Keynes’s Theory of Business Cycles

Keynes’s Theory of Business Cycles

John Maynard Keynes was an British economist. He wrote book ‘General Theory of Employment, Interest and Money’ in 1936.

According to Keynes’s theory, in the short run, the level of income, output or employment is determined by the level of aggregate effective demand. In a free private enterprise, the entrepreneurs will produce that much of goods as can be sold profitably. Now, if the aggregate demand is large (if the expenditure on goods and services is large), the entrepreneurs will be able to sell profitably a large quantity of goods and therefore they will produce more. In order to produce more they will employ a larger amount of resources.

In short, a higher level of aggregate demand will result in greater output, income and employment. On the other hand, if the level of aggregate demand is low, smaller amount of goods and services can be sold profitably. This means, that the total quantity of national output produced will be small. And a small output can be produced with a small amount of resources. As a result, there will be unemployment of resources.

The changes in the level of aggregate effective demand will bring fluctuations in the level of income, output and employment.

According to Keynes, the fluctuations in the economic activity are due to the fluctuations in the aggregate effective demand. Fall in aggregate effective demand will creates the conditions of recession or depression. If the aggregate demand is increasing, economic expansion will take place.

Now the question arises

What causes fluctuations in aggregate demand ?

The aggregate demand is composed of demand for consumption goods and investment goods. So, aggregate demand depends on the total expenditure of the consumers on consumption goods and entrepreneurs on investment goods. Propensity to consume is more or less stable in the short run, fluctuations in the aggregate demand depends primarily on fluctuations in investment demand.

Keynes shows that the fundamental cause of fluctuations in aggregate demand and in economic activity is the fluctuations in investment demand.

Investment demand is very unstable and volatile and brings business cycles in the economy.

Explanation of the Keynes’s Theory –

Let’s start from the phase of economic expansion to explain Keynes’s theory of business cycles.

We first explain how in Keynesian theory expansion comes to an end and recession sets in.

During an economic expansion two factors eventually work to cause investment to fall.

First, during the expansion phase increase in demand for capital goods due to large scale investment activities leads to the rise in the prices of the capital goods. Higher prices of the capital goods raise the cost of investment projects (cost of production) and reduces marginal efficiency of capital (expected rate of return).

Secondly, as income rises during the expansion phase, the demand for money increases which raises interest rate. Higher interest rate makes some potential, projects unprofitable. This causes fall in marginal efficiency of capital on one hand and a rise in interest rate on the other which in turn causes decline in investment demand. Declining trend of investment, raises doubts about the prospective yield (profits) on capital goods which is more important factor in determining marginal efficiency of capital (rate of return) than the cost of investment projects and rate of interest.

When among businessmen pessimism sets in about future profitability of investment projects stock prices tumble. The crash in stock prices worsens the situation and causes investment to fall even more. Fall in prices of shares, reduces wealth of household.

Wealth according to Keynes is an important factor determining consumption. So the decline in stock prices, reduces autonomous consumption demand of household with the fall in both investment and consumption demand, aggregate demand declines, which result in accumulation of unintended inventories, with the firms. This induces the firms to cut production of goods.

Besides the rise in cost of capital goods and the rise in interest rate towards the end of the expansion phase, it is the fall in expected prospective yields that reduces the marginal efficiency of capital (rate of return) and causes investment demand to fall.

This induces a wave of pessimistic expectations among businessmen and speculators. These pessimistic expectations, cause stock prices to tumble. They cause a further fall in the marginal efficiency of capital. Turning Point from expansion to contraction is caused by a sudden collapse in marginal efficiency of capital.

A sudden fall in the marginal efficiency of capital causes a leftward shift in the investment demand curve.


Decrease in investment does not automatically decrease the rate of interest.

According to Keynes, a decrease in investment expenditure causes a decline in income, which in turn reduces consumption expenditure. The reduction in consumption expenditure further reduces income and the process of reduction in income continues further.

The total fall in income (change in income or ∆Y) due to an initial decline in investment (∆I) will be equal to change in investment multiplied by the value of multiplier.

If Marginal Propensity to Consume is 0.75, the multiplier will be equal to four. Thus, a decline in investment by 100 crores will lead to a decline in income by 400 crores.

The multiplier process magnifies the effect of decline in investment expenditure on aggregate demand and income and further deepens the depression.

As income and output are falling rapidly under the multiplier effect, the employment also goes down.

So, the Keynes theory of income multiplier plays and significant role in causing magnify the changes in income, output and employment, following a reduction in investment.

In Keynes’s views, wages and prices are not flexible enough to offset the decline in investment expenditure, and restore full employment.

This is in sharp contrast to the classical theory, where changes in wages and prices ensures continues full employment.

