The contraction phase of business cycle is brought about by a fall in the marginal efficiency of capital relatively to the prevailing rate of interest. When all the remunerative channels for investment are fully utilized, then the scope for further investment declines. Due to excessive demand for loan able funds, the reserves of the banks get depleted. The market rate of interest goes up.
The higher rate of interest induces people to save more money. The higher liquidity preference or the increasing demand for money to hold reduces the demand for consumer goods. When the business prospects appear bleak, the investors are then not prepared to renew or extend their capital equipment. Due to excess of savings over investment, the income and employment declines.
It may be remembered here that J.M. Keynes has used three psychological propensities in formulating his theory of business cycle. They are: Propensity to consume, propensity to save and the marginal efficiency of capital. He also introduced the concept of multiplier in order to show the effect to increase in total income due to increase in investment. Keynes is of the view that upswing of business cycle is caused by a rise in the marginal efficiency of capital.
The higher rate of interest induces people to save more money. The higher liquidity preference or the increasing demand for money to hold reduces the demand for consumer goods. When the business prospects appear bleak, the investors are then not prepared to renew or extend their capital equipment. Due to excess of savings over investment, the income and employment declines.
It may be remembered here that J.M. Keynes has used three psychological propensities in formulating his theory of business cycle. They are: Propensity to consume, propensity to save and the marginal efficiency of capital. He also introduced the concept of multiplier in order to show the effect to increase in total income due to increase in investment. Keynes is of the view that upswing of business cycle is caused by a rise in the marginal efficiency of capital.
