Joseph Schumpeter, a German economist, presented the innovation theory. According to him, trade cycle is brought about by innovations introduced by entrepreneurs. He defines his theory as, “By innovations, I understand such changes of the combinations of the production as cannot be affected by infinitesimal steps or variations on the margin. They primarily consist of changes in methods of production and transportation or in changes in industrial organization or in the production of a new article, or in the opening up of new markets, or of new sources or material.”

Based on this definition, Schumpeter introduces his theory of trade cycle with the assumptions of a static economy. He assumes the economy to be in static equilibrium as

i) All firms in the country are in equilibrium where Total Revenue = Total Cost.
ii) Where average revenue = average cost.
iii) Where the rate of interest = 0
iv) And that there is to be full employment in the economy which means that there is no involuntary unemployment in the economy.

Schumpeter says that innovations break the equilibrium of a static economy and make it dynamic.

Primarily, technological innovations lead to an increase in the demand for capital goods due to which investment go up and capital accumulation take place. As a result the output level increase and consequently the National Income increases due to a greater demand for consumption goods. As a result of an increase in the price level, profits of entrepreneurs increase as well and hence entrepreneurs are induced to introduce more innovations and they obtain loan from banks to make the investment needed. Thus, the economy expands.

During the boom period, imitators imitate the innovations. Hence, the supply of goods and services increases and eventually exceeds demand. Thus, this results in the general price level failing and profits of entrepreneurs begin to diminish. As a result of this, many firms would have to close down as they are incapable of staying in the market. Only those entrepreneurs whose innovations are of the latest trend are all to stay in the market. Banks being the most sensitive, quickly take back their loans and the rate of interest which was high during the expansion phase has now gone down. In this way pressure to innovate in the depression of an economy.

Schumpeter’s trade cycle starts from a point on the static equilibrium and ends at another point on the static equilibrium. This means that Schumpeter says that cycles are not a continuous process whereas in fact it is a continuous phenomenon. Innovations are mainly brought about by sociologist factors and it is very hard to ascertain the role of sociological factors in bringing about the trade-cycle.