Hayek’s theory is called ‘monetary’ overinvestment theory’ because it considers ‘overinvestment’ of the economy’s resources in the capital goods sector as the sole cause of the business cycle, and the overinvestment takes place when there is too much expansion of money; cheaper money encourages the producers to introduce more roundabout (capital-intensive) methods of production because these have lower cost of production and hence give a higher rate of profit to them.
If the productive structure of the economy is to be kept in balance, then there must be an equilibrating proportion of the resources devoted between consumer goods and capital goods production. Producers decide to invest resources in their individual capacity.
They have no regular plan at the economy level for maintaining the desired proportion. Thus unplanned changes in the structure of production of the economy brought about by the divergence between the money rate and the natural rate of interest are considered to be the main cause of instability of the system.
