Theories of Trade cycle

Theory of trade cycles

Climatic theory (harvest theory) / Sunspot theory

According to this theory, trade cycles occur due to changes in climatic conditions. When climate conditions are favorable, it leads to economic expansion; conversely, unfavorable climate causes a decline in outputs in agriculture and in agro-based industries, therefore leading to economic decline.

Jevons sunspot theory, according to Stanley Jevons, spots appear on the face of the sun at regular intervals. These spots affect the emission of heat from the sun, which in turn conditions the degree of rainfall. The rain affects agriculture, which in turn affects trade and industry.

Monetary theory

According to this theory, trade cycles occur due to changes in money supply and money demand.

a. Change in money supply

• Increase in money supply: when money supply increases through increase in provision for credits, investments are encouraged and thus employment, incomes, effective demand increases as well as the standard of living. This is a period of boom or economic recovery.
• Decrease in money supply: when money supply decreases it discourages investment; as a result, employment, income and effective demand fall, hence an economic recession occurs.

b. Changes in money demand

• Increase in money demand: an increase in money demand for transaction motive situation insertion and production thus causes an economic expansion.
• Decrease in demand: a decrease in money demand for transaction motive discourages effective demand and production; therefore, it results in a recession or depression.

c. Over-investment theory

According to this theory, trade cycles occur due to over-investment. Over-investment occurs due to the following reasons:

• Fall in the rate of interest: when the rate of interest is low, investors are encouraged to borrow money for investment; hence more investments are created, leading to economic growth.
• Technological innovations: invention of new technology causes an increase in production and economic expansion.
• Increase in effective demand: when effective demand increases, production increases; therefore the economy undergoes economic growth.

d. Psychological theory

Attempts are made by some economists to explain trade cycles in terms of psychology. There are moods of optimism alternating with moods of pessimism. At some stage people just think trade is good and that it is going to remain good. Business activity is intensified and becomes flourishing. Then all of a sudden, people start thinking that the period of prosperity has lasted long enough and adversity is round the corner. Thus, although there is no valid reason for depression to come about, it is brought about by the people themselves. It is all psychological.

The psychological theory lacks any sound basis. There is a conjectural element in it. There is no doubt that individual fluctuations are affected by the waves of optimism and pessimism and are intensified by them. But they do not explain the cause of the trade cycles or their periodic aspect.

e. Under-consumption theory

According to under-consumption theory, there is too much saving during a boom and further additions to saving reduce the level of consumption. A reduction in the level of consumption in the case of increasing productive capacity must sooner or later lead to the collapse of the boom.

The under-consumption or over-saving theory contains an element of truth. But it cannot be the adequate explanation. For example, if the under-consumption theory were exclusively relied on, we would expect the consumption goods industries to fluctuate more than investment goods industries. But exactly the reverse is the case in real life during a trade cycle.

f. Keynes theory

According to Keynes, trade cycles are caused by changes in the rate of investment. The rate of investment is caused by the marginal efficiency of investments, i.e., profitability of investments. If the rate of profit declines, investors are discouraged from increasing investments, the economy falls into a recession, and if the rate of profit increases, investors are encouraged to increase investments; therefore the economy will experience recovery.

g. Political theory

According to this theory, fluctuations in economic activities are caused by:

• Actions of politicians who apply expansionary monetary and fiscal policy for their political interest, i.e., to gain popularity. This policy leads to economic prosperity in the short run, but after winning elections, politicians apply contractionary monetary and fiscal policies which lead to economic contraction.
• Political stability and instability: when there is political stability, investors are encouraged to increase investments, causing economic growth. In contrast, when there is political instability, investors are discouraged from investing and thus an economy falls into recession.

h. Modern theory

According to this theory, trade cycles occur due to multiplier and accelerator processes. An increase in investments leads to an increase in income which stimulates further increase in investments through the accelerator process, and increase in investments stimulates further increase in income. Therefore, economic recovery or a boom is caused by the effectiveness of the multiplier and accelerator processes, while economic recession is caused by ineffectiveness of the multiplier and accelerator processes.

Measures to control business cycles

a. Expansionary monetary policy

This involves the central bank, through commercial banks, increasing money in circulation in order to deal with depression and recession. Under this, the central bank will reduce the bank rates, reduce legal reserve requirements, and so on, which will encourage banks to lend more to customers and businessmen. This will result in more investments, increase in aggregate demand which will finally result in expansion of economic activities.

b. Expansionary fiscal policy

Under this, the government should opt for the following in order to deal with depression and recession:

1. Increase in government expenditure especially in productive areas such as construction of roads, which will result in increase in money supply and stimulation of business activities.
2. The government should as well lower direct and indirect taxes, which will also stimulate aggregate demand of goods and services, hence stimulation of economic activities.

The government can also employ direct controls in order to ensure proper allocation of resources in order to bring about price stability and economic stability. Such controls will take different forms such as:

1. Exchange rate policy: under this, the government evaluates its currency in order to encourage exports, which helps to boost up domestic production.
2. Price and wage control: under this, the government fixes minimum prices in order to encourage production. It can also increase wages in order to increase aggregate demand.
3. Monopoly control: under this, the government can monitor the operation of monopoly firms so that they do not limit output, which helps to stimulate production.