KALDOR'S THEORY OF BUSINESS CYCLE

In the model of business cycle Nicholas Kaldor developed, consumption or saving is a function of income while investment is directly related to income and inversely related to the stock of capital. The investment demand function is of the capital-adjustment type. Kaldor’s theory is very simple and neat discussion of the business cycle based on the Keynesian saving-investment analysis.

Kaldor’s business cycle theory is an extension of the income determination model where the saving supply function was of the form S= -a +sY and the investment demand function was of the form I = IA + eY. The stability condition required there was that the marginal propensity to invest (MPI) should be less than the marginal propensity to save (MPS) i.e. MPI < MPS. The slope of the investment demand function should be less than the slope of the saving supply function. For the stability of equilibrium, the investment demand function must intersect the saving supply function from above.If the MPI > MPS i.e. if the investment demand function intersects the saving supply function from below, the resulting equilibrium will be unstable. In both situations of stable and unstable equilibriums the planned saving is equal to the planned investment. For his business cycle analysis, Kaldor takes the non-linear saving and investment functions. According to Kaldor, the saving supply and the investment demand functions cannot both be linear over the entire range of changes in the income which takes place during the  course of business cycle.

Dividing the full business cycle into relatively low, normal and relatively high income phases, the marginal propensity to invest will not be the same during all the three phases. During the course of the business cycle, the non-linear investment demand function will behave in such a manner that the MPI or the slope of the investment function will be relatively low at both relatively low and relatively high levels of income. The investment demand function is likely to be income inelastic at low income levels due to the presence of excess plant capacity in the economy. It is likely to be the same at high levels of income.