This theory reflects the work of John Maynard Keynes. However, it is not systemically presented as such, but its main points are extracted from Keynes book “The General Theory of Employment, Interest and Money.”

According to Keynes, the fluctuations which occur in the income are a result of the fluctuations in the level of investment. Whenever the investment level increases, for example, due to inventions it results in the growth of production and restoration of business confidence, and the introduction of new developments projects in a country. This ultimately sets a stage for the expansion of economy.

Banks play their role by creating credit money and stock markets show bullish activities. As a result of an increase in the investment level, income and consumption also rise. The gap between the two i.e. savings rise following an increase in investment. According to Keynes the consumption function remains stable in the short run and as a result and as a result of the increase in saving and investment the level of income and employment rises as well.

The force of the multiplier results in a rapid growth in the income level and during the phase of expansion of the Marginal Efficiency of Capital (MEC) remains much above the rate of interest. Hence, investment continues to expand. Excessive demand leads to an increase in the demand for the factors of production in the capital goods industries due to which their rewards are increased. This in return results in the cost of production rising and hence the supply price of capital goods rises as well. On the other hand due to vigorous competition among the producers, prices of goods and services fall in the product market and hence entrepreneurs detect a secular decline in the MEC.

Similarly at the same time interest rate shoots up due to the excessive demand for loans. Hence, investment becomes unprofitable and starts declining. The economy starts facing crises; the income and output level fall fast due to the reverse operation of the multiplier. This establishes the phase of contraction and during the period, interest rates are very low as is the case with the MEC. This is become entrepreneurs do not demand loans.

With the passage of time entrepreneurs find that term is a severe shortage of capital goods in a country and they are unable to make any investment at all. Thus, their demand for capital goods leads to an increase in the production of capital goods in the respective industries and therefore MEC in this sector rises while the interest rate is still practically low. Hence, entrepreneurs become optimistic and continue to increase the investment due to which the economy starts reviving.

This theory clearly explains the phase of depression through a secular decline in the MEC but it fails to explain the expansion phase of an economy. Hence, this is a theory of depression rather than a theory of the whole trade-cycle.