiplier can never be unity or infinity, but remains between these two
limits.
Working of Multiplier:
The working of the multiplier can be understood with the help of an example as given in
Table-2.

31
Suppose, the MPC is 0.5. Thus, according to the formula of multiplier, K = 1/(1 – MPC) =
1/(1 – 0.5) = 2. Again suppose that investment is increased by Rs. 100 crores. This means the
income (of those who get this increased investment) also increases by the same amount. Of
this Rs. 100 crores, Rs. 50 crores are saved and Rs. 50 crores are spent on consumption (MPC
= 1/2).

The induced consumption of Rs. 50 crores leads to an increase in income by the same amount
(i.e., Rs. 50 crores) in period 2. In the same manner, income increases by Rs. 25 crores in
period 3, by Rs. 12.5 crores in period 4 and so on till the total income has increased by Rs.
200 crores (i.e., 2 times the initial investment of Rs. 100 crores).

32
Reverse Working of Multiplier:
Multiplier works both in the forward direction as well as in the backward direction. If
investment decreases, the multiplier operates in the reverse direction. A reduction in
investment leads to contraction in income and consumption which, in turn, causes cumulative
decline in income and consumption level till the contraction in total income is the multiple of
initial decrease in investment.

Suppose, investment decreases by Rs. 20 crores. With MPC = 0.5 and K = 1/(1-MPC) = 2,
there will be net reduction in income to the extent of Rs. 40 crores.
The higher the MPC the greater the value of multiplier and the greater the cumulative decline
in income. Or, in other words, the higher the marginal propensity to save (MPS), the lower is
the size of the multiplier and the smaller is the cumulative decline in income (because K =
1/MPS).
Thus, a higher multiplier would cause greater jerks and shocking decline of income whenever
the investment falls. But, there is one ray of hope. Since MPC is always less than one,
33
multiplier is never infinity. Just as consumers do not spend the full increment of income on
consumption, similarly, they do not curtail the consumption expenditure by the full amount of
decrement of income.

Figure-2 illustrates the reverse operation of multiplier. SS curve is the saving curve which is
drawn on the assumption of MPS = 0.5. In this case, multiple K = 1/MPS = 1/0.5 = 2. SS
saving curve intersect I0I0 investment curve at point E0, giving the initial equilibrium level
of income OY0.

When investment declines from I0 I0 to I1I1 (i.e., by I0 I1 or ∆I amount), income also


declines from OY0 to OY1 (i.e., Y0Y1 or ∆Y amount). The decrease in income is double the
decrement in investment (Y0Y1 = 2 I0I1 or ∆Y = 2∆I).

Assumptions of Multiplier:

The working of multiplier is based on a number of assumptions. As these assumptions are not
fulfilled in the actual world, they limit the operation of multiplier.

34
Main assumptions are as follows:

(i) There is no induced investment. Multiplier specially applies to autonomous investment


which is free from profit motive.

(ii) Marginal propensity to consume remains constant during the adjustment process.

(iii) Consumption is a function of current income.

(iv) The output of consumer goods is responsive to effective demand for them.

(v) There is surplus capacity in the consumer goods industries to meet the increased demand
for these goods as a result of a rise in income following the increased investment.

(vi) Other factors and resources of production are easily available in the economy.

(vii) The new higher level of investment is maintained for the completion of the adjustment
process.

(viii) There is net increase in investment. In order words, increase in investment in one sector
is not offset by a decline in investment in some other sector.

(ix) There are no time lags involved in the multiplier process. An increase in investment
instantaneously leads to a multiple increase in income.

(x) There is a closed economy implying the absence of international trade.

(xi) Multiplier process operates in the industrialized economy.

(xii) There is no change in the prices of commodities and raw materials, etc.

35
(xiii) The situation of less-than-full employment prevails in the economy.

Leakages of Multiplier:

In actual practice, the operation of multiplier is affected by a number of factors. Given the
MPC, the whole of the increment of income in each period may not be spent on consumption.
This is because there are several leakages from the income stream as a result of which the
process of income propagation is slowed down.

