Hawtrey’s Monetary Theory of Business Cycles
An old monetary theory of business cycles was put forward by Hawtrey. His monetary theory of business cycles relates to the economy which is under gold standard. It will be remembered that economy is said be under gold standard when either money in circulation consists of gold. coins or when paper notes are fully backed by gold reserves in the banking system. According to Hawtrey, increases in the quantity of money raises the availability of bank credit for investment. Thus, by increasing the supply of credit expansion in money supply causes rate of interest to fall. The lower rate of interest induces businessmen to borrow more for investment in capital goods and also for investment in keeping more inventories of goods.
Thus Hawtrey argues that lower rate of interest will lead to the expansion of goods and services as a result of more investment in capital goods and inventories. Higher output, income and employment caused by more investment induce more spending on consumer goods.
Thus, as a result of more investment made possible by increased supply of bank credit economy moves into the expansion phase. The process of expansion continues for some time. Increases in aggregate demand brought about by more investment also cause prices to rise. Rising prices lead to the increase in output in two ways.
First, when prices begin to rise businessmen think they would rise further which induces them to invest more and produce more because prospects of making profits increase with the rise in prices. Secondly, the rising prices reduce the real value of idle money balances with the people which induces them to spend more on goods and services. In this way rising prices sustain expansion for some time.
However, according to Hawtrey, the expansion process must end. He argued that rise in incomes during the expansion phase induces more expenditure on domestically produced goods as well as more on imports of foreign goods. He further assumes that domestic output and income expand faster than foreign output.
As a result, imports of a country increase more than its exports causing trade deficit with other countries, If exchange rate remains fixed, trade deficit means there will be outflow of gold to settle its balance of payments deficit. Since the country is on gold standard, outflow of gold will cause reduction in money supply in the economy.
The decrease in money supply will reduce the availability bank credit, Reduction in the supply of bank credit will cause the rate of interest to rise. Rising interest rate will reduce investment in physical capital goods. Reduction in investment will cause the process of contraction to set in.
As a result of reduced order for inventories, producers will cut production which will lower income and consumption of goods and services. In this state of reduced demand for goods and services, prices of goods will fall. Once the prices begin to fall businessmen begin to expect that they will fall further. In response to it traders will cut order of goods still causing further fall in output. The fall in prices also causes real value of money balances to rise which induce people to hold larger money holdings with them. In this way contraction process gathers momentum as demand for goods start declining faster and with this economy plunges into depression.
But after a lapse of sometime depression will also come to an end and the economy will start to recover. This happens because in the contraction process imports fall drastically due to decrease in income and consumption of households, whereas exports do not fall much.
As a result, trade surplus emerges which causes inflow of gold. The inflow of gold would lead to the expansion of money supply and consequently availability of bank credit for investment will increase. With this, the economy will recover from depression and move into the expansion phase. Thus, the cycle is complete. The process, according to Hawtrey, will go on being repeated regularly.
Critical Appraisal:
Hawtrey maintains that the economy under gold standard and fixed exchange rate system makes his model of business cycles self-generating as there is built-in tendency for the money supply to change with the emergence of trade deficit and trade surplus which cause movements of gold between countries and affect money supply in them. cyclical
Changes in money supply influence economic activity in a fashion. However, Hawtrey’s monetary theory does not apply to the present day economies which have abandoned gold standard in 1930s. However, Hawtrey’s theory still retains its importance because it shows how changes in money supply affect economic activity through changes in price level and rate of interest. In modern monetary theories of trade cycles this relation between money supply and rate of interest plays an important role in determining the level of economic activity.
