BUSINESS CYCLE

Meaning and Characteristics of Business Cycle.

Business cycle is also called Trade Cycle. The business is never steady. There are always
ups& downs in economic activity. This cyclical movement both upwards and downwards
are commonly called Trade Cycle. This is a wave like move in regular manner in
business cycle .In business, there are flourishing activities which takes economy in
prosperity and growth where as there are periods when there is recession which leads to
decline in the employment, income and output. When the economy goes into downswing
then there is a stage of recovery to reach a new boom.
Definition.
eynes! Trade Cycle is composed of periods of good trade characterised by rising price
and low unemployment percentage altering with periods of bad trade characteri"ed by
falling price and high unemployment percentage. To put it in simple words!#
Business Cycle is a fluctuation of the economy characteri"ed by periods of prosperity
followed by periods of depression.
Characteristics of Business Cycle!
The fluctuations are wave like movement and are recurrent in nature.
Business Cycle is characteri"ed by waves of e$pansion and contraction but these
are not only two phases of business cycle there are four phase of business cycle. %
&$pansion, 'ecession, Contraction and 'evival or 'ecovery.
The movement from peak to trough and again trough to peak is not symmetrical.
(ccording to eynes prosperity phase of business cycle comes to end fast but dip
is gradual and slow.
Business Cycle is self generating. &very phase has germs of the ne$t phase, that is
e$pansion has the germs of the recession in it.
Phases of Business Cycle
(fter understanding what is business cycle and their characteristics we will take each
phase of business cycle in details.
1. Prosperity or Expansion
This phase of business cycle is called the upswing. This phase is in the upper half of
the cycle which you can see in figure )I % *.+ ,*-To start with we will try to see how this
phase begins. It starts from e.uilibrium position, when the demand increase the demand
of raw material also increase and so the employment which again leads to increase in
employment in other industry. (s the consumption increases general employment also
increases. The wages, salaries, interest rates, ta$es and the cost do not increase in the
same proportion and conse.uently profit margins go up. There is general feeling of
optimism and production capacity of the economy is fully utili"ed. The rise general price
is marked in this phase.
In this phase, investment activity increases due to increase in demand for consumption
goods. This optimistic sentiment can be seen in real estate and share market boom.
/anufacturers pile up stock with improved prospects of increase in demand. This
activity of producers increase in production is faster than consumption. But this process
cannot be indefinitely continued. This phase ends and turns into phase of recession. The
factors for recession to start are, when the gap between cost and price starts rising and the
profit margin declines. This happens because of scarcity felt in different factor market
and therefore the price of factors of production rises.
2. Recession:-
This is a turning period which is relatively shorter. But in this phase the production of
consumer good do not decline immediately. The demand for consumer good falls with
lag but the fall in demand for capital goods falls drastically. 0roducers cancel their future
investment programmers so the demand for machinery decreases and therefore the capital
goods manufacturing sectors responds more .uickly. In this period over optimism gives
way to over pessimism. (ll the investment seems unprofitable and so there is collapse of
/arginal &fficiency of Capital. The employment situation gets bad as investment activity
declines. This is referred as mild recession but when recession is severe it is called crisis.
3. Depression or Contraction:-
This phase is a phase of low economic activity. There is fall in production and
employment throughout the economy. But it is not uniform in all sectors. The fall in
demand for consumer good is less than the fall in demand for machines and e.uipments.
1uring depression the e$penditure on durable goods fall more than consumer goods,
therefore the production and employment is affected in the sectors producing durable
goods. (griculture sectors are not much affected as it is necessary for subsistence. The
producers and wholesalers start li.uidating their inventories piling up during prosperity
phase. This phase shows low a economic activity with fall in production, fall in
employment and fall in general price level and the profit margins also. 0roducers are not
interested to venture fresh investment as the /&C totally collapses. The price structure is
distorted as some price galls little where as some goods the price vertically collapses
making the income distribution worst and this prolongs the phase of depression. 2n the
other hand not all the cost falls at a e.ual rate as wages and salaries tend to be sticky
during this period due to trade unions and labour laws. 'ents, interest rates and ta$es
come down slowly while price falls down continuously and cost rigidity wash away the
profit margins for producer. Turning point of depression is trough is a very short period
but sometimes its for 3#4 years. e.g great depression of early 35s. (fter this, the recovery
phase starts.