According to Peterson, “Income that is not spent for currently produced consumption goods
and services may be regarded as having leaked out of income stream.” Or, in other words,
leakages of multiplier constitute that portion of prior income which has been lost to the
income stream.

Important leakages are described below:

I. Saving:---Saving constitutes an important leakage to the process of income propagation.


Since marginal propensity to consume is less than one (MPC < 1), the whole of the increment
of income is not spent on consumption. A part of it is saved and peters out of the income
stream, thereby limiting the value of multiplier.

The whole of saving forms a leakage and the size of multiplier is inversely related to the
marginal propensity to save (MPS). According to the formula of multiplier (i.e., K = 1/MPS =
1/Leakage), the higher the MPS, the greater the leakage and the lower the value of multiplier.

II. Debt Cancellation:---If some of the income received by the people is used for paying off
old debts, that part peters out of the income stream and becomes leakage.

III. Imports:--Net imports form another leakage in the domestic income stream. If there is an
excess of imports over exports, a part of the increased domestic income as a result of
increased investment will flow out to foreign countries.

36
IV. Price Inflation:---Price inflation is another important leakage from the income stream of
an economy. When there is a rise in prices of consumption goods, a major part of the
increased income is dissipated on higher prices, instead of promoting consumption, income
and employment.

V. Hoarding:---If people have a tendency to hoard the increased income in the form of idle
cash balances, they will reduce the expenditure on consumption in the economy. This will
constitute another leakage, restricting the value of the multiplier.

VI. Purchase of Old Shares and Securities:---If people purchase old stocks and securities with
the newly earned income, this type of financial investment will reduce consumption and
restrict the value of multiplier.

VII. Taxation:---Taxes reduce the disposable income of the tax payers, discourage
consumption expenditure and lower the size of the multiplier.

VIII. Undistributed Profits:--If a part of profits of the company is not distributed to the
shareholders in the form of dividends and is kept in reserve fund, it forms a leakage from the
multiplier process.

Effect of Leakages:

The leakages interfere with the smooth flow of income stream and thereby lead to the
slowing down of the pace of multiplier. Had the entire higher income been spent and none
saved, the process of income generation will go on endlessly.

37
The effect of leakages (e.g., saving) can be understood with the help of the example given in
Table- 2. In that table, it is clearly shown that when investment is increased by Rs.100 crores
in period 1, income also increases by the same amount in the same period. But, in the
subsequent periods, only half of the increased income is consumed (because of MPC = 0.5).
Other half is saved (because of MPS = 0.5). The saved portion becomes a leakage in the
multiplier process.

Figure-3 shows the effect of leakage. C0 is the basic consumption in each period. Initial
investment (i.e., ∆I) made in period 1 leads to induced consumption (C1 + C2 +C3 + …) in
subsequent periods which goes on decreasing by half the amount in each period because of
MPC = 0.5. S1 + S2 + S3 (= shaded area) are the total savings in each period which indicate
leakage from the multiplier process. As a result of leakage, income in each period increases
only by the amount of induced consumption.

Criticisms of Multiplier:
Keynes’ concept of multiplier has been criticised on the following grounds:
I. Limitations and Qualifications:
The ‘ideal’ multiplier operates on the basis of a number of assumptions, like the availability
of consumer goods, maintenance of investment, net increase in investment, autonomous
investment, closed economy etc. These assumptions may not be found in practice. Thus, the
‘actual’ multiplier may be greatly restricted and will be different from the ‘ideal’ multiplier.

