Keynes Theory
Keynes views about trade cycle entitled notes on the trade cycle of his classic the general theory of employment interest and money published in 1936. Although Keynes main concern in the book was to refute the classical theory of employment and output along with the traditional approach to interest rate, saving investment and the quantity theory of money he also wrote about the cyclical fluctuations. According to Keynes the problem of trade cycle in the economy was caused by a cyclical change in the marginal efficiency of capital though complicated and often aggravated by associated changes in the other significant short period variables of the economic system. Thus the prime force of cyclical fluctuations inheres in investment changes generated by the cyclical changes in the marginal efficiency of capital.
The marginal efficiency of capital is governed by entrepreneurs expectations of future returns on investments made in the present. The entrepreneurs expectations are significantly influenced by the uncontrollable and disobedient psychology of the business world. The marginal efficiency of capital which together with he market rate of interest determines investment that businessmen will be willing to undertake, fluctuates with changes in the mood of business community. During cyclical upswing. The businessmen in their over enthusiasm are prone to overestimate the expected rate of returns from investment projects which causes actual over investment in the economy. In due course of time they realise their mistake that expected rate of profit will not be realised. This realisation on businessmen s part given a jolt to their confidence making them pessimistic. This pessimism on the part of businessmen causes the marginal efficiency of capital to collapse with consequent decline in investment. A cumulative contraction grips the economy. Once the marginal efficiency of capital has collapsed , confidence can revive only after certain time has elapsed and even the fall in the rate of interest ( even if it were possible ) cannot revive the confidence of the business community. But how does recovery come about? As time passes inventory stocks with merchants diminish below the desired ratio of sales to inventory requiring replenishment. Fixed capital also wears out requiring replacement. All this creates demand for investment in the economy. Once business confidence revives it feeds itself and recovery takes its own course.
In Keynes explanation of trade cycle , the marginal efficiency of capital is more important than the rate of interest. It is the villain of peace which by disturbing economy equilibrium cause cyclical fluctuations in economic activity in the system. Rate of interest lends supports to the action of the marginal efficiency of capital by rising at a time when it ought to have fallen in the interest of stability . the other important factor in the theory is investment multiplier without whose active operation the trade cycles would have been milder than what they have in reality been seen occurring. Starting at the bottom of depression, the marginal efficiency of capital is high due to the shortage of capital and inventories requiring replenishment. At this time the rate of interest also happens to be low due to easy liquidity position of the banks. Aided by investment multiplier, the process of increase in investment and employment assumes a cumulative character. The sudden burst in investment activity leads to boom. In due course of time the boom creates conditions of instability. Goods are over accumulated. Price crash, business men incur substantial losses while the costs of production continue to rise. The process of downswing once started become cumulative and investment multiplier now operates in the reverse direction.
Keynes theory is a psychological theory. Consequently, it does not explain the real factors which cause variations in the businessmen expectations . Keynes makes at best few tentative suggestions about the optimism boom ending eventually while his explanation of the pessimism in slump coming to end is incomplete.