Definition: The Monetary Over-Investment Theory posits that imbalance between the actual and desired investments, i.e. actual investments exceeding the desired investments, explain the fluctuations in the economic activities.
The monetary over-investment theory was proposed by Hayek, who stresses that in order to maintain economy’s equilibrium the pattern of investments should correspond to the consumption pattern. And in order to keep the economy in stable equilibrium, it is necessary to have the voluntary savings equal to the actual investments.
This theory asserts that total investments should be distributed among various industries in such a way that each industry produces only as much as the consumer demands. Thus, in every industry, the supply is equal to the demand. Given these equilibrium conditions, there will be no tendency to increase the consumption and hence the economy remains in the state of stable equilibrium.
The economic equilibrium and stability get disturbed by the changes in the money supply and saving-investment relations. The saving-investment relation might change due to the increase in the investment without a corresponding increase in the voluntary savings. The investment may increase due to several reasons, such as a fall in the interest rate, increase in the marginal efficiency of capital, optimism about the future business prospects, etc.
If the increased bank credit is used to finance the increased investments, then it will result in over-investment, specifically in capital goods industries. With new investments, the additional income gets generated and thereby additional consumer demands. Because of the time lag between the demand and supply, the excess demand causes inflation and will result in reduced purchasing power. Thus, the real demand does not increase at the rate at which the investment is increasing.
With the increase in the consumer demand, the existing rate of investment cannot be maintained. The consumer continues demanding due to the increase in the labor income and as a result, the price of consumer goods rises and surpasses the prices of the capital goods. Thus, the profitability of the consumer goods industries becomes higher than the capital goods industries. Due to this, there will be a shift in the investment from the capital goods to the consumer goods industry, i.e. the demand for bank credit increases in the consumer-goods industries.
But, however, the unwillingness and inability of the bankers to extend credit, even more, when there is a competitive demand for the fund from the capital goods industry, will lead to a financial crisis. This will result in the decline in the capital goods production because of a fall in the marginal efficiency of the capital and decline in the investments under the pressure of high cost. As a result, the unemployment prevails in the capital goods industries. This unemployment so created is too rapid to be absorbed by the consumer goods industries, and therefore, it gets widespread. This marks the beginning of the depression.
The following are the major criticisms of monetary over-investment theory:
- It is assumed that when the market rate is lower than the natural rate (at which the demand for and supply of goods is equated), the new bank credit is extended to the capital goods industries. This is possible only under the situation of full employment. But, however, the business cycles have occurred even when the resources are not completely employed.
- This theory lays emphasis on the change in the interest rate as the major determinant of investment and ignores other important factors, such as cost of capital equipment, businessman’s own expectations, etc.
- An undue emphasis is laid on the imbalance between the investments in the capital goods and consumer goods as in the modern economy, such imbalances are self-correcting and do not result in serious depressions.
Despite these shortcomings, the monetary over-investment theory is widely applied and accepted in determining the economic equilibrium and stability.