Psychological Theory of Business Cycle:
This theory is associated with the name of Prof. A. C. Pigou who developed it in his well-known work Industrial Fluctuations. The psychological theory attempts to explain the business cycle phenomenon on the basis of changes in the psychology of the industrialists. According to this theory, business fluctuations are the result of waves of optimism and pessimism among businessmen and industrialists. At times, businessmen and industrialists are prone to be optimists. The big among them feel optimistic about the future prospects of business. So they radiate their optimism to other businessmen and industrialists, who, in their turn, pass it on to others. In this way, the entire business community becomes optimistic-minded. And in their mood of optimism, they make new investments in all branches of the economy. This leads to the emergence of boom conditions in the country. At other times, businessmen and industrialists become pessimists with regard to future business prospects. The big among them communicate their pessimism to others, and ultimately the entire business community becomes pessimistic-minded. New investments are stopped. Even the existing production facilities are curtailed. There is a general atmosphere of gloom and despair throughout the economy. This leads to the emergence of a slump in the country. The booms and slumps are, thus, due to the alternating waves of optimism and pessimism on the part of investors.
The psychological theory has been criticized on the ground that it does not furnish a comprehensive explanation of the business cycle. According to this theory, the fluctuations in business activity are due to the alternating waves of optimism and pessimism in the moods of businessmen. True, but the theory does not explain what causes these alternating waves of optimism and pessimism. After all, the alternating moods of optimism and pessimism are not self-generated. There must be extraneous factors responsible for these waves of optimism and pessimism. The fact of the matter, as pointed out by Keynes, is that the psychology of the investors is influenced by the marginal efficiency of capital which itself is determined by certain monetary and non-monetary factors.
It does not, however, mean that the theory is useless. The theory has an element of truth in it. Changes in the psychology of businessmen do affect fluctuations in business activity. For example, a depression having occurred is further deepened by the overall pessimistic psychology of the investors. Likewise, a boom having occurred is further heightened by the overall optimistic outlook of the businessmen. In short, the psychological factors are the accentuating rather than the originating factors of the business cycle.