Hicks theory of Business Cycle
Prof. Hicks tries to provide a more adequate explanation of trade cycles by combining the multiplier and acceleration principles. According to him, “the theory of acceler? ion and the theory of multiplier are the two sides of the theory of fluctuations, just as the theory of demand and the theory of supply are the two sides of the theory of value.”
In the Hicksian model, the following concepts play an important role:
1. The warranted rate of growth.
2. Induced and autonomous investment.
3. The multiplier and the accelerator. The warranted rate of growth is defined as the rate of growth which will sustain itself in congruity with the equilibrium of saving and investment. Thus, when real investment in an economy is in line with real saving, the economy is said to be growing at a warranted rate of growth. According to Hicks, the interaction of the multiplier and the accelerator causes economic fluctuations around the warranted rate of growth.
Hicks considers two types of investments viz., autonomous and induced. Autonomous investment is that which is independent of changes in the level of output (income). That is to say, it is not a function of the changes in the level of output. Thus, autonomous investment is not related to the growth of the economy.
According to Hicks, “public investment, investment which occurs in direct response to inventions, and much of the ‘long-range’ investment which is only expected to pay for itself over a long-period-all of these can be regarded as autonomous investment.” He assumes that investment increases at a regular rate so that it remains in progressive equilibrium if it were not disturbed by extraneous forces.
On the other hand, induced investment is that which depends on changes in the level of output (income). Thus, it is a function of the economy’s growth rate. This induced investment is central to Hicks theory of cycles, for the operation of the acceleration principle a key factor depends on it.
An increase in output (consequent upon a permanent increase in demand) from one period to the next causes a “hump” in investment, i.e., expansion of capital stock (induced investment) which, then, interacts through the multiplier. This is Hicks accelerator.
According to Hicks, an expansionary phase starts in the economy when there is an autonomous increase in investment due to exogenous factors like technological improvements, territorial developments or population changes. This new autonomous investment will generate an enlarged amount of income, once again under the multiplier effect.
Likewise, a super cumulative process of income generation and investment expansion based on the “interaction of the multiplier and the accelerator” will be encountered in a free economy. It is interesting to note that economists use the term “leverage effect” to denote the full, enlarged rise in income that occurs as a result of autonomous investment and the combined multiplier-accelerator leverage is termed as the “super multiplier”. According to Hicks, the process of interaction of the multiplier and accelerator will continue to operate till the expansion of economic activity (measured in terms of income and employment) reaches the “full employment ceiling point of the economy.
In other words, the upper limit to the expansion of income and employment is determined by the level of full employment in the economy. In a dynamic economy, however, there will be an expanding or rising ceiling and therefore, it takes much longer time than in a static society to reach the ceiling point; but once the ceiling point is reached, the cycle will undergo a downward movement. After the upper turning point has been reached, a surplus capacity appears, and therefore, investment declines. With each decline in investment, due to the backward operation of the multiplier, income and consumption expenditure fall further.
In Hicks’ view, there is a marked asymmetry in one respect between the upswing that takes place after the lower turning point and the downswing that follows the upper turning point. During the upswing, an increase in consumption induces an increase in additional investment in capital goods so that there is a positive acceleration effect operating together with the multiplier effect.
On the other hand, during a contractionary phase, the accelerator effect becomes inoperative because investment cannot fall below zero and disinvestment cannot exceed the replacement requirements. Disinvestment in fixed capital can only take place only by a cessation of gross investment. thus, the adjustment of fixed capital to a decline in the level of output and income takes place only by a slow process of wearing out and hence, must take considerable time.
Once this condition is reached, a further fall in output can induce no further disinvestment in fixed capital, at least not immediately. Thus, during the downswing, the extent to which the decline in investment can be carried is not determined according to the accelerator relation (as it is determined during the upswing) but by the magnitude of excess capacity. aring the downswing, the place of the accelerator is taken by something which behaves quite differently-something which can best be treated as a downward adjustment in autonomous investment. Hicks’ view that while the upswing is the result of the combined action of multiplier and accelerator the downswing is largely a product of the multiplier alone, the accelerator remaining inoperative for the most part. Hicks describe it as a “mere ghost” of what it was in the boom. He gives two reasons for this: 1. The reduction of fixed capital can take place only by the process of its wearing out. Thus, it is only the rate of depreciation of capital goods and not the accelerator ratio that can determine the reduction of the capital assets.
