The Over-Investment Theory was developed by Prof. F.A. Hayek. The main feature of this theory is that the expansion in the economy takes place at a time when the capital goods industries expand more than the consumer goods industries. Similarly the economy contracts then the capital goods industries contract more than the consumer goods industries. Prof. Hayek has presented a structure of production comprising two types of industries i.e. capital goods industries and consumer goods industries.

Capital goods industries fall in higher stages of production as they are not directly related to the consumers. On the other hand, consumer goods industries fall in lower stages of production as they are directly linked with the consumers. Prof. Hayek says that “when the market rate of interest is less than the natural rate of interest the entrepreneurs get loans from commercial banks and expand their investment.”

Eventually the employment level expands and the economy gradually reaches the full employment level. Due to expansion of investment at full employment level resources would divert from the consumer goods industries to capital goods industries or resources would shift from lower stage of production to higher stage of production. Thus, more capital goods are available in the market rather than the consumer goods. This phenomenon results in an expansion of economy. This type of expansion cannot take place for long, as the incomes of the individuals increase due to the expansion of the economy they tend to create demand for consumer goods. Thus prices of consumer goods increase.

Hence, a new production structure is developed. A production resource from the capital goods industries and more investment is made here. For this reason entrepreneur in the capital goods industries face losses. Hence according to Hayek loss would result in a contraction of the economy. Eventually the general level of income and employment falls hence, the demand for consumer goods fall more sharply than consumer goods prices. Hence, capital goods industries shrink more than consumer goods industries. This eventually results in depression of the economy and it continues for some time until the entrepreneurs take steps to revive investment in the capital goods industries.

Expansion and contraction take place simultaneously in both capital and consumer goods industries simply because the demand for capital goods is a derived demand which depends upon demand for consumer goods. But this theory says that the cyclical fluctuation depends mostly on the capital goods industry rather than both. The phase of contraction is not properly calculated and furthermore methods of reviving the economy is not mentioned.

Purely Monetary Theory was developed by R.G.Hawtery. He says, “The trade-cycle is a monetary phenomenon because the general demand itself is the monetary phenomenon.” According to Hawtery, expansion and contraction take place automatically and business cycles are self generating cycles. He says that cyclical fluctuations depend purely on the changes which occur in money supply and that are brought about the creation of credit money on the part of commercial banks. Hawtery highlights the role of banks in the following words: “Variations in effective demand which are the real substance of the trade cycle, must be traced to changes in bank credit.” According to this theory, when bands create credit facilities, entrepreneurs are able to increase their investment expenditure. This results in the aggregate money income increasing the consumption expenditure and capital expenditure increase further. Here, an expansion occurs in the economy.

Initially in the phase of expansion the interest rate and wage rates are generally low and consequently the expected rate of return goes up. This induces entrepreneurs to obtain more loans from commercial banks. The aggregate money income goes up further, which results in an increase (further increase) in the demand for consumer and capital goods. Hence, the general price level in the country goes up and the expected rate of return of the entrepreneurs increase. They obtain more loans for further investment. This results in the supply of money and its velocity to go up tremendously. Thus, the money income, money expenditure of production level and prices continue to increase. They affect the international trade as well. Imports exceed exports due to higher demand for goods. Thus, the outflow of gold takes place on a large scale. This situation increases the liabilities of commercial banks compared to their available assets. Thus, banks become nervous and ask for the repayment of their loans. The phenomenon results in the expansion of an economy coming to an abrupt halt! Due to fall in credit facilities, the supply of money and its velocity both go down, investment and output also squeeze and consumer’s income and expenditure go down. Entrepreneurs purchase and consumer income and expenditure save money so that they are able to pay back the loans to the commercial banks.

As a result of a fall in the supply of money, prices fall as well. The expected rate of return becomes low and the investment and income fall down even further. This situation results in further contraction of the economy. In the phase of depression, consumers cut down their demand for consumer goods even though prices are very low due to their low level of incomes. As a result they increase their savings and deposit them in the commercial banks, and gold follows in the country because exports in the phase of depression. These two factors increase the cash deposits of commercial banks and enable them to create credit facilities and thus entrepreneurs will once again be able to receive the economy.

Monetary factors do play a vital role in fostering cyclical fluctuations, but they however, are unable to initiate trade-cycles as these come about through the vital role played by the real economic factors. This theory shows that cyclical fluctuations are a national phenomenon, but trade cycles are universal in nature. Thus, banks of a country may be able to initiate fluctuations in a country but not in the whole world. Hawtery has ignored the importance of capital goods in bringing about fluctuations by giving excessive importance to money.