Keynes’ Theory of Trade Cycle

Introduction:

The Keynesian theory of the trade cycle is an integral part of his theory of income, output, and employment. Trade cycles are periodic fluctuations of income, output, and employment. Keynes regards the trade cycle as mainly due to “a cyclical change in the marginal efficiency of capital, though complicated and often aggravated by associated changes in the other significant short-period variables of the economic system.”
According to Keynes, the principal cause of depression and unemployment is the lack of aggregate demand. Revival can be brought about by raising aggregate demand which, in turn, can be raised by increasing consumption and/or investment. Since consumption is stable during the short run, revival is possible by increasing investment. Similarly, the main cause of the downturn is a reduction in investment. Thus in the Keynesian explanation of the trade cycle, “the cycle consists primarily of fluctuations in the rate of investment. And fluctuations in the rate of investment are caused mainly by fluctuations in the marginal efficiency of capital.”
The MEC (marginal efficiency of capital) depends on the supply price of capital assets and their prospective yield. Since the supply price of capital assets is stable in the short run, the MEC is determined by the prospective yield of capital assets, which, in turn, depends on business expectations. Fluctuations in the rate of investment are also caused by fluctuations in the rate of interest. But Keynes gives more importance to fluctuations in the MEC as the principal cause of cyclical fluctuations.
To explain the course of the Keynesian cycle, we start with the expansion phase. During the expansion phase, the MEC is high. Businessmen are optimistic. There is a rapid increase in the rate of investment. Consequently, output, employment, and income increase. Every increase in investment leads to multiple increases in income via the multiplier effect. This cumulative process of rising investment, income, and employment continues till the boom is reached. As the boom progresses, there is a tendency for the MEC to fall due to two reasons. First, as more capital goods are being produced steadily, the current yield on them declines. Second, at the same time, the current costs of new capital goods rise due to shortages and bottlenecks of materials and labour.
During the downturn, investment falls due to a fall in the MEC and a rise in the rate of interest. This leads to a cumulative decline in employment and income via the reverse operation of the multiplier. Further, the fall in the MEC may shift the consumption function downward thereby hastening the depression. Keynes attaches more importance to the sudden collapse of the MEC than to a rise in the rate of interest as an explanation of the downturn of the cycle leading to the crisis and the depression. 
Unlike the sudden collapse of the economic system, the revival takes time. It depends on factors that bring about the recovery of the MEC. “The time which must elapse before recovery begins depends partly upon the magnitude of the normal rate of growth of the economy and partly upon the length of life of capital goods. The shorter the length of life of durable assets, the shorter the depression. And also, the more rapid the rate of growth, the shorter the depression.” Another factor which governs the duration of depression is the “carrying costs of surplus stocks.”
According to Keynes, the carrying cost of surplus stocks during the depression is seldom less than 10 percent per annum. So for a few years, disinvestment in stocks will continue till the surplus stocks are exhausted. Optimism takes the place of pessimism. The MEC increases. Fresh investment starts taking place. Revival has started.

Criticisms:

Keynes’s theory of the trade cycle is superior to the earlier theories because “it is more than a theory of the business cycle in the sense that it offers a general explanation of the level of employment, quite independently of the cyclical nature of changes in employment.” However, critics are not lacking in pointing out its weakness.
(1) Overemphasis on the Role of Expectations: Keynes has been criticised for his analysis of the business cycle based on expectations. In fact, he over-emphasised the role of expectations in influencing the MEC. According to Hart, Keynes relied on “convention” for forecasting changes in business expectations. The reliance on the conventional hypothesis makes Keynes’ concept of expectations superfluous and unrealistic.
(2) Psychological Theory: Keynes considers the trade cycle as mainly due to fluctuations in the MEC. The MEC, in turn, determines the rate of investment. And investment decisions, depend upon the psychology of businessmen or producers. Thus Keynes’ theory is not much different from Pigou’s psychological theory of the trade cycle.
(3) Incomplete Theory: Another weakness of Keynes’ theory of the trade cycle is that some of its variables such as expectations, MEC, and investment cannot explain the different phases of the cycle. In the words of Dillard, “It is less than a complete theory of the business cycle because it makes no attempt to give a detailed account of the various phases of the cycle.”
(4) Not Based on Empirical Data: Keynes' theory has also been attacked for lacking in factual proof. Keynes makes no attempt to test any of his deductions with facts. 
(5) One-Sided Theory: One of the serious omissions of Keynes’s theory of the trade cycle is the acceleration principle. This made his theory one-sided because his explanation centers around the principle of the multiplier. As pointed out by Sir John Hicks, “The theory of acceleration and the theory of multiplier are two sides of the theory of fluctuations, just as the theory of demand and the theory of supply are the two sides of the theory of value.”