In Keynes model wages and prices are ‘sticky’ downward, which implies that through wages and prices do not remain constant, But when demand falls wages and prices will fall, but not sufficient to restore full employment in the economy.

Since wage and price flexibility does not ensure the recovery of the economy, out of the state of depression. Keynes thinks that marginal efficiency of capital must rise to stimulate investment.

During depression investment falls to a very low level capital stock begin to wear out, and requires replacement, some existing capital equipment become technologically obsolete and has to be abandoned. This generates demand for replacement investment. A long period of time is necessary for existing capital to depreciate because most capital goods are durable, as well as irreversible.

By durability of capital goods, mean that they last for a long time and by irreversibility, mean, that they cannot be used for purposes other than those for which they are meant.

Collapse of marginal efficiency of capital is the main cause of upper turning point. Similarly, the revival of the marginal efficiency of capital (rate of return) is the cause of lower turning point which is recovery from the recession.

Restoration of Businessmen’s confidence is the most important, yet, the most difficult to achieve. Even if the rate of interest is reduced, the investment will not increase. This is because of the absence of confidence, that profitability in investment may remain so low that reduction in the interest rate will stimulate investment.

The interval between the upper turning point, and lower turning point is conditioned by two factors.

1. The time necessity for wearing out of durable capital assets, and

2. The time required to absorb the excess stocks of goods left over from the boom.

As the stock of capital goods goes down, there grows a scarcity of capital goods, then the expected rate of returns (profits) rises, which induces the businessmen to invest more. When level of investment increases, income increases by a magnified amount due to the multiplier effect.

Over time as depreciation of capital stock occurs, some existing capital equipment becomes technologically obsolete, the size of capital stock declines. New investment must be undertaken even to produce a reduced depression level of output.

Once investment increases, it induces further rise in income and consumption demand through the multiplier process. Now, the multiplier works to magnify the effect of increase in investment on raising aggregate demand. The businessmen becomes optimism, which increases stock prices. All these factors increases the economic activity.

However, this recovery process takes a very long time.  So, Keynes suggests that the government should not wait for long for the natural recovery to occur. He advocated for the active intervention by the government to raise aggregate through fiscal policy (that is increasing its expenditure or reducing taxes).

He argued for the adoption of policy of deficit budget to boost aggregate demand, and lift the economy out of recession or depression.

Keynes business cycle theory is self generating. In it the economy passes through a long phase of expansion, but eventually some forces automatically work, for example, the growing abundance of capital stock, which reduces marginal efficiency of capital. Pessimism which overtakes businessmen. This causes a reduction in investment, which is responsible for bringing downswing in the economy.

The idea that it is the fluctuations in investment that brings about the fluctuations in the level of economic activity, is an important contribution, made by Keynes.

Keynes provided a definite relationship between a change in investment and the resulting change in income and employment, this relationship is given in his theory of multiplier.

The Critical Appraisal of Keynes’s Theory –

Keynes has made three important contributions to the business cycle theory.

First, it is fluctuations in investment in that cause changes in aggregate demand, which bring changes in economic activity (income output and employment).

Secondly, fluctuations in investment demand are caused by changes in expectations of businessmen. Regarding making a profits (marginal efficiency of capital, or the rate of return).

Thirdly, Keynes put forward an important theory of multiplier which tells us how changes in investment, bring magnified changes in the level of income and employment.

But, Kingston’s theory of multiplayer alone does not offer a full and satisfactory explanation of cycles, a basic feature of the cycles is its cumulative character, both in upswing and downswing. That is, once economic activity starts rising or falling, It gathers momentum for a time.

So, what we have to explain is the cumulative character of economic fluctuations. The theory of multiplayer alone does not gives adequate explanation for this.

For example, suppose that investment raises by 100, rupees, and that the magnitude of multiplayer is 4, from the theory of multiplayer, that national income will arise by 400. And if multiplayer is the only force at work, that will be the end of the matter, with the economy reaching a new stable equilibrium at a higher level of national income. But in real life this is not likely to be so, for a rise in income produced by a given rise in investment will have further repercussions in the economy. This reaction is described in the principle of the accelerator.

According to the principle of acceleration, a change in national income will tend to induce changes in the rate of investment.

While multiplier refers to the change in income as a result of change in investment, the acceleration principle describes the relationship between a change in investment, as a result of change in income.

In the above example, an income has risen in by 400 rupees, people spending power has risen by an equivalent amount. This will induce them to spend more on goods and services. When the demand for the goods rises, initially, this will be met by overworking the existing plant and machinery. All this leads to an increase in profits with the result that businessman will be induced to expand their productive capacity and install new plants.

They will invest more than before, which will income which in turn will lead to a further induced increase in investment. The accelerator describes this relation between an increase in income and the resulting increase in investment.