Jump to ContentJump to Main Navigation
Business Cycle Theory$

Lutz G. Arnold

Print publication date: 2002

Print ISBN-13: 9780199256815

Published to Oxford Scholarship Online: October 2011

DOI: 10.1093/acprof:oso/9780199256815.001.0001

Show Summary Details
Page of

PRINTED FROM OXFORD SCHOLARSHIP ONLINE (www.oxfordscholarship.com). (c) Copyright Oxford University Press, 2017. All Rights Reserved. Under the terms of the licence agreement, an individual user may print out a PDF of a single chapter of a monograph in OSO for personal use (for details see http://www.oxfordscholarship.com/page/privacy-policy). Subscriber: null; date: 14 December 2017

(p.155) Appendix 2 The Over-investment Theory

(p.155) Appendix 2 The Over-investment Theory

Source:
Business Cycle Theory
Publisher:
Oxford University Press

The over-investment theory represented the most prominent theory of business cycles in the pre-Keynes era. Cassel, Hayek, Robertson, Spiethoff, and Wicksell, among others, contributed to the development of the theory.

The analysis of the multiplier accelerator model in Section 2.3 proves that if the Keynesian consumption function is valid, the principle of acceleration alone is sufficient to explain both cumulative upward and downward movements as well as the turning points of aggregate economic activity. Like the multiplier accelerator model, the over-investment theory relies on the principle of acceleration to explain the upswing and the downswing: ‘After the upward movement has been started, the acceleration principle explains the rapid absorption of unused factors of production’ (Haberler 1937/1941: 103), and vice versa for a downturn. But it offers an independent explanation for the turning points, which is centred around a clear distinction between investment goods industries and consumption goods industries. Most attention is focused on the upper turning point. The over-investment theory emphasizes that projects do not require a one-off investment, but a stream of investment outlays spread over a considerable period of time. During the upswing, as consumption rises and factor markets become tighter, it becomes continually more difficult for firms to finance the investment outlays required to complete still unfinished projects: ‘factors of production are enticed away from the higher stages of production [investment goods industries] and employed in the lower stages [consumption goods industries]. The price of labour (wages) and of other mobile means of production, which can be used in various stages and can be transferred from the higher to the lower stages, rises. This involves a rise in money cost, which affects both higher and lower stages of production. But, while in the lower stages demand has risen, this is not true of the higher stages. The collapse of the boom has begun’ (Haberler 1937/1941: 50). Firms have to interrupt investment projects before the returns can be reaped. Business profits are squeezed and investment declines: ‘it becomes (p.156) clear that the newly initiated extensions of the structure of production cannot be completed, and the work on the new but incompleted roundabout processes must be discontinued. The investment boom collapses and a large part of the invested capital is lost’ (Haberler 1937/1941: 45). Less agreement prevails among the over-investment theorists about the causes of the lower turning point. Spiethoff and Cassel contend that as wages and interest rates fall during the downswing, investment and aggregate production recover. Schumpeter emphasizes that, since the flow of technical inventions (i.e. possible innovations) is relatively smooth and (actual) investment is low, the pool of unused inventions fills up during recessions. Only a few entrepreneurs have the abilities necessary to transform the inventions into marketable innovations. But once they have taken the lead and shown up fields for profitable innovation, many have the ability to follow. Innovation activity rises sharply and initiates the cumulative upswing. Wicksell adds that the recession can be terminated via expansionary monetary policy. Hayek stresses the importance of reductions in the interest rate for the initiation of recovery. In sum, the concurrence of falling factor prices and promising investment opportunities paves the way for the recovery.

Many observers hold that the US recession of 2001 is a good example of such an over-investment cycle, initiated by excessive investment in information technology during the ten-year long expansion of 1991–2001.

Further reading

The exposition here follows Haberler’s (1937/1941) brilliant account of the over-investment theory. Hansen (1964) provides an alternative treatment. The central positions of many pre-Keynesian business cycle theorists are summarized in Persons (1927).

References

Haberler, G. (1st edn 1937/cited edn 1941). Prosperity and Depression. Geneva: League of Nations.

Hansen, A. H. (1964). Business Cycles and National Income (expanded edn). New York: W.W. Norton.

Persons, W. M. (1927). ‘Theories of Business Fluctuations: I. A Classification of the Theories’. Quarterly Journal of Economics, 41: 94–128.

Exercises

  1. A2.1 Two-period investment projects and the principle of acceleration. Suppose that the completion of investment projects takes two periods. One project (p.157) started at time t − 1 requires one unit of investment at t − 1 and κ units of investment at time t. Denote the number of projects started at time t as I t (neglect autonomous investment, so that I t 〈 0 is admissible). Assume all projects are completed, and let consumption equal cY t−1. Then,

    Appendix 2 The Over-investment Theory

    where ε t is white noise and reflects autonomous changes in aggregate expenditure. Show: If the number of investment projects started obeys the acceleration principle without a lag (I t = vΔY t), then

    Appendix 2 The Over-investment Theory

    Characterize the range of parameters that give rise to business cycles.

  2. A2.2 Two-period investment projects and changes in factor costs. The goods market condition from the previous problem remains valid. In the wagesetting process, real wages are set as an increasing function of lagged income (W t/P t = χY t−1), and investment starts now depend on the current real wage rate (I t =−vW t/P t). Show:

    Appendix 2 The Over-investment Theory

    Characterize the range of parameters that give rise to business cycles.