4. Recovery:-
This phase is gradual. It starts when the price stops falling this is said to start when the
pilled up stock is e$hausted and supply reaches its. 6ow the producers start planning for
production. This generates employment and income which again leads to demand for
consumer goods. The /&C starts improving. This leads to correction of price and so
also to the relationship between cost and price. The profit starts replacing losses and
recovery gathers momentum. 'ising price encourages companies towards new
investment and pro7ects. This phase of recovery takes the economy to the phase of
prosperity. Thus is the cycle again ready to repeat itself.
THEORIES OF BUSINESS CYCLE:-
What are the factors that cause these fluctuations in business cycle8 There are many
theories proposed by various economists to e$plain the causes of business cycle. We will
discuss some important theories of business cycle.
Schumpeters Innoation !heory"#
9oseph :chumpeter has e$plained the e$pansion and contraction through industrial
innovation. Innovation # actual application of invention where as invention is discovery
of something new. Invention converts into innovation. ;ere in this theory, the
innovation can be introduction of new product, market source of raw material, opening of
new market in business. (n entrepreneur are innovators, he has knowledge to do
something new, daring and foresight to go ahead of others and in this process he demands
funds from banking system. 6ow we will e$amine how innovation causes business
fluctuations. In this theory he says any innovation can move the economy to
dise.uilibrium from e.uilibrium and this will continue till the new e.uilibrium position is
reached. ;ere let us say the innovation is the introduction of a new product in a full
employment economy. The new industry has to reward the e$isting factors of production
heavily to attract them. The new industry is financed by bank credit. (s the factor of
new industry get higher rewards their purchasing power increases and the demand of old
industry product increases, as the new product is yet to come in the market. Therefore
the demand and production of old products increases. The old industry will now take
credit from bank for e$pansion. In the mean while the new product comes to the market
due to novelty, there is decrease in the demand for old products. The old industry starts
cutting down on production, therefore the income to factors of production in decreases.
(s a result the demand for old and new product decreases. 1ue to more and more
7oblessness the vicious circle of deflation starts and the economy gets into downswing.
:o this theory says that the economic fluctuations due to innovation in the industry.
This theory was challenged and the limitations are#
The full employment assumption is unrealistic.
Bank is not the only source of finance for every innovation in business.
/any times the profits are ploughed back to finance innovations.
Innovation cannot be the sore cause of business cycle.
$er Inestment !heory of Business Cycle"#
(.<.;ayek assumes economy in e.uilibrium, whenever this e.uilibrium is disturbed then
there is e$pansion or contraction. This theory says that when the economy is in
e.uilibrium, the rate of interest is such that :aving = Investment there is no unemployed
resources. 6ow if suppose the bank credit e$pansion takes place then the e.uilibrium
rate of interest is disturbed. This low market rate of interest will tempt the businessmen to
borrow more and invest in new ventures. This leads to upswing in business cycle as a
result employment, output, profit and demand increases. But then this phase does not
continue indefinitely.. 1ue to scarcity of resources this e$pansion phase cannot go on and
on. But due to increase in price the people are forced to decrease consumption and start
saving more. This forced saving due to high price makes the bank ease credit and
investment starts. The economy comes out of its downswing as income increases and
people revert back to earlier consumption and e$penditure levels. This helps economy to
recover and the upswing starts again. This theory says that the over investment due to
forced saving by people in inflation is the cause of fluctuations in economic activities.
;e says voluntary saving leads to change in structure of production permanently but
forced saving brings changes which are not permanent. The limitation for this theory are#
(ssumption of full employment is unrealistic.
>ndue importance is given to banks rate of interest. &ven if the rates of interest
are constant there will be variation in production when the business starts getting
profits.