2. The working capital may also be prevented from declining in the proportion suggested by the acceleration coefficient. Businessmen may hold back their stocks rather than sell them at a loss. In Hicks’ opinion, since the induced investment tends to be negative during a depression, the lower turning point or recovery is initiated solely by the operation of the autonomous investment. During a depressionary phase, there is some production, but much below the economy’s production possibility frontier in terms of, the existing capital stock. However, during the process of production, equipment tends to depreciate and maintain the plant capacity, the worn out capital assets have to be replaced.
This is provided for out of existing surplus plant capacity. Therefore, at the end of each time period, the excess or surplus plant capacity is less than what it was at the beginning of this period. Ultimately, all the excess plant capacity will be used up. And, provision for further replacement of worn-out capital has to be made by fresh investment,
The need to replace the worn-out equipment acts as stimulant to the economy during a depression. During a depression, thus, a stage is reached when the amount of disinvestment turns out to be less than the amount of autonomous investment so that there will be an increase in the net investment expenditure. And once there is an increase in net investment, income, output and expenditure tend to increase in a multiplier fashion with which the accelerator also will join hands. Thus, the interaction to the multiplier and accelerator will lead to a cumulative expansion in the economy. And the cycle will move on the path of prosperity. In Hicks opinion, the analysis of the upper turning point of a cycle is not so easy. However, he provides an explanation of the upper turning point by adopting the concept of natural rate of growth as developed by Prof. Harrod.
According to Harrod, the natural rate of growth is one which is permitted under the constraint of the increase in population, capital accumulation, development of technology and the given work-leisure preference pattern. This is the production ceiling beyond which the economy cannot afford to expand. According to Hicks, cycles have weak endings and strong endings. Cycles with weak endings are called free cycles and cycles with strong endings are called constrained cycles. A free cycle with a weak ending takes place when the interaction between the multiplier and the accelerator is not very strong so that economy moves along the path of production ceiling set by the natural rate of growth. In such a cycle, the upper turning point occurs.
A constrained cycle, a cycle with a strong ending, takes place when the interaction between the multiplier and the accelerator is strong enough to lead the economy along the path of expansion until the restraint determined by the production ceiling is reached.
The course of the expansion phase is constrained by the production ceiling set by the natural rate of growth. No further expansion beyond this ceiling is possible. And when the production ceiling is reached, the expanding force of the multiplier and the accelerator becomes inadequate for the expansion to continue any longer; the most that the expansion path can do is to creep along to the ceiling.
But Hicks opines that the economy cannot do so for more than a very limited time, because, “when the path has countered the ceiling, it must (after a little while) bounce off from it, and begin to move in a downward direction” According to Hicks, this downward movement is inevitable because initial burst of autonomous investment is supposed to be short lived at this point, the upper turning point is finally and fully reached.
In spite of its various merits, the Hicksian theory of trade cycle suffers from the following weaknesses its fundamental shortcoming is that Hicks assumes a fixed value of the multiplier during the fixed phases of the cycles. Here he seems to follow Keynes blindly regarding the stable consumption function.
Empirical studies of modern economists, however, reveal that the marginal propensity to consume is not constant in relation to the cyclical changes in income. As the economy passes from one cyclical phase to another, the multiplier changes.
Kaldor points out that the vulnerable point of the Hicksian theory is the use of the crude and misleading acceleration principle. This principle assumes that investment generated by a change in output is some coefficient of the change of output that is independent of the absolute size of the change.
In reality, however, the rate of expansion of firms conforms to their financial resources and they cannot take advantage of the large investment opportunities during the prosperity phase as assumed by Hicks. The Hicksian explanation of the phenomenon of trade cycles was highly mechanical and in the real world, movements do not take place so mechanically as has been depicted by Hicks. Therefore, Hicks’ theory is regarded as inadequate as it fails to stress the psychological forces arising from future uncertainty and expectations which play an important part in the dynamic capitalist economy.
