Keynesian Theory of Trade Cycles

John Maynard Keynes, one of the most influential economists of the 20th century, never worked out a pure theory of trade cycles, though he made significant contributions to the trade cycle theory. Keynes states, “The trade cycle can be described and analyzed in terms of the fluctuations of the marginal efficiency of capital relatively to the rate of interest.” According to Keynes, the level of income and employment in a capitalist economy depends upon effective demand, comprising of total consumption and investment expenditure. Changes in total expenditure will imply changes in effective demand and will lead to changes in income and employment in the country. Therefore, in the Keynesian system fluctuations in total expenditure are responsible for fluctuations in business activity. Now, according to Keynes, consumption expenditure is relatively stable, and consequently it is the fluctuations in the volume of investment that are responsible for changes in the level of employment, income and output.

Investment depends upon two factors: (a) marginal efficiency of capital, and (b) the rate of interest. Investment is carried on up to the point where the marginal efficiency of capital (the profitability of capital) is equal to the rate of interest (i.e., the cost of borrowing capital). Keynes argues that the rate of interest will depend upon the liquidity preference of the people in the country and the quantity of money available. In the short period, the rate of interest will be stable and hence it is not responsible for causing cyclical fluctuations in trade cycles. According to Keynes the fluctuations in the marginal efficiency of capital are the fundamental cause of fluctuation in trade cycles.

The following Figure shows how trade cycle depends upon the marginal efficiency of capital, which according to Keynes, is the villain of the piece. The substance of Keynesian Theory of Trade Cycles is that an initial investment outlay will generate multiple amount of income and employment under the influence of the multiplier and acceleration effects. On the other hand, contraction of investment will similarly lead to multiple contractions of income and employment. But whether a fresh investment will be undertaken will depend upon the marginal efficiency of capital. We can explain these points a little more elaborately.

How Recovery Starts?

Let us start at the bottom of a depression. At this point, the marginal efficiency of capital will be high due to exhaustion of accumulated stocks and necessity to replace capital goods. At the same time, the rate of interest may be low because of large cash balances with commercial banks or due to fall in the public liquidity preference. As a result, the entrepreneurs may borrow funds from banks and make fresh investments. Under the impact of the multiplier and acceleration effects, the process of increased investment and employment gets an upward trend. There is heavy economic activity everywhere in the primary, secondary and tertiary sectors of the economic system. This sudden shoot in investment activity gives rise to boom and as long as it lasts, the economic situation appears very easy and bright.

How the Boom Crashes?

The boom conditions themselves contain the very seeds of their own destruction. Very soon goods are accumulated beyond the expectations of entrepreneurs and competition among them to dispose their accumulated stocks bring crash in prices. While the prices of finished goods are declining, their costs of production continuously rise because factors of production are becoming scarce and hence are commanding higher prices. The marginal efficiency of capital is sandwiched between rising costs of production on the one side and falling prices of finished goods in the other hand. The marginal efficiency of capital, therefore, collapses and brings about a crash in the investment market.

Ineffectiveness of the Rate of Interest

Keynes believes that the rate of interest could have prevented the collapse of the marginal efficiency of the capital and revives the confidence among the entrepreneurs, by exerting its pressure to reduce cost. But then, the rate of interest  is very high, like all other prices and wages. The rate of interest goes up due to a rise in the liquidity preference of the people. The marginal efficiency of capital falls below the current rate of interest and thus, the decline of investment is aggravated. Keynes believes that at this stage a reduction in the rate of interest is neither easy nor adequate to restore confidence and revive investment. In Keynesian Theory of Trade Cycles, the marginal efficiency of capital has great significance than the rate of interest. In fact, it disturbs the equilibrium of the economy and thereby causes fluctuations in the economy. The other factor that occupies an equally important place in Keynes theory is the “investment multiplier“. However, for the active operation of investment multiplier, the cycle needs to be milder in magnitude than what it actually is.

Weaknesses of the Keynesian Analysis

Keynes’ theory of the trade cycle has been regarded as quite convincing since it explains exactly the cumulative processes, both in the upswing as well as in the downswing. Besides, Keynes’ advocacy of fiscal policy to bring about business stability has been widely used. However, critics have found some weaknesses in the Keynesian Theory of Trade Cycles. First, according to Keynes, marginal efficiency of capital is the most important factor that guides the investment decisions of the entrepreneurs. However, this important factor depends on entrepreneurs’ anticipation of future prospects that further depend upon the psychology of investors. If  such a case, Keynes’ theory of trade cycles approaches close to Pigou’s psychological theory, which assumes that the changing assumptions of entrepreneurs regarding future market conditions play a key role in the cyclical fluctuations of capitalist reproduction. Secondly, in Keynes’ theory, the rate of interest plays a minor role. Keynes expresses the opinion that sizable fall in the rate of interest can do something to revive the confidence among the entrepreneurs by exerting pressure on the cost of production. However, Keynes himself has pointed out that this has been sufficiently proved to be correct that the rate of interest does not have any influence on investment. Thirdly, his theory does not throw light on the periodicity aspect of the trade cycle.

Finally, some critics like Hazlitt have pointed out that Keynes’ concept of the rate of interest does not tally with actual market conditions. For instance, according to Keynes, in a period of recession and depression, the rate of interest ought to be high because of strong liquidity preference but precisely during this period, the rate of interest is low. Likewise during boom conditions, the rate of interest ought to be lower because of the weak liquidity preference among the people instead it is high.

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About Abey Francis

Abey Francis is the founder of MBAKnol - A Blog about Management Theories and Practices - and he's always happy to share his passion for innovative management practices. You can found him on Google+ and Facebook. If you’d like to reach him, send him an email to: [email protected]

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