Unit-5

Points to be covered
Business Cycle and different phases Theories of Business Cycle Inflation and limit of inflation Methods of measuring inflation Types of Inflation Effects of inflation Cost push and Demand Pull Inflation Inflation and economic growth

What is business cycle?

Business cycle refers to the fluctuations in economic

activity that occur in a regular time sequence in all capitalist societies.

Phases of Business Cycles

Steady Growth Line

Growth Rates

Time

Prosperity Phase of The Business Cycles

PROSPERITY

Expansion

Peak

Recession
(The Turning Point)

Multiplier Effect

Input falls short of demand. Inputs gets costlier

Increase in Demand Halts

Rise in output, consumers, capital etc

Consumer Resistance gets momentum

Supply Exceeds Demands

Depression Phase of The Business Cycles

Depression

Trough

Recovery

Growth Rate is negative

Renovation Programs

Decline of National Income, Expenditure, Employment etc.

Additional Investments pushes consumptions

Theories of Business Cycle

Pure Monetary

Hicks Theory

Monetary OverInvestment

Trade Cycle Theories

Schumpeters Innovation

MultiplierAccelerator Interaction

The Pure Monetary Theory

Theory Business Cycle is caused by fluctuations in monetary and credit market. All changes in levels of economic activities is due to changes in cash flows. Principal factor which effect money supply is credit mechanism where banks expand credit facility up to a point. When credit expansion gets halted downswing sets in. Critical Evaluation Non-Monetary factors play a crucial role in altering the course of economic activities e.g.: aggregate demand, cost structure etc. Monetary factors are not able to completely explain the turning points. Future business prospects and marginal efficiency of capital plays an important factor in business decision making.

Monetary Over-Investment Theory

Critical Evaluation
Desired Investment

Actual Investment

When market rate of interest is lower than the natural rate credit flows to the capital goods industries only under full employment.. Ignores important factors such as businessmans expectation, cost of capital etc. Undue emphasis on the imbalance between the investment in capital and consumer goods industries.

Schumpeters Theory of Innovation

Business cycles are almost exclusively the result of
Initial impact of innovation results in credit and borrowings from the bank which reduces money supply and recession sets in Subsequent waves are created due to speculation. Wave of expansion causes further investment which in long run will cause prices to fall and thus depression starts 1. Most arguments based on sociological than economic factors and so non-testable 2. Not much different from Over-Investment theory except for the cause of variation 3. Does not consider other important factors

First Approximation

Second Approximation

Critical Evaluation

Multiplier-Accelerator Interaction Theory Samuelsons Model

Autonomous investment is carried out by the firm which results in increased income (multiplier effect) and thus increase in demand for goods leading to derived investment to increase output. This again causes increase in demand. Assumptions
1. No excess production capacity 2. One-year lag in consumption 3. One-year lag in increase in consumption and investment demand 4. No government activity and no foreign trade

Critical Evaluation
1. Far too simple 2. Other factors, e.g., producers expectation, change in preferences etc. not considered 3. Constancy of capital/output ratio 4. Cyclic patterns do not confirm to real world

Hicksian Theory of Trade Cycle

Assumptions Equilibrium rate of growth: Realized and natural growth are equal Samuelson type of consumption function: Ct=aYt-1 Autonomous investment as a function of current output Ceiling and Bottom for the upswing and downswing Critical Evaluation Does not provide for linear consumption function and constant multiplier Assumption of constancy of multiplier is skeptical Seems to be an abstract formulation

Inflation
Inflation means persistent and appreciable increase in general level of prices over a period of time

Inflation is Desirable because

