Hayek’s Monetary Over-Investment Theory of Trade Cycle

Introduction:

F.A. Hayek formulated his monetary over-investment theory of the trade cycle. He explained his theory on the basis of Wicksell’s distinction between the natural interest rate and the market interest rate. The natural rate of interest is the rate at which the demand for loanable funds equals the supply of voluntary savings. On the other hand, the market rate of interest is the money rate that prevails in the market and is determined by the demand and supply of money. According to Hayek, so long as the natural rate of interest equals the market rate of interest, the economy remains in a state of equilibrium and full employment. Trade cycles in the economy are caused by inequality between the market and natural interest rates. When the market interest rate is less than the natural rate, there is prosperity in the economy. On the contrary, when the market interest rate is more than the natural rate, the economy is in depression. 
According to this theory, prosperity begins when the market rate of interest is less than the natural rate of interest. In such a situation, the demand for investment funds is more than the supply of available savings. The demand for investment funds is met by the increase in the supply of money. As a result, the interest rate falls. Low-interest rate induces producers to get more loans from banks. The producers get more loans to invest in the production of more capital goods. They adopt capital-intensive methods for producing more capital goods. As a result, production costs fall and profits increase. The production process becomes very lengthy with the adoption of capital-intensive methods. This has the effect of increasing the prices of capital goods in comparison to consumer goods.
There being full employment in the economy, they transfer factors of the production from consumer goods sector to capital goods sector. Consequently, the production of consumer goods falls, their prices increase and their consumption decreases. Forced savings increase with the fall in consumption which is invested for the production of capital goods. This leads to an increase in their production. On the other hand, with the increase in the prices of consumer goods, their producers earn more profits. Induced by high profits, they try to produce more. For this, they pay higher remuneration to factors of production in comparison with the producers of capital goods. There being a competition between the two sectors, prices of factors and prices in the economy continue to rise. This leads to the atmosphere of prosperity in the country and monetary over-investment on factors spreads the boom.
According to Hayek, when the prices of factors are rising continuously, the rise in production costs brings a fall in the profits of producers. The producers of capital goods invest less in the expectation of loss in the future. Consequently, the natural interest rate falls. Simultaneously, banks impose restrictions on giving loans to them. With low profits and a reduction in loans, producers reduce the production of capital goods and adopt labour-intensive production processes. There is less investment in capital goods. Production process being small and labour-intensive, the demand for money is reduced, which increases the market interest rate which is more than the natural interest rate. Producers transfer the factors from the production of capital goods to that of consumer goods. But more factors cannot be used in the consumer goods sector as compared to the capital goods sector. This leads to a fall in the prices of factors and resources become unemployed. Thus, with the continuous reduction in the prices of goods and factors in the economy, a long period of depression and unemployment begins.
According to Hayek, when the fall in prices comes to an end during the depression, banks begin to raise the supply of money which reduces the market interest rate below the natural interest rate. This encourages investment and the process of revival begins in the economy.

Limitations:

The monetary over-investment theory of Hayek has been criticised on the following grounds:
1. Narrow Assumption of Full Employment: This theory is based on the assumption of full employment according to which capital goods are produced by reducing consumer goods. In reality, there is no full employment of resources. If resources remain unutilized, the expansion of both the capital goods sector and consumer goods sector may occur simultaneously. In such a situation, there is no need of transferring resources from one sector to the other.
2. Unrealistic Assumption of Equilibrium: The assumption of this theory that in the beginning savings and investment are in equilibrium in the economy and the banking system destroys this equilibrium is unrealistic. This is because the equilibrium may deviate due to both internal and external reasons.
3. Interest Rate is not the only Determinant: Hayek assumes changes in the rate of interest as the cause of fluctuations in the economy. This is not correct because, besides changes in the rate of interest, the expectations of profit, innovation, invention, etc. also affect trade cycles.
4. Undue Importance to Forced Savings: The theory has been criticised for giving undue importance to forced savings. When people with fixed incomes reduce their consumption with the increase in prices and the high-income groups also reduce their consumption to the same extent, savings will not be forced but voluntary.
5. Investment does not fall with an Increase in Consumer Goods: Hayek argues that with the production of consumer goods and the increase in profits from them, investment falls in capital goods. This is not correct. According to Keynes, the marginal productivity of capital increases with the increase in profits of consumer goods. As a result, investment in capital goods also increases and does not fall.
6. Incomplete Theory: Hayek’s theory is incomplete because it does not explain the various phases of the trade cycle.