Over-Investment Theory of Business Cycle from Managerial Economics

Monday, April 12, 2010

A.F. Hayek assumes economy in equilibrium. Whenever this equilibrium is disturbed then there is expansion or contraction. This theory says that when the economy is in equilibrium, the rate of interest is such that Saving = Investment there is no unemployed resources.

Suppose the bank credit expansion takes place, then the equilibrium rate of interest is disturbed. This low market rate of interest will tempt the businessmen to borrow more and invest in new ventures. This leads to upswing in business cycle; as a result employment, output, profit and demand increases.

But then this phase does not continue indefinitely. Due to scarcity of resources, this expansion phase cannot go on and on. But due to increase in price, the people are forced to decrease consumption and start saving more. This forced saving due to high price makes the bank ease credit and investment starts.

The economy comes out of its downswing as income increases and people revert to earlier consumption and expenditure levels. This helps economy to recover and the upswing starts again. This theory says that the over investment due to forced saving by people in inflation is the cause of fluctuations in economic activities. Hayek says, voluntary saving leads to change in structure of production permanently but forced saving brings changes which are not permanent.

The limitations for this theory are –

Assumption of full employment is unrealistic.

Undue importance is given to bank’s rate of interest. Even if the rates of interest are constant, there will be variation in production when the business stars getting profits.

We already have discussed about Schumpeter theory of business cycle. This theory was also not complete just like Over-Investment theory of business cycle. A.F. Hayek assumes about the Over-Investment theory of business cycle. He sees only one aspect just like Joseph Schumpeter. There are also many disabilities in Hayek’s Over-Investment theory.

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