Hawtrey considers the business cycle as a purely monetary phenomenon. There is a direct relationship between volume of money supply and the economic activity. A change in the flow of money or money supply causes business fluctuations.
Inventory cycles result from fluctuations caused in the desired ratio of stocks to sales in response to changes in the rate of interest. Hawtrey explains that merchants, particularly wholesalers play a dominant role.
A rise in the rate of interest banks charge on loans from merchants, by raising the cost of holding inventories, lowers the desired ratio of stocks to sales while a fall in the rate of interest raises this ratio. When banks possess excess cash reserves and are anxious to utilize these reserves they reduce the interest rate in order to induce the entrepreneurs to borrow funds to increase inventory and promote expansion. When merchants decide to increase their desired ratio of stocks to sales consequent upon a fall in the rate of interest they place fresh orders with the manufacturers who in turn increase the scale of their production creating added demand for factors of production resulting in the increase in incomes of factor owners who in turn spend a part of their additional income on the purchase of consumer goods which is reflected in the brisk sales and fast depletion of merchants’ inventories inducing them to place further orders with the manufacturers. The cumulative expansion continues so long as banks continue to extend liberal credit facilities at low interest rates to the merchants. However, the banks cannot continue with this loan literalism forever as their capacity to lend is circumscribed by the extent of excess cash reserves.
Hawtrey further observes that in the process of credit creation the limit is eventually reached when the banks can lend no more; in fact, they begin to recall their old loans and raise the rate of interest. This is enough to create panic and merchants impatiently start reducing inventory holdings and cancel unexecuted orders pending with the manufacturers who in turn take no time to curtailing their scale of operations throwing workers out of employment. Faced with unemployment, workers and other factor owners curtail their spending reducing the aggregate effective demand in the process. Soon the markets for consumer goods present a deserted look with merchants sitting idle. The intractable recession grips the economy in its hold. The cumulative process of contraction confronts the banks as their loans are paid back with excess reserves to employ. They once again lower the rate of interest. At this point the process of revival and expansion starts over again.
The theory is criticized on the following points.
Inventory cycles result from fluctuations caused in the desired ratio of stocks to sales in response to changes in the rate of interest. Hawtrey explains that merchants, particularly wholesalers play a dominant role.
A rise in the rate of interest banks charge on loans from merchants, by raising the cost of holding inventories, lowers the desired ratio of stocks to sales while a fall in the rate of interest raises this ratio. When banks possess excess cash reserves and are anxious to utilize these reserves they reduce the interest rate in order to induce the entrepreneurs to borrow funds to increase inventory and promote expansion. When merchants decide to increase their desired ratio of stocks to sales consequent upon a fall in the rate of interest they place fresh orders with the manufacturers who in turn increase the scale of their production creating added demand for factors of production resulting in the increase in incomes of factor owners who in turn spend a part of their additional income on the purchase of consumer goods which is reflected in the brisk sales and fast depletion of merchants’ inventories inducing them to place further orders with the manufacturers. The cumulative expansion continues so long as banks continue to extend liberal credit facilities at low interest rates to the merchants. However, the banks cannot continue with this loan literalism forever as their capacity to lend is circumscribed by the extent of excess cash reserves.
Hawtrey further observes that in the process of credit creation the limit is eventually reached when the banks can lend no more; in fact, they begin to recall their old loans and raise the rate of interest. This is enough to create panic and merchants impatiently start reducing inventory holdings and cancel unexecuted orders pending with the manufacturers who in turn take no time to curtailing their scale of operations throwing workers out of employment. Faced with unemployment, workers and other factor owners curtail their spending reducing the aggregate effective demand in the process. Soon the markets for consumer goods present a deserted look with merchants sitting idle. The intractable recession grips the economy in its hold. The cumulative process of contraction confronts the banks as their loans are paid back with excess reserves to employ. They once again lower the rate of interest. At this point the process of revival and expansion starts over again.
The theory is criticized on the following points.
1. Changes in money supply might play a role in fluctuations in economic activity, but they are not the cause of business cycles.
2. The role of banks and businessmen is over exaggerated.
3. The theory wilt not works if people invest their own money and do not borrow from banks.
4. The theory fails in the situation of liquidity trap.
5. The theory does not take into account the non-monetary factors such as innovations, multiplier, accelerator etc.
5. The theory does not take into account the non-monetary factors such as innovations, multiplier, accelerator etc.
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