HAYEK'S THEORY OF BUSINESS CYCLE

According to Hayek, monetary disturbances are the sine qua non of cyclical fluctuations in economic activity. Hayek assumes that (i) economy is in equilibrium at full employment. (ii) Bank maintain a 100 per cent ratio of reserves to deposits; and © there is no change either in the money supply or in its velocity of circulation.

Under these circumstances, all borrowings for investment must be supplied from funds released through current savings. Consequently, the amount of current output, which can be devoted to investment and through investment to expanding the income stream, will be determined by the community’s saving habits. If the community takes the decision to consume less at present in order to consume more in the future, savings will increase and resources will be released for consumption. This will cause the rate of interest to fall and investment to increase. The rate of interest will fall enough to enable the entire resources released in the form of savings to be absorbed in investment.

Hayek observes that the resources released through savings will either be devoted to the production of consumption goods or to the production of investment goods. When the economy is operating at full employment increase in investment causes the resources to be shifted away from the higher to the lower stages of production. As a result, the structure of production is lengthened, i.e., the “roundaboutness” of production increases. So long as the increase in the roundaboutness of production, which occurs as a result of the increase in investment, reflects the voluntary behaviour of savers in the economy, no harm can take place. The difficulty arises when the lengthening of the structure of production that takes place due to an increase in investment is financed not through current savings but through the easy credit created by the banking system. Such a situation, in which investment is financed through the bank credit, creates the temporary illusion among the entrepreneurs regarding the profitability of lengthening the structure of production. As a result, this temporary illusion which disappears with the bank stopping credit creation more resources than can be sustained on the basis of funds released through current savings are devoted to the production of capital goods causing ‘vertical maladjustment’ and losses. A recession during which the structure of production is shortened, grips the economy.

The limitations for this theory are –
Assumption of full employment is far from reality.
Rate of interest receives undue importance.  Even if the rates of interest remain the same, there will be changes in production when the business starts gaining profits.
This theory is also not complete just like Over-Investment theory of business cycle.
He looks at only one aspect just like Joseph Schumpeter.