38
II. Mere Tautology:
According to Haberler, Keynes’ concept of multiplier is a mere tautology. In other words, the
definition of multiplier is a mere tautology. In other words, the definition of multiplier as K
=1/1-MPC is simple truism; it does not tell anything. As Hansen has pointed out, “Such a
coefficient is a mere arithmetic multiplier (i.e., a truism) and not a true behaviour multiplier
based on a behaviour pattern which establishes a verifiable relation between consumption and
income. A mere arithmetical multiplier, 1 / (1-(∆C/∆Y)) is tautological.”
III. Mechanical Relationship:
Hazlitt has criticised the theory of multiplier on the ground that it expresses only a
mechanical relationship between macro variables. He maintains that there is never any
precise, pre-determinable or mechanical relationship between social income, consumption,
investment and extent of employment,
IV. Static Concept:
Keynes’ multiplier is a static concept. It shows the process of income propagation from one
point of equilibrium to another and that too under static assumptions. It gives little insight
into the process by which the economy achieves a new equilibrium. It fails to explain- (a)
what happens in between the initial investment and the final increase in aggregate income; (b)
how and by what stages of time intervals the final increase in the aggregate income is
attained; and (c) how the sequence of events may be hampered by time and other factors.
V. Neglect of Time Lags:
Keynes regards the concept of multiplier as a timeless concept by assuming an instantaneous
relationship between income, consumption and investment. In reality, however, a time lag
exists between the receipt of income and its expenditure on consumption goods, and then also
in producing consumption goods.
VI. Assumption of Consumption Function:
Keynes’ theory of multiplier rests on the simple assumption of linear relationship between
consumption and income with the hypothesis that the MPC is less than one and greater than
zero. Empirical studies show that the relationship between income and consumption is
complicated and non-linear and not as simple as assumed by Keynes.
VII. Exclusive Emphasis on Consumption:
In Gordon’s view, the greatest weakness of the theory of multiplier is its exclusive emphasis
on consumption. He maintained that it would be more realistic to use the term ‘marginal
propensity to spend’ in place of marginal propensity to consume’ and then to consider the
effect of an initial increase in investment, not on consumption, but also on total private
investment and government spending.
VIII. Acceleration Effect Ignored:
Multiplier is concerned with the effect of original investment on consumption and income. It
ignores the effects of increased consumption on investment. The value of the multiplier will
be much greater and achieved much earlier if both the effects, i.e., (a) the effect of investment
on consumption (multiplier effect), and (b) the effect of consumption on investment
(acceleration effect), are taken into account.
IX. Saving is not Hoarding:
Another fallacy in Keynes’ multiplier theory is the assumption that the entire fraction of a
country’s income that is not consumed is hoarded, and no part of this unconsumed income is
invested. In reality, saving does not mean hoarding and most of the savings are used for
investment
X. Other Critical Comments:

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Some of the important comments made by the critics are as follows: According to Hutt, “The
conventional multiplier apparatus is rubbish and that it should be expunged from the text
books.” To Stigler, “It is the fuzziest part of Keynesian theory.” Hazlitt calls multiplier ‘a
worthless theoretical toy’, ‘a strange concept’, ‘a myth’, ‘much ado about nothing’.
Despite these attacks by the critics, the post-Keynesians, like Hansen, Samulson, Harrod,
strongly defended the theory of multiplier, introduced many improvements and made the
whole analysis dynamic.
The true position regarding the criticism of multiplier can be summed up in the following
remarks of Harris, “In the discussion of the multiplier, many economists have gone on fishing
expeditions, but though they had many bites, they did not catch any large fish. Indeed, they
have added much to Keynes’ relatively simple and unverified presentation.

Importance of Multiplier:
Despite the various qualifications, limitations and weaknesses, the concept of multiplier
continues to be of great theoretical and practical importance:
i. Importance of Investment:
The concept of multiplier highlights the importance of investment as the major dynamic
element in the process of income generation in the economy.
ii. Income Generation Process:
The theory of multiplier not only indicates the direct creation of income and employment, it
also reveals that income is generated in the economy like a stone causing ripples in the lake.
iii. Trade Cycle:
The knowledge of the process of multiplier is of vital importance for understanding different
phases of trade cycle and for its accurate forecasting and control.
iv. Economic Policy:
Multiplier is a useful tool in the hands of the policy-makers for formulating suitable
economic policies for the achievement of full employment and for the control of business
fluctuations.
v. Saving-Investment Equality:
The multiplier process helps to understand how equality between saving and investment is
brought about. An increase in investment leads to increase in income. As a result of increase
in income, saving also increases and becomes equal to investment.
vi. Deficit Financing:
The theory of multiplier emphasises the importance of deficit financing. Increases in public
expenditure by creating deficit budget help in creating income and employment multiple
times the initial increase in expenditure.
vii. Public Investment:
The concept of multiplier highlights the special significance of public investment (in the form
of government expenditure in public works, and other public welfare activities) in achieving
and maintaining full employment.

