Definition: The Pure Monetary Theory was proposed by Hawtrey, according to him the changes in the money flows in the economy cause the fluctuations in the level of economic activities. Thus, this theory posits that the business cycle is caused due to the fluctuations in the monetary and credit markets.
The fluctuations in the supply of money and the bank credit are the main causal factor of a cyclical process. With an increased supply of money, the prices rise, profit increases, total output increases and thus overall growth takes place. On the other hand, if the supply of money falls, then the price fall, profits decline, total output falls as production activities become sluggish, and the economy enters into the depression phase.
The principle factor behind the supply of money is the credit created by the banking system. The economy observes the upswing with the expansion of bank credit and continues to expand as long as the banks create the credit. The banks expand the credit facility because the situation is as such that they find profitable to offer the credit at a relatively lower interest rate. This encourages the entrepreneurs to undertake productive activities and avail the benefits of bank credits.
Till the process of credit expansion continues, the general level of price increases as after a certain limit, the rate of increase in the demand will be more than the supply rate. The supply increases at a lower rate because of limited production capacity and the gestation period of new investments. Thus, credit expansion helps in accelerating the economy and at the same time helps in the price rise. The economy observes the upswing and enters into the expansion phase.
After a point of time, the banks might restrain the credit expansion at the prevailing rate because their cash and reserves got depleted due to the increase in loans and advances, withdrawal of deposits for quicker returns, reduced inflow of deposits, etc. With the contraction of credit, the businessmen can no longer obtain bank credit for furthering their business activities. As a result of this, the expansion slows down and marks the beginning of the downswing.
The pure monetary theory is criticized on the following grounds:
- The monetary factors, though, are the major contributors to business fluctuations, the business cycles are not purely a monetary phenomenon. The fluctuations in the economic activities are also seen due to the non-monetary factors like aggregate demand, expectations of the businessmen, demand for new investment, etc.
- Although, the monetary factors play a crucial role in the cumulative process of contraction and expansion, it is not efficient enough to fully explain the turning points. In fact, at turning points, the non-monetary factors are seen to have played an important role.
- It is assumed that that the businessmen are highly sensitive to the fluctuations in the interest rates which is quite doubtful. As most crucial factors in the business decisions are the future prospects in the business and the marginal efficiency of the capital.
In spite of these shortcomings, the pure monetary theory is regarded as more reasonable and logical in explaining the economic fluctuations.