Can You Explain The Psychological Theory Of Trade Cycle?

The psychological theory is mainly attributed to professor Pigou. According to him, business cycles are caused by alternating moods of optimism and pessimism of businessmen. When trade is brisk, businessmen lured by high profits, expand investment and production. They over estimate the future demand of goods and in competition with over industrialists plunge deeper into business. A wave of optimistic sentiments in one quarter generates similar feelings among others. Production is stimulated. A period of prosperity is thus in full swing. The businessmen being optimistic about the future demand of the goods commit errors of forecast. They over-expand their businesses.

The market becomes over flooded with consumption goods. When supply, exceeds demand at current prices and the goods are not sold at a profit, the businessmen curtail further investment and production and try to clear the stocks already accumulated by them. They begin to underestimate the future prospects of business. A wave of pessimism spreads in business circles which ultimately lead to full fledged crisis.

There is no doubt that this story contains much truth in it but the pity is, that it does not offer true explanation of the trade cycle. The psychological theory fails to explain the periodicity of the trade cycle. Moreover, it does not explain as to how people are infected with optimistic expectations.