Pure Monetary theory of Business Cycle"%&a'treys Monetary !heory of
Business Cycle("#
(ccording to 0rof. '.?. ;awtrey, a British economist, there is direct relationship
between volume of money supply and the economic activity. Where ever there is change
in the flow of money or money supply changes, there will be business fluctuations. ;ere
he means the credit creation by the banking system that is e$pansion in bank credit leads
to in demand and so the upswing of business cycle starts. 2n the other hand when there is
decrease in money supply through contraction of bank credit, it leads to down swing and
thus leads to depression.
@et us take it in detail#
&$pansion of bank credit happens when interest rates are reduced which means the loans
are cheaper. 1ue to liberal loans the profit margins changes as they are very sensitive to
the change in interest rate. Thus investment increases and so the employment which in
turns increases the income and demand. This increase in demand leads to increase in
price and profit margins, therefore the upward trends start that is the upswing starts. But
as each phase has the germs of other phase the turning point starts when bank changes its
policy of credit e$pansion as the cash reverse with the bank reduces. The lending rates
are increased to discourage the demand for fresh loans and they start calling to return
loans. The producers start disposing for their stock to repay loans. The restricted policy
on credit and high rate of interest discourages a new investment which leads to
downswing. The income falls and cash starts coming back to the bank. But as the cash
reserve with the bank improves, again the bank starts using liberal attitude towards credit
creation and so the revival starts. This takes the economy to e$pansion or prosperity.
(ccording to ' ? ;awtrey flow of money supply is the sole cause for business
fluctuations. This theory was not unchallenged. :ome limitations are#
Business cycle is a very comple$ phenomenon and we cannot attribute it
completely to credit creation by banking system.
Bank plays a important role in the financing of business but it cannot be the only
reason for business crisis. It can 7ust aggravate the situation.
Too much of importance is given to bank credit. /any times traders donAt borrow
from bank but plough back their profit.
Investment not only depends on interest rates but on the rate of return also.
;awtrey has totally ignored /&C.
This theory has totally ignored the non monetary factors like innovation, climatic
conditions, psychological factors etc.
Multiplier ) *cceleration theory of Business Cycle
:amuelsonAs model is regarded as the first step in the direction of integrating theory of
/ultiplier and the principle of (cceleration. ;is model shows how the multiplier and
acceleration interaction with each other to generate income, to increase consumption and
investment demand more than e$pected and how this causes economic fluctuations.
To understand :amuelsonAs model, let us first understand derived investment, derived
demand is the investment in capital e.uipment, which is undertaken due to increase in
consumption making new investment necessary. We will try to understand this
interaction briefly. When autonomous investment takes place in a society, income of the
people rises and the process of /ultiplier start increasing the income which leads to the
increase in demand for consumer goods depending on the marginal propensity to
consume. If there is e$cess production capacity, the e$isting stock of capital would prove
inade.uate to produce consumer goods to meet the rising demand. 0roducers trying to
meet the growing demand undertake new investments. Thus, increase in consumption
creates demand for investment. This is derived investment. This derived marks the
beginning of (cceleration process, when derived investment takes place income
increases further, in the same manner as it happens when the autonomous investment
takes place. With increase in income, demand for consumer goods rises. This is how the
/ultiplier and the (ccelerator interact with each other and make the income grow at a
rate much faster than e$pected. with the help of both the /ultiplier and (cceleration
principle he tried to relate the upswings and downswings of business cycle. there some
criticism regarding the assumptions, they as follows#
There is no government activity and no foreign trade
6o e$cess capacity
2ne year lag in increase in consumption and investment demand
Conclusion:-
Though many economists had different approaches, some attribute business cycle to
e$pansion and contraction of money supply some say it is due to the interaction of
/ultiplier & (cceleration which changes the aggregate demand and leads to fluctuations
but some attribute it to the innovations in one sector which spreads to the rest of the
economy that causes recession and boom. There are other economist who attributes
fluctuation of business cycle to the politicians manipulating economic policies and some
say supply shocks for eg *BC5As sharp increase in oil prices, increased inflation. (ll these
theories have elements of truth but they are not valid in all the places and time. The key
is to understand them and combine these theories and use the knowledge of macro
economics to decide when and where to apply it.
