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Can You Explain The Over Investment Theory Of Trade Cycle?

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Robert Lamp Profile
Robert Lamp answered

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.

Muhammad Abdullah786 Profile
The over investment theory is associated with the name of Professor Hayek. According to him, the primarily cause of the business cycle is monetary over estimate which is brought about by discrepancies between the rate of interest charged by the bankers and the natural rate of interest. If the banks begin to charge a rate of interest which is below the equilibrium rate, the business borrows more funds.    The structure of production is unduly lengthened i.e., it becomes roundabout and more specialized. The lower rate of interest also encourages the setting up in efficient and uneconomic firm. The result is over investment in capital goods industries. Due to increased demand for loan able funds, the bank look up to their reserves and funds that they have exceeded their lending limits. They immediately apply breaks, restricts expansion of credit and raise bank charges.    When the producers find that business has become unprofitable, they shorten the structure of production and thus a crisis is predicated. This theory was also criticized and the reason for its criticisms was on the following grounds.Firstly it is inadequate to explain the periodicity of the trade cycle.Secondly, Dr. Hayek assumes that the factors of production are in full employment but the fact is that in the real word they are not.

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