In recent years John Maynard Keynes proposed a thought provoking theory of the business cycle.
A cyclical change in the marginal efficiency of capital caused the problem of business cycle in the economy, though associated changes in the other significant short-period variables of the economic system complicated and often aggravated it. Thus, the prime factor of cyclical fluctuations is inherent in investment changes generated by the cyclical changes in the marginal efficiency of capital.
The entrepreneurs’ expectations of future return on investments made in the present monitor the marginal efficiency of capital. The uncontrollable and disobedient psychology of the business world significantly influences the entrepreneurs’ expectations. The marginal efficiency of capital along with the market rate of interest determines the level of investment that businessmen will be ready to make, fluctuates with changes in the psyche of the business community. Within a cyclical upswing the business community in its over-enthusiasm tends to overestimate the expected rate of return from investment projects leading to actual over-investment in the economy. In due course however, they recognize their mistake that the expected rate of profit is unlikely to be realized. This proves a jolt to their confidence turning them pessimistic about the future.
The marginal efficiency of capital is greater than the rate of interest in Keynes’ explanation of the business cycle. The marginal efficiency of capital disturbs the economy’s equilibrium which causes cyclical fluctuations in economic activity in the system. The rate of interest supports the action of the marginal efficiency of capital by rising at a time when it ought to have fallen in the interest of stability. The investment multiplier adds speed to the operation of business cycle. Starting at the bottom of the depression, the marginal efficiency of capital is high due to the shortage of capital stock and inventories requiring replacement. At this time the rate of interest also happens to be low due to easy liquidity position of the banks. The investment multiplier assists the process of increase in investment and employment. The sudden burst in investment activity leads to a boom. In due course the boom creates conditions of instability. Goods are over-accumulated; prices fall steeply, and businessmen incur substantial losses while the cost of production continues to go up. The downswing process once started gets speedier and the investment multiplier now operates in the opposite direction.
A cyclical change in the marginal efficiency of capital caused the problem of business cycle in the economy, though associated changes in the other significant short-period variables of the economic system complicated and often aggravated it. Thus, the prime factor of cyclical fluctuations is inherent in investment changes generated by the cyclical changes in the marginal efficiency of capital.
The entrepreneurs’ expectations of future return on investments made in the present monitor the marginal efficiency of capital. The uncontrollable and disobedient psychology of the business world significantly influences the entrepreneurs’ expectations. The marginal efficiency of capital along with the market rate of interest determines the level of investment that businessmen will be ready to make, fluctuates with changes in the psyche of the business community. Within a cyclical upswing the business community in its over-enthusiasm tends to overestimate the expected rate of return from investment projects leading to actual over-investment in the economy. In due course however, they recognize their mistake that the expected rate of profit is unlikely to be realized. This proves a jolt to their confidence turning them pessimistic about the future.
The marginal efficiency of capital is greater than the rate of interest in Keynes’ explanation of the business cycle. The marginal efficiency of capital disturbs the economy’s equilibrium which causes cyclical fluctuations in economic activity in the system. The rate of interest supports the action of the marginal efficiency of capital by rising at a time when it ought to have fallen in the interest of stability. The investment multiplier adds speed to the operation of business cycle. Starting at the bottom of the depression, the marginal efficiency of capital is high due to the shortage of capital stock and inventories requiring replacement. At this time the rate of interest also happens to be low due to easy liquidity position of the banks. The investment multiplier assists the process of increase in investment and employment. The sudden burst in investment activity leads to a boom. In due course the boom creates conditions of instability. Goods are over-accumulated; prices fall steeply, and businessmen incur substantial losses while the cost of production continues to go up. The downswing process once started gets speedier and the investment multiplier now operates in the opposite direction.
The Keynesian theory of business cycle is criticized on the following grounds:
(i) Keynes’ theory offers incomplete explanation of the business cycle and fails to explain the periodicity of the trade cycles.
(ii) Through the concept of investment multiplier Keynes explained the process of downswing and upswing of trade cycle. The fact however is that multiplier alone does not offer satisfactory explanation of the business fluctuations. It is the multiplier acceleration interaction which brings about expansion or contraction of the economic activity.
(iii) Keynes ’theory of business cycle is very near to the psychological theory of the classical economists. It does not explain the real factors which cause changes in business expectations.
(iv) Keynes did not build up an exclusive theory of the trade cycle. He just gave a systematic explanation of the upturn and the down turn in economic activity.
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