Sta+ilisation policies to control +usiness cycle"#
(s you are introduced to the stabili"ation policies and know how it works from >nit #)
we will now see how these policies are used in controlling the fluctuation of business
cycle. To start with we will take monetary policy. /onetary policy includes all the
instruments through which central bank controls the credit creation.
/onetary 0olicy in depression!#
We will 7ust brush up the atmosphere in depression# low /&C, falling price, income,
output and lots of uncertainty. In this atmosphere there is need to encourage investment
and so the loans are made cheaper to stimulate investment and increase the demand by
increasing income and employment because a cheap money policy will discourage saving
and promote investment. Though it is said /onetary 0olicy has less scope in depression
and fails to bring the economy out of depression as the /&C is low and so the
businessmen are scared to invest, even though the rate of interest is low. 'ate of interest
is the factor but not the only factor for investment. Businessmen borrow when the
business is e$panding not when it is declining. @ow rate of interest cannot make
businessmen borrow as one can make a horse come to water but cannot make it drink.
But however we cannot say it is totally useless because it can stimulate demand for
durable goods and private investment. But open market operation can increase the
li.uidity overall in the economy, even if credit policy cannot turn the business cycle but
it can create the necessary atmosphere for the other policies to be successful.
Monetary Policy during Inflation:-
Inflation is faced at the prosperity phase when /&C is high, rising prices, output and
employment. The condition in the economy is very optimistic and business activities are
rapidly increasing. Though this condition cannot go on continuously with increase in
consumer spending and investment spending the credit condition in the economy
becomes tight. The banks start feeling difficult to cope with demand for credit in such a
situation the rate of interest is raised by the banks to control the li.uidity in the economy.
The Cash 'eserve 'atio, :tatutory @i.uidity 'atio are raised and a tight money policy is
in effect to control the boom from turning into inflation. The effect of /onetary 0olicy
in inflation is much greater than in depression.
6ow we will try to understand how fiscal policy controls the business cycle.
Fiscal Policy during inflation:-
1uring inflation there is e$cessive aggregate spending and need to control the demand.
We will discuss the measures of fiscal policy in controlling inflation.
*. Taxation! # There is need of new ta$es to be introduced to wipe out the surplus
purchasing power. The e$isting ta$ structure should not be increased too much otherwise
it may lead to business recession by de#motivating the investments. The ta$ structure
should be such that the demand for commodities should reduce or redistribution of ta$ so
that it works as a measure for raising and stabili"ing the consumption function. This
means manipulating the ta$ structure in such a way that ta$ing low spending of high
income group and ta$ing high spending of low and middle income group people. This
work better than interest rates as it is a direct hit on the demand and thus works a
aggregate demand management.
+. Pulic spending!# The government spending should be controlled in inflation.
Though there is a minimum limit beyond which the government e$penditure cannot be
reduced but schemes such as construction of building, parks, schools etc can be
postponed. ?overnment can vary their e$penditure pattern to control the inflationary
pressures. But at the same time the revenue should be increased to create budget surplus.
3. Pulic !or"!# This e$penditure has two areas#
&$penditure on public works %such as hospitals, buildings, post offices, roads, schools
etc.
Transfer 0ayment!# This includes pensions, unemployment insurance, subsides, social
security benefits etc. The government should take up some work when the economy
shows the signs of recession and in such inflationary situations such programmes should
be given up completely so the public investment will not compete with private
investment.
Fiscal Policy in Depression:-
Taxation! # This phase needs more encouragement for private consumption and
investment. 'eduction in corporate and income ta$ is favorable as this increase the
disposable income with people and so the purchasing power increases. @ow corporate ta$
will encourage businessmen to enter new ventures. Though it cannot be a perfect
solution for unemployment but private investment can be encouraged by change in
corporate ta$ and consumption can be increased by lowering sales ta$ and e$cise duties.
