Monetary Theory

We have seen that Schumpeter theory which runs in terms of innovations and technical change, is at best an incomplete explanation of trade cycle . there are economists who have explained the complex phenomenon of trade cycle in terms of the monetary disturbances. According to these economists monetary factors can generate instability and monetary policy may offset or accentuate those forces which generate cyclical fluctuations. Among the monetary theorists, particular mention may be made of the names of the well known Austrian economist F.A Von Hayek and the eminent British economist R. G. Hawtry.

According to Hayek, monetary disturbances are the sine qua non of cyclical fluctuations in economic activity. let us assume that the

(a) economy is in equilibrium at full employment

(b) banks maintain a 100per cent ratio of reserves to deposits: and

(c) there is no change either in the money supply or in its velocity of circulation.

Under these assumptions, all borrowings for investment must be supplied from funds released through current savings. Consequently, the amount of current output which can be devoted to investment and through investment to expanding the further income stream will be determined by community saving habits. If the community takes the decision to consume less in present in order to consume more in future, savings will increase and resources will be released from consumption, this will cause the rate of interest to fall and investment to increase. The rate of interest will fall enough to enable the entire resources released in the form of savings to be absorbed in investment.

The resources released through saving will either be devoted to the production of consumption goods or to the production of investment goods. According to Hayek, the former resources are said to be used in the higher stages of production since the goods produced are closest to the consumer while the resources used in production of investment goods are said to be utilised in the lower stages of production. When the economy is operating at full employment increase in investment causes resources to be shifted away from the higher to the lower stages of production. As a result, the structure of production is lengthened i.e. the roundaboutness of production increases. So long as the increase in the roundabountess of production that occurs as result of the increase in investment reflects the voluntary behaviour of the savers in the economy no harm can take place. The difficulty arises when the lengthening of the structure of production that takes place due to an increase in investment is financed not through current saving but through the easy credit created by the banking system. such a situation in which investment is financed through the bank credit creates the temporary illusion among the entrepreneurs regarding the profitability of lengthening the structure of production. As a consequence of this temporary illusion which disappears with banks stopping credit creation, more resources than can be sustained on the basis of funds released through the current saving are devoted to the production of capital goods causing vertical maladjustment and losses. A recession during which the structure of production is shortened grips the economy.