Hawtrey’s Monetary Theory of Trade Cycle:

Introduction:

According to Prof. R.G. Hawtrey, “The trade cycle is a purely monetary phenomenon.” It is changing in the flow of monetary demand on the part of businessmen that lead to prosperity and depression in the economy. He opines that non-monetary factors like strikes, floods, earthquakes, droughts, wars, etc. may at best cause a partial depression, but not a general depression. Cyclical fluctuations are caused by expansion and contraction of bank credit which, in turn, lead to variations in the flow of monetary demand on the part of producers and traders. Bank credit is the principal means of payment in the present times. Credit is expanded or reduced by the banking system by lowering or raising the rate of interest or by purchasing or selling securities to merchants. This increases or decreases the flow of money in the economy and thus brings about prosperity or depression.
The expanded phase of the trade cycle starts when banks increase credit facilities. They are provided by reducing the lending rate of interest and by purchasing securities. These encourage borrowings on the part of merchants and producers. This is because they are very sensitive to changes in the rate of interest. So when credit becomes cheap, they borrow from banks in order to increase their stocks or inventories. For this, they place larger orders with a producer who, in turn, employs more factors of production to meet the increasing demand. Consequently, money incomes of the owners of factors of production increase thereby increasing expenditure on goods. The merchants find their stocks being exhausted. They place more orders with producers. This leads further increase in productive activity, income, outlay, demand, and further depletion of stocks of merchants. According to Hawtrey, “Increased activity means increased demand, and increased demand means increased activity. A vicious circle is set up, a cumulative expansion of productive activity.”
As the cumulative process of expansion continues, producers quote higher and higher prices. Higher prices induce traders to borrow more in order to hold still larger stocks of goods so as to earn more profits. Thus optimism encourages borrowing, borrowing increases sales, and sales raise optimism. According to Hawtrey, prosperity cannot continue limitlessly. It comes to an end when banks stop credit expansion. Banks refuse to lend further because their cash funds are depleted and the money in circulation is absorbed in the form of cash holdings by consumers. Another factor is the export of gold to other countries when imports exceed exports as a result of the high prices of domestic goods. These factors force the banks to raise interest rates and refuse to lend. Rather, they ask the business community to repay their loans. This starts the recessionary phase.
In order to repay bank loans, businessmen start selling their stocks. This sets the process of falling prices. They also cancel orders with producers. The latter curtail their productive activities due to a fall in demand. This, in turn, leads to a reduction in the demand for factors of production. There is unemployment. Incomes fall. Falling demand, prices, and incomes are the signals for depression. Unable to repay bank loans, some firms go into liquidation thus forcing banks to contract credit further. Thus the entire process becomes cumulative and the economy is forced into depression. According to Hawtrey, the process of recovery is very slow and halting. As depression continues, traders repay bank loans by selling their stocks at whatever prices they can. As a result, money flows into the reserves of banks and funds increase with banks. Even though the bank rate is very low, there is a “credit deadlock” which prevents businessmen to borrow from banks due to pessimism in economic activity. This deadlock can be broken by following a cheap money policy by the central bank which will ultimately bring about recovery in the economy.

Limitations:

The pure monetary theory is criticized on the following grounds:
1. The monetary factors, though, are the major contributors to business fluctuations, the business cycles are not purely a monetary phenomenon. The fluctuations in the economic activities are also seen due to the non-monetary factors like aggregate demand, expectations of the businessmen, demand for new investment, etc. 
2. Although the monetary factors play a crucial role in the cumulative process of contraction and expansion, it is not efficient enough to fully explain the turning points. In fact, at turning points, the non-monetary factors are seen to have played an important role.
3. It is assumed that that businessmen are highly sensitive to the fluctuations in the interest rates which is quite doubtful. As most crucial factors in the business decisions are the future prospects in the business and the marginal efficiency of the capital.