Hawtreys Monetary Theory of Trade Cycles

The British economist Ralph G. Hawtrey regards trade cycle as a purely monetary phenomenon. According to him, non-monetary factors like wars, earthquakes, strikes and crop failures may cause partial and temporary depression in particular sectors of an economy. However, these non-monetary factors cannot cause full and permanent depression involving general unemployment of the factors of production in a trade cycle. On the other hand, changes in the flow of money are the exclusive and sufficient cause of changes in trade cycle. In Hawtrey’s opinion, the basic cause of trade cycle is the expansion and contraction of money in a country. According to Hawtrey, changes in the volume of money are brought about by changes in the rate of interest. For instance, if banks reduce their rate of interest, producers and traders will be induced to borrow more from banks so as to expand their business. Borrowing from banks will lead to more bank money and rise in the price level and business activity. On the other hand, if banks raise their rate of interest, producers and traders will reduce their borrowing from banks. This will reduce the price level and business activity. Thus, in Hawtrey’s analysis, changes in interest rates lead to changes in borrowing from banks and, therefore, changes in the supply of money. Changes in the supply of money lead to changes in business activity.

Trade Cycle in Just Inflation and Deflation

Hawtrey argues that the trade cycle is nothing but small-scale replica of an outright money inflation and deflation. The upward phase of a trade cycle, such as revival, prosperity and boom is brought about by an expansion of money and bank credit and also by increase in circulation of money supply. On the other hand, the downward swing of money supply is nothing but a monetary deflation.

Expansion of bank loans is made possible by fall in rate of interest, which induces the merchants to increase their stocks since banks grants loan more liberally. Therefore, merchants begin to place more orders and increase production by employing more resources. There is greater demand for factors of production all round and consequently higher income and employment leading to further increased demand of goods. In course of time, a cumulative upward trend is set in motion. As the volume of business expands and factors of production arc rendered fully employed, prices rise further and further induce upward business expansion, resulting in inflationary conditions or boom conditions. However, the boom crashes when the banking authorities suspend their policy of credit expansion.

Why the Boom Crashes Suddenly?

The banks suspend credit and call on the borrowers to return the loans, either because banks have reached the maximum point beyond which they cannot give any more loans or they are afraid that the phase of business expansion has reached a saturation point and hence a downward trend may set in the immediate future. Now the sudden suspension of credit facilities by the banks comes as a shock to entrepreneurs and merchants. Until now entrepreneurs and merchants were enjoying liberal policy of the banks and now, contrary to their expectations, they receive sudden notices of immediate call-back of loans to dispose of their stocks at any price in order to repay bank loans. This general desire of businessmen to dispose of their stocks will definitely depress the market and bring down the prices. With every fall in prices, the desire to dispose of the stocks as quickly as possible will lead to confusion and collapse of the market. Marginal and average firms may even go into liquidation, thus worsening the position still further and making the banks extremely nervous. Banks will proceed to further contraction and like the period of expansion, it will become cumulative. Producers curtail output and consumers income and outlays decrease and contraction spirals in a downward direction, until it touches the lowest level possible.

How the revival takes place?

When the economy is working at the level of depression, the rate of interest is low and the banks will have large cash reserves. On one hand, low interest rates make it profitable to borrow and invest. On the other hand, large cash reserves induce banks to lend. This starts the phase of revival, which because of its cumulative character, leads to prosperity and boom conditions. This, according to Hawtrey, the inherently unstable nature of the modem monetary and credit system is the mother or economic fluctuations. This monetary explanation of the trade cycle has received powerful support from Milton Freidman, who says, “In every deep depression, monetary factors play a critical role.” According to Freidman, there is a direct relation between the volume of money supply and the level or business activity in a country. If the money supply increases at a rate faster than the economy’s real output of goods and services, prices will decline and the economy is bound to contract. Thus, there is direct relation between the level of income and economic activity, on the one side and the volume of money supply on the other. If the economy has to be stable, monetary expansi9n and contraction has to be avoided.

Weaknesses of the Monetary Expansion

The weakness of monetary expansion is as follows:

  • Finance is the soul of commerce and trade in modern times and the banking system plays quite an important part in financing trade activities. However, it is correct to say that banks cause business crises.
  • Hawtrey’s theory would have been all right in those days when the gold standard was universal and when the volume of money supply was fixed to gold reserves. Currency and credit could expand only when gold reserves increases. These days, gold standard does not exist and, therefore, Hawtrey’s theory is really weak.
  • Borrowing and investment will not depend upon the rate of interest, as Hawtrey believes. A high rate of interest will not deter people from borrowing for investment, and a low rate of interest will always induce people to borrow and invest.
  • Expansion and contraction of money alone cannot explain prosperity and depression.
  • According to Hawtrey, expansion and boom are the result of expansion of bank credit, but it is pointed out that the mere expansion of bank credit by itself cannot initiate a boom.
  • Further, according to Hawtrey, a depression is marked by contraction of bank loans and advances but actually, the contraction of bank credit is the result of depression.           .
  • Lowering of interest rate and willingness of banks to give loans and advances cannot be a sufficient reason to stimulate the economy to revive. Businessmen will not borrow and invest unless they are convinced that the economy will definitely survive.
  • The conclusion, which follows, is that the banking system can accentuate a boom or a depression but it cannot originate one. In other words, expansion and contraction of bank credit can be a supplementary cause but not the main cause of trade cycles.

Credit: Managerial Economics-MGU MBA