Public investment is autonomous in nature and avoids the uncertainty and instability of
private investment. Public investment is particularly important during depression when
private investment is not forthcoming due to very low profitability.

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To conclude, the concept of multiplier is one of Keynes’ path-breaking contributions in the
sense that it has not only enriched economic analysis but also has influenced economic
policy.

super-multiplier
The below mentioned article provides a note on super-multiplier.

The term ‘super-multiplier’ was first coined by J.R. Hicks in his business cycle theory. The
object was to show the relationship between change in induced investment and the
corresponding change in income. To be more specific, it indicates the ratio between the two
changes, i.e., in investment and in equilibrium output. In fact, if we know the super-multi-
plier, we can easily calculate the level of income that would correspond to any fixed
(exogenous) level of autonomous investment.

Therefore, total income will be:


Y = C + Ia + IP
where, Y = total income, C = consumption expenditure, Ia = autonomous expenditure and Ip =
induced (private) investment.
Induced investment, like private consumption, may now be taken to be a function of income.
As we have noted earlier, the major driving force behind any change in induced investment is
the demand for consumer goods or household expenditure on consumption.

But, consumption, as Keynes specified, is a stable function of the income level — i.e., C =
bY, where b = m.p.c. = dC/dY, i.e., change in consumption induced by a change in income.
Likewise, the marginal propensity to invest (MPI), to be denoted by i, is the ratio of the
change in the aggregate induced investment to a given unit change in aggregate income
(dl/dY).

We may now write the equilibrium condition of income as:


Y = C + Ia + Ip
= bY + Ia + iY
or, by rearranging, we get:
Y – bY – iY = Ia
Y (1 – b – i) = Ia
or, Y = Ia/1 – b – i = 1/1 – b – i (Ia) = K’ (Ia) … (1)

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Here, 1 / (1 – b – i) is the super-multiplier (K’).

Now, if autonomous investment increases by a given amount (ΔIa) the corresponding


increase in income would be:
ΔY = ΔIa /1 – b – i = ΔIa. 1/1 – b – a
Here, 0 ≤ b ≤ 1 and 0 ≤ i ≤ 1. Moreover, 0 ≤ b + i ≤ 1. Equation (1) above makes it
abundantly clear that the change in income will be equal to the autonomous investments
multiplied by the super-multiplier. Thus, induced investment makes the value of the
multiplier larger.

In the words of G. Ackley:


“If a rise in income not only leads to increased consumption but also to increased investment
(creating the basis for further expansion of income, consumption and investment in endless
but diminishing chain), the ultimate increase in income will be greater than if only
consumption so responded”.

This model is actually the source of the so-called paradox of thrift.

In the language of Ackley again:


“An increased propensity to save, in the simpler Keynesian model, left total saving (and
investment) unchanged, although reducing income. Yet in the present model the effort of the
community to save more is actually self-defeating; the new equilibrium involves not only
lower income but lower saving also. Yet, a community that loses its thrifty habits succeeds in
saving more than it did previously”.

Example, suppose, marginal propensity of induced investment is 0.2 and marginal propensity
to consume is 0.6. If autonomous investment increases by Rs. 20 crore, what will be the final
increase in income?

Solution:
Here, the super-multiplier

k’ = 1/1 – b – i

= 1/1 – 0.2 – 0.6 = 1/0.2

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Therefore, the increment in income,

ΔY = ΔIa × 1/0.2
= 20 × 1/0.2 = Rs. 100 crore

But, under simple multiplier,

Δ Y = Δ Ia × 1/1 – 0.6 = 20 ×1/0.4 = Rs. 50 crore

The Accelerator Theory of Investment:

The accelerator principle states that an increase in the rate of output of a firm will require a
proportionate increase in its capital stock. The capital stock refers to the desired or optimum
capital stock, K. Assuming that capital-output ratio is some fixed constant, v, the optimum
capital stock is a constant proportion of output so that in any period t,

Kt =vYt

Where Kt is the optimal capital stock in period t, v (the accelerator) is a positive constant, and
Y is output in period t.

