Hawtrey’s Theory of Business Cycle:

Monetary Theories of Trade Cycle- Hawtrey's Theory

Prof. Mahendra Kumar Ghadoliya

Introduction-
Hawtrey, regards trade cycle as a purely monetary phenomenon. According to him, non-monetary factors like wars, strikes, earthquakes, crop failures, etc., may cause partial and temporary depression in particular sectors of the economy, but they cannot cause a full permanent depression involving general unemployment of the factors of production in the form of a business cycle. Business cycles are caused by the expansion and contraction of bank credit. Hawtrey’s business cycle theory is based on three important factors:

1.      Traders play an important role in the economy. They are very sensitive to the change of rate of interest.

2.      Money supply in the economy is affected by the level of consumer spending.

3.      At the sudden crash of boom, banks suspend credit and call on the borrowers to return the loans.

According to Arthur F. Burns and W. C. Mitchell, a typical or standard trade cycle consists of four closely interrelated phases of revival, expansion, recession, and contraction. The peak and trough the critical mark-off point in the cycle. According to Schumpeter, a trade cycle involves the four phase cycle consisting of the prosperity, recession, depression, and recovery. The trade cycle is divided in two parts the upper half and the lower half. The upper part of the cycle above trend or equilibrium line is divided into prosperity and recession while the lower part of the cycle below the trend line is divided into depression and recovery. Figure below illustrates the four phases of a trade cycle:

It is important for any theory of trade cycle to answer two important questions as to how boom conditions are created. And why the boom crashes and depression starts?

The Upswing or Boom:

According to Hawtrey the upward phase of the business cycle is brought about by an expansion of bank credit and also by an increase in the velocity of circulation of money. When the banks have excess reserves the rate of interest is lowered, producers and traders will be induced to borrow more from banks. It has already been pointed out that the business people are very sensitive to change in the rate of interest. Borrowing at low rate of interest lead to expansion in business activities and rise in the price level. Producers employ more people this leads to more income and more production. The income goes in the hands of the factors of production. The increased income is spent on consumer goods thus increase in demand of consumer goods. The increase demand leads to further expansion of demand of investment goods. In this way a cumulative expansion takes place during the prosperity. Banks grant more and more loans to business. The boom crashes when banks stop expansion of credit.

The downswing or Depression:

How the depression does develops according to this theory? As said above, the banks suddenly suspend their policy of credit expansion which they were following. Why do they do so?  With the expansion of credit the banks reach at maximum point beyond which they cannot any more loans. This may be because of the understanding that the peak has reached and that the economy may take a downturn in the immediate future. The scarcity of cash forces banks to raise the rate of interest and start withdrawing the short term and call loans from their clients. This comes as big shock to the businessmen who were enjoying the liberal policy of banks. The sudden call backs of loans forces businessmen to sell their stock at any price and repay the loans. This depresses the market. Prices crashes and with every fall in prices the desire to dispose of the stocks leads to nervousness and collapse of the market.

Once the downtrend starts it gathers the momentum with the lapse of time. There is an atmosphere of pessimism and gloom throughout the economy. This is depression.

Conditions for revival:

During the depression the rate of interest is low and banks have excess reserves. The conditions are favourable for revival. The low rate of interest induces businessmen to borrow and the excess reserves with banks induces banks to lend. The revival starts and because of its cumulative character leads to prosperity and boom conditions.

In short it can be said that elastic money supply is the root cause of the operation of a trade cycle.

Criticism of the Theory:

1.      The theory is criticized for not furnishing a comprehensive explanation of the trade cycle.

2.      The rate of interest alone may not affect business decisions.

3.      It is also incorrect to say that business fluctuations are caused by the actions of the banks

4.      It ignores non-monetary factors, several non-monetary factors, such as new investment demands, cost structure, and expectations of businessmen, can also produce changes in economic activities.

5.      Hawtrey’s theory that businessmen are more sensitive to the interest rates that is true but they are influenced by future opportunities to earn profit. Thus bank credit alone cannot explain the conditions of boom and depression.

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