Pulic #pending!# 0ublic e$penditure is the right type of fiscal policy in depression as it
encourages investment, production, employment and income. ?overnment e$penditure
plays a very important role to bring about the variation in total income. In this phase, the
private investment is below normal and therefore there is a need to increase the public
investment. These investments done by the government will have /ultiplier &
(cceleration effects and in turn will increase the income consumption and employment.
When the private spending is less due to business recession, public spending should
improve to stimulate the investment and bring back the economy to a upward swing.
Pulic !or"!# In depression, when there is need to increase the purchasing power the
public work should be taken up to stimulate investment and generate employment but the
problem is many pro7ects which have been started in depression cannot be given up later
and they cannot fill the gap of unemployment in private sectors. The social security
measures like pensionsD unemployment benefits etc not only raise employment but also
leads to stabili"ation in long run. There is a need of correct co#ordination of public work
and security measures, these things has to be financed by progressive ta$ation.
Conclusion!# The fiscal system with built # in #fle$ibility and built #in #stabili"ers are
one where in a change in employment and output changes the employment and ta$es
already in operation e.g. when the economy faces boom, the revenue collected through
ta$ increases automatically and decreases when there is recession.
INFLATION
/oney is used as measuring rod to measure the value of goods and services. ( measuring
rod is e$pected to be stable in its value like meters, liters, kilogram etc. value of money
refer to its purchasing power which depends on price level. Ealue of money and price
level is inversely related. ( continues increase in general price level is called inflation.
Inflation is a price rising. ( sporadic rise in price cannot be termed inflation. :imilarly it
refers to a general price level and not sect oral or price of individual commodity
INFLATIONARY GA
The concept of inflationary gap was introduced by eynes. Inflation according to eynes
it is post employment phenomenon. It is a situation where there is e$cess demand for
goods and services over the available at constant supply. It the difference between the
aggregate money demands for the consumer goods and services and their supply. When
the economy reaches full employment the supply tends to remain constant but due to
increase in money supply increases the demand
INFLATION IN DE!ELOING COUNTRIES
1eveloping countries are in situation less than full employment or we can say that the
resources are fully utili"ed. :o strictly speaking they should not suffer with inflation but
the factors responsible for inflation in these countries#
*. 1eveloping countries need a lot of e$penditure in developing pro7ects, but these
pro7ects are financed by deficit financing which results to increase in the money
supply in the system and this in turns leads to increase in the demand.
+. many a times the large portion of public e$penditure goes to unproductive
purposes and this in7ects additional purchasing power without increase in the
supply of goods and services resulting in increase general price
3. capital intensive techni.ues of production has a long gestation period but during
this period the demand increases without increase in the supply
F. 0oor people spend ma7or portion of their income on food grain, shortage in
agricultural items can be due to low productivity of agriculture. Increase in the
prices of agricultural commodities leads to cost#push inflation. ;igher the prices
of food grain higher will the demand for the worker to increase the wages and this
leads to cost push inflation.
4. in developing countries the /0C and the income elasticity of demand is high
where as the elasticity of supply is low then naturally the price will increase.
G. Increasing population leads to demand pull inflation because as the population
increases the demand for goods and services will also increase but supply can not
be increase at the rate and this leads to inflation.
C. the anti inflation measures are less effective due to ta$ base, dishonest and non
committed administration and even the economic and political factors
H. Inflation in developing countries is the result of demand pull and cost push
factors. The need to spend for the development increase the supply of money and
result in increases in demand
DE"AND ULL !s COST USH INFLATION
:ome insist on demand pull inflation and others blaming on cost push inflation. The
government was held responsible for the demand pull inflation as the e$cess demand was
the result of budget deficit, trade union and monopoly power of the supplier of raw
materials or other inputs were blamed for cost push inflation. Inflation can not sustain
without the interaction of both factors, though it might have been initiated by any one of
them. &$cess demand generated in economy by itself would not cause inflation, if supply
of goods and services could be increased at constant cost. Inflation started with demand
pull but supported and aggravated by cost push forces. :imilarly inflation caused by an
increase in coat due to higher wages or higher input prices would not last long unless