Demonetization Impeded Indian Economic Growth? Test of Hawtrey's Theory of Business Cycles.

AuthorArora, Nitin


The Indian government announced sudden demonetization on 8th November, 2016 that can be considered as a monetary shock to the Indian economy which resulted in the cancellation of legal tender of 85 per cent of Indian currency (i.e., making it redundant). Subsequently, the Indian economystarted experiencing a dip in the growth rate from 7 per cent in quarter January-March, 2017 to 5.7 per cent in quarter April-June, 2017. The demonetization has been blamed as the sole demon behind this deceleration in economic growth rate. This study has been investigating this low growth phase of the economy through the growth rate cycle approach. Amongst various theories explaining business cycle phenomenon (1), Hawtrey (1927) had given his monetary theory of business cycles according to which business cycles occur due to changes in effective demand through changes in bank credit. The credit creation leads to increase in money supply which further affects the effective demand and eventually business cycles are experienced by the economy. So, according to the monetary theory of business cycles, only monetary factors are responsible for fluctuations in overall economic activity, meaning thereby, the monetary factors are playing a key role as leads for the business cycles to occur. In this paper, an attempt has been made to identify the relationship between changes in money stock and fluctuations in overall economic activity for the Indian economy on the line of reasoning advocated by Hawtrey (1927).

The fluctuations in the economic activity are captured and represented by the trade cycles or more popularly known as the "business cycles". The fluctuations affect all dimensions viz. output, employment, price and GDP of an economy. Therefore, such volatility in economic activities is necessary to examine as it helps in comprehending the nature of the economy and facilitate the formulation of appropriate monetary, fiscal and foreign policies. For the Indian economy, the business cycle research is gaining importance day by day because of its growing openness and inter-linkages with rest of the world and the structural transformation of the economy.

Mechanism of Business Cycles: A Theoretical Survey

There are various views of leading economists and their respective theories trying to explain the causes of business cycles. The classical economists always believed in full employment equilibrium in the long-run therefore, could not develop any full-fledged theory of trade cycles in terms of recurring pattern generated by the endogenous forces. Some of the economists like David Ricardo, John Stuart Mill talked about revulsions and crisis but, by and large, the systematic study of trade cycles as a recurring phenomenon in business activity did not begin. Thomas Robert Malthus also could not explain the causes of depression and unemployment. Thus, the classical macroeconomic theory is deficient in respect of the trade cycle analysis. According to Schumpeter (1939), Clement Juglar was the first to make a systematic study of the trade cycle. Juglar (1862) discussed the trade cycles with three phases of prosperity, crises and liquidation with the cycle length of 9-10 years. Also, Schumpeter (1939) made innovations the central cause of the recurrence of business cycles in the modern industrial economies. Accordingly, the recurring bursts of innovational investment activity can clearly explain the trade cycle phenomenon. Hawtrey (1927) attributed the trade cycle phenomenon to the monetary disturbances taking place in the economy and has advocated that depressions can be corrected through injecting monetary stimulus in an economy, however, Hayek (1929)developed his monetary over-investment theory and held the inequality between market and natural interest rates to be responsible for the occurrence of business cycles. According to Keynes (1936), the problem of trade cycles in the economy was caused by a cyclical change in the marginal efficiency of capital, though complicated and often aggravated by associated changes in the other short-period variables of the economic system. In Kaldor's (1940) model of the trade cycle, the non-linear investment demand and saving supply functions are crucial in explaining the occurrence of the trade cycles. Samuelson's(1939) basic linear multiplier accelerator model attributes the occurrence of business cycles to the change in net investment caused by change in aggregate income through interactions between accelerator and multiplier. Metzler (1941) has shown the effects of different inventories and explicit expectations in his model for explaining the reasons responsible for the occurrence of trade cycles. Victor Zarnowitz has termed the good times in the economy as "prosperity" and the bad times as "depression", thus, transition from prosperity to depression was labeled as "crisis" and the transition from depression to prosperity was called "revival" (Zarnowitz, 1991). However, the term used for a mildly depressed period is "recession".

The National Bureau of Economic Research (NBER), founded in New York in 1920, initiated research into understanding the repetitive sequences that trigger business cycles and the NBER's Business Cycle Dating Committee has been dating the turning points for the US economy since 1978. The business cycle research was pioneered by Wesley C. Mitchell and Arthur F. Burns through their work Measuring Business Cycles published in 1946. Wesley C. Mitchell first established a working definition of the business cycle that he, along with Arthur F. Burns, later characterized as:"Business cycles are a type of fluctuation found in the aggregate economic activity of nations that organize their work mainly in business enterprises: a cycle consists of expansions occurring at about the same time in many economic activities, followed by similarly general recessions, contractions and revivals which merge into the expansion phase of the next cycle; this sequence of changes is recurrent but not periodic; in duration business cycles vary from more than one year to ten or twelve years; they are not divisible into shorter cycles of similar character with amplitudes approximating their own."

However, Koopmans (1947), while reviewing the Burns and Mitchell's work (1946), has also pointed towards the absence of theoretical propositions in their explanations of cyclical fluctuations. In his view, it is the "measurement without theory". In the existing literature, it has also been emphasized that a business cycle is an empirical phenomenon (Zarnowitz, 1991).

The area of business cycle research and analysis is new for developing nations. In fact, theory and empirical evidence on business cycles originated in developed industrialized nations only. Moreover, the past research on developing nations reveals that the features of...

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