Can You Explain The Over Investment Theory Of Trade Cycle?

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.