Hayek's Monetary Theory of Trade Cycle

Hayek's Monetary Theory of Trade Cycle:

The traditional business cycle theory take into consideration the monetary and credit system of an economy to analyse business cycles. Therefore, theories developed by these traditional theorists are called monetary theory of business cycle. The monetary theory states that the business cycle is a result of changes in monetary and credit market conditions. 

For example, when there is increase in money supply, there would be increase in prices, profits, and total output. This results in the growth of an economy. On the other hand, a fall in money supply would result in decrease in prices, profit, and total output, which would lead to decline of an economy. According to Hayek monetary disturbances are the root cause of cyclical fluctuations in the economic activity. He says, “Over issue of bank credit at artificially low interest rates are responsible for the operation of the business cycle.

According to Hayek so long investment is financed through current saving there is stability in the economy. The problem starts when the investment is financed through easy bank credit. He also advocated that the main factor that influences the flow of money is the credit mechanism. In economy, the banking system plays an important role in increasing money flow by providing credit.

An economy shows growth when the volume of bank credit increases. This increase in the growth continues till the volume of bank credit increases. Banks offer credit facilities to individuals or organizations due to the fact that banks find it profitable to provide credit on easy terms. The easy availability of funds from banks helps organizations to perform various business activities. This leads to increase in various investment opportunities, which further results in deepening and widening of capital. Apart from this, credit provided by banks on easy terms helps organizations to expand their production. Under fractional reserve system it is possible for the banks to supply excess credit even at full employment

When an organization increases its production, the supply of its products also increases to a certain limit. After that, the rate of increase in demand of products in market is higher than the rate of increase in supply. Consequently, the prices of products increases. Therefore, credit expansion helps in expansion of economy. The inflationary boom started due to the process of credit creation by commercial banks lasts only as long as the low market rate of interest prevails in the economy. However there is a limit beyond which commercial banks may not expand credit. They curtail further lending and the market rate OF INTEREST RISES. The economic condition is reversed when the bank starts withdrawing credit from market or stop lending money.

This is because of the reason that the cash reserves of bank are washed-out due to the following reasons:

a.                       Increase in loans and advance provided by banks

b.                   Reduction in inflow of deposits

c.                    Withdrawal of deposits for better investment opportunities

When banks stop providing credit, it reduces investment by businessmen. This leads to the decrease in the demand for consumer and capital goods, prices, and consumption. This marks the symptoms of recession. Hayek identified the difference between natural rate of interest and market rate of interest. So long as the market rate of interest coincides with the natural rate of interest there is no trouble and the economy remains in equilibrium. But when the two differs the trouble starts. Now suppose the market rate of interest is less than the natural rate of interest the demand for investment will exceed the available supply of saving. The gap will be filled by expansion of credit. The additional bank credit will increase supply of money which increases the price level resulting in the condition of prosperity and boom. And the reverse happens when the market rate is higher than the natural rate of interest.

Some of the points on which the pure monetary theory is criticized for not furnishing a comprehensive explanation of the trade cycle. He considers trade cycle as monetary phenomenon that is not true. Apart from monetary factors, several non-monetary factors, such as new investment demands, cost structure, and expectations of businessmen, can also produce changes in economic activities. Hayek’s theory describes only expansion and recession phases and fails to explain the intermediary phases of business cycles. Further he assumes that businessmen are more sensitive to the interest rates that is not true rather they are more concerned about the future opportunities.

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