Business Cycles – Theory of Over-Investment

Theory of Over-Investment –

It has been observed that over time investment varies more than that of the total output of final goods and services and consumption. This has led economists to investigate the causes of variation in investment and how it is responsible for business cycles.

Two versions of over-investment theory have been put forward.

One theory by Hayek emphasizes on monetary forces causing fluctuations in investment.

The second version of over-investment theory has been developed by Knut Wickshell which emphasizes on increase in investment brought by innovation.

In both the versions of this theory distinction between natural rate of interest and money rate of interest plays an important rule.

Normal rate of interest is defined as the rate at which saving equals investment and this equilibrium interest rate reflects marginal revenue product of capital or rate of return on capital.

Money rate of interest is the rate at which banks give lines to the businessmen.

Hayek’s Monetary Version of Over-Investment Theory –

According to Hayek – Monetary forces causes fluctuations in investment which are the prime cause of business cycles. Hayek’s theory is similar to Hawtrey’s monetary theory except that it does not involve inflow and outflow of gold causing changes in money supply in the economy.

Let’s assume that the economy is in recession, therefore businessmen’s demand for bank credit is very low. Thus, lower demand for bank credit in times of recession pushes down the money rate of interest below the natural rate because of which businessmen will be able to borrow funds (bank credit) at a rate of interest which is below the expected rate of return. This stimulates the businessmen to invest more in capital goods or productivity activities. This causes the investment to exceed saving by the amount of newly created bank credit. With the increase in investment expenditure, the expansion of the economy begins. Due to increase in investment, employment and income rises which increases consumption expenditure as well as production of consumer goods.

According to Hawtrey, the competition between capital goods and consumer goods industries for scarce resources causes their prices to rise which in turn causes the prices of goods and services to rise.

But this process of expansion cannot go indefinitely. The availability of bank credit decreases rapidly, while the demand for it increases which causes the money rate of interest to increase more than the natural rate of interest. This makes further investment unprofitable. But at this point of time there has been over-investment in the sense that savings fall short of what is required to finance the desired investment. The decline in investment causes income and consumption to fall. In this way expansion comes to an end and the economy starts to move downwards.

After some time the demand for bank credit fall which causes the money rate of interest to fall below the natural rate of interest. This again gives the boost to investment and the recession ends. In this way alternating periods of expansion and contraction occur periodically.

Wickshell’s Over-investment Theory –

Over-Investment Theory developed by Wickshell is of non-monetary type. It attributes cyclical fluctuations to stimulates of investment caused by new innovations introduced by entrepreneurs themselves. The introduction of new innovations or opening of new markets makes some investment projects profitable by either reducing cost or raising demand for the products. This expansion in investment is made possible because of the availability of bank credit at a lower money rate of interest. The expansion of economic activity stops when investment exceeds saving. There is over-investment because the level of saving is insufficient to finance the desired level of investment. The end of investment expenditure causes the economy to go into recession. When another set of innovations occurs or more new markets are found which stimulates investment, the economy revives and moves into the expansion phase once again.

Appraisal –

Through the over-investment theory does not gives an adequate explanation of business cycles, it contains an important element that fluctuations in investment are the prime cause of business cycles. It does not gives an valid explanation as to why changes in investment takes place quite often. This theory point to the behavior of banking system that causes the changes in money rate of interest and natural rate of interest.

This theory falls to give adequate explanation of business cycles.