Any change in output will lead to a change in the capital stock. Thus

Kt – Kt-1 = v (Yt – Yt-1)

and Int = v (Yt – Yt-1) [Int=Kt– Kt-1

= v∆Yt

Where ∆Yt = Yt – Yt-1, and Int is net investment.

This equation represents the naive accelerator.

In the above equation, the level of net investment is proportional to change in output. If the
level of output remains constant (∆Y = 0), net investment would be zero. For net investment
to be a positive constant, output must increase.

This is illustrated in Figure 1 where in the upper portion, the total output curve Y increases at
an increasing rate up to t + 4 periods, then at a decreasing rate up to period t + 6. After this, it

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starts diminishing. The curve In in the lower part of the figure, shows that the rising output
leads to increased net investment up to t + 4 period because output is increasing at an
increasing rate.

But when output increases at a decreasing rate between t + 4 and t + 6 periods, net investment
declines. When output starts declining in period t + 7, net investment becomes negative. The
above explanation is based on the assumption that there is symmetrical reaction for increases
and decreases of output.

In the simple acceleration principle, the proportionality of the optimum capital stock to output
is based on the assumption of fixed technical coefficients of production. This is illustrated in
Figure 2 where Y and Y1 are the two isoquants.

The firm produces T output with K optimal capital stock. If it wants to produce Y 1 output, it
must increase its optimal capital stock to K 1. The ray OR shows constant returns to scale. It
follows that if the firm wants to double its output, it must increase its optimal capital stock by
two-fold.

Eckaus has shown that under the assumption of constant returns to scale, if the factor-price
ratios remain constant, the simple accelerator would be constant. Suppose the firm’s
production involves the use of only two factors, capital and labour whose factor-price ratios
are constant.

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In Figure 3, Y, Y1 and Y2 are the firms’ isoquants and C, C1 and C2 are the isocost lines which
are parallel to each other, thereby showing constant costs. If the firm decides to increase its
output from Y to Y1, it will have to increase the units of labour from L to L 1 and of capital
from K to K1 and so on.

The line OR joining the points of tangency e, e 1 and e2 is the firms’ expansion path which
shows investment to be proportional to the change in output when capital is optimally
adjusted between the iosquants and isocosts.

Duesenberry’s Accelerator Theory of Investment:

J.S. Duesenberry in his book Business Cycles and Economic Growth presents an extension of
the simple accelerator and integrates the profits theory and the acceleration theory of
investment.

Duesenberry has based his theory on the following propositions:

(1) Gross investment starts exceeding depreciation when capital stock grows.

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(2) Investment exceeds savings when income grows.

(3) The growth rate of income and the growth rate of capital stock are determined entirely by
the ratio of capital stock to income. He regards investment as a function of income (Y),
capital stock (K), profits ( ) and capital consumption allowances (R). All these are
independent variables and can be represented as

I = f(Y t-1, Kt-1, t-1 , Rt )

Where t refers to the current period and (t-1) to the previous period. According to
Duesenberry, profits depend positively on national income and negatively on capital stock.

=aY- bK

Taking account of lags, this becomes

=aYt-1– b Kt-1

Where t refers to profits during period t, Y t-1 and Kt-1 are income and capital stock of the
previous period respectively and a and b are constants. Capital consumption allowances are
expressed as

R, = kKt-1

The above equation shows that capital consumption allowances are a fraction (k) of capital
stock (K t-1).

Duesenberry’s investment function is a modified version of the accelerator principle,

I t = αYt-1 + βK t-1…. (1)

where investment in period t is a function of income (X) and capital stock (K) of the previous
period (t—1). The parameter (a) represents the effect of changes in income on investment,
while the parameter ((3) represents the influence of capital stock on investment working
through both the marginal efficiency of investment and profits.

Since the determinants of investment also affect consumption, the consumption function can
be written as,

Ct = f (Yt-1 – t-1 – R t-1+ dt)

Where dt stands for dividend payments in period t. Since = f (Y, K), R = kY and d=f (∏),
these independent variables can be subsumed under Y and K. Thus

Ct = a Y t-1 + bKt-1 …. (2)

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The parameter, a, in equation (2) is MPC and it also reflects increase in profits. This increase
is reduced by the effect of profits on dividends and the effect of changes in dividends on
consumption. The influence of changes in capital stock on consumption is reflected by the
parameter b. This influence results from the influence of capital stock on profits through the
influence of profits on dividends on consumption. The capital stock is represented by the
following equation which is an identity,

The a (MPC) in equation (7) will be much smaller than MPC out of disposable income
because it reflects the influence of changes in income on profits and business savings.
Simultaneously, the a in the above equation will be much less than the average capital-output
ratio which is the accelerator in simple multiplier- accelerator models.

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An increase, say, $100 in income, with capital stock constant, will increase the rate of
business investment by an amount which is not much larger than the increase in business
savings resulting from $100 increase in income. It will be only, say, $25. Thus an increase in
income will have a smaller immediate effect on expenditure than would occur in a simple
multiplier-accelerator model.

On the other hand, the negative effect of an increase in capital stock, with income constant,
will be much smaller than in the simple multiplier-accelerator model. If there is an increase in
business capital stock of say, $100, income being constant, it will reduce profits by a very
small amount and will have correspondingly a small effect on business investment.

But a part of the decline in business investment will be offset by a reduction in business
saving. Such changes will reduce the effect on an increase in income on expenditure for some
time because investment will decline slowly, as capital accumulates, provided there is no
further increase in income. The system will therefore, be much more stable than a simple
multiplier-accelerator system.

Control of trade cycles

1. Monetary Policy A Control of Business Cycle


Monetary policy as measure to control business cycle fluctuation refers to all those measures
which are taken with a view to control money and credit supply in the country. When we are
in the state of full employment and we are facing inflation, a deflationary policy may be
adopted. The central bank can reduced the quantity of money in circulation. The bank can
adopt different measures for this purpose, like increase in the bank rate, selling of securities
in the market, increasing the reserve ratio of the member banks etc.

On the other hand, in case of deflation the central bank can adopt inflationary monetary
policy by lowering the bank rates or purchase of securities. Monetary policy has achieved a
very limited success in the past, because central bank has not full power over the supply of
money and credit in the country. Moreover, the quantity of money has failed during the world
depression of 1930s.

2. Fiscal Policy Measure to Control of Business Cycle Fluctuation


Fiscal policy as measure to control business cycle fluctuation nowadays is considered to be a
powerful anti-cycle weapon in the hands of the government. Fiscal policy involves the
process of shaping the public finance (income and expenditure) with a view of reduce
fluctuations in the business cycle and attainment of full employment without inflation.

In case of inflation the governments reduces the public work programs, imposing heavy taxes
on business profits to discourage private investment, reduces purchasers power, taking loans
from the people, prepares surplus budget to reduce public debt. All these fiscal measures
greatly help in reducing the inflationary trend in the economy.

If the economy facing depression, the government increases it expenditure on public works
programs like construction of new canals, new roads, buildings etc. Increase in government

48
expenditure, income, employment, profit and consumption of the people. In order to
encourage private investment the government reduces taxes on profit. The government also
prepares deficit budget and the deficit is met by loans. All these fiscal measures to control
business cycle sets in upswing in the economy.

3. State Control of Private Investment


Some economists have suggested that if a government takes control of private investment is a
tool to control of business cycle fluctuations can be controlled within the limits. The other
economists, who disagree with the above view state that if a government takes control of
private investment, private investment will be discouraged. Low investment will reduce
employment and income. J.M Keynes is of the view that if we adopt the middle way we can
get control of business cycle fluctuation.

4. International Measures Control of Business Cycle


Today, every country has trade relations with the rest of the world. If there is inflation or
deflation in one country, it can be easily carried to other countries. The example of great
depression can be given. Business cycle is an international phenomenon and it should be
tackled on international level. Different measures to control business cycle fluctuations have
been suggested by some well-known economists these are:

 Control of International Production


 International Bill Stock Control
 International Investment Control
5. Reorganization of Economic System
Some economists suggest that there should be complete reorganization of the whole
economic system to control of business cycle fluctuation. The capitalistic system of
production should be replaced by the socialistic system of production. In socialistic economy,
there are few chances of cyclic fluctuations. In 1930, when all capitalist countries of the
world were suffering from depression, it was only socialist countries which were free from
such crisis.

Control of trade cycles

1. Monetary policy to control trade cycle


Monetary factors aggravate the operation of trade cycle. Monetary inflation, leading to higher
income and profits, strengthens the boom conditions. Similarly, monetary deflation reinforces
the downswing in the economic activities leading to depression. So, the monetary policy
should be adopted in an anti-cyclical way. During the period of upswing and boom, supply of
money and credit should be controlled and regulated.

The central bank of the country should adopt all or chosen methods of credit control. The
weapons of credit control, such as bank rate, open market operations, reserve ratio, etc.
should be utilized and to control inflationary tendencies and over-expansion of business

49
activity. In times of depression or signs of recession, expansionary, credit policy should be
adopted to mitigate the severity of recession and depression.
2. Fiscal policy
Monetary policy alone may not be sufficient to check the instability created by business
cycle. It should be reinforced with suitable fiscal policy. Keynes and others have
recommended compensatory finance or compensatory fiscal policy to bring about
stabilization of business activity. The three main instruments of fiscal policy are:

1. taxation,
2. spending, and
3. borrowing..
These three instruments have to be effectively utilized to control the severity of boom or the
difficulties of depression. During the periods of recession and depression, the government
should reduce substantially the taxes and leave more money in the pockets of individuals for
spending and investment.

The government should stimulate economic activity by initiating public works project. In
time of boom, the government should try to mop up extra or the surplus money through
attractive borrowing schemes.

3. Anti-cyclical budgeting
The budgetary policy of the government should be in tune with the measures already
indicated to combat the instability created by business cycle. During times of depression, a
policy of deficit budgeting should be adopted. This will increase the flow of income in the
economy. During upswing, surplus budgeting should be adopted. Thus, the budgeting should
be done in anti-cyclical method.

4. Automatic stabilizer or Built-in-stabiliser


When fluctuations take place in the economy, the available monetary and fiscal tools cannot
be geared quickly to set right the imbalance. Further it is also too much to expect the
government officials to act quickly to the tempo of change in economic activity; So the
policy makers make provisions for automatic adjustments in the fiscal structure. These built-
in-stabilisers or automatic stabilizers will automatically come into play in proportion to the
rise and fall of economic activity.

By this method, the tax rates are so fixed that in the upward phase of the trade cycle, with
increase in national income, the tax yield will go up automatically at a faster rate without any
change in the tax structure. The progressive rate of taxation is one of the important built-in-
stabiliser in the tax structure.
Another important built-in-stabiliser is the unemployment insurance scheme. During periods
of prosperity or upswing, the employers pay taxes and the employees pay some amount
towards unemployment insurance scheme. This money gets accumulated.

During times of depression and the consequent unemployment, the public spending is
automatically effected by doling out money to the unemployed people. Thus, the flow of
money is regulated automatically from the people to the government in times of prosperity,

50
and from government to the people in times of adversity. The built-in-stabilisers play a
strategic role in fighting recessions.

From the above discussions, we can note the following observations:

1. There is no fool-proof method of solving the problem of trade cycles. All measures
suggested must be carefully coordinated and implemented to achieve economic stabilisation.

2. These stabilization objectives should not be interpreted rigidly. We cannot expect them to
eliminate all fluctuations in employment, output and prices. Cyclical fluctuations are an
inherent characteristic of capitalist society and cannot be eliminated completely but can be
controlled reasonably if measures are effectively adopted.

3. Some fluctuations may be beneficial to economic growth. Therefore, stabilization policy


should be applied only to suppress inappropriate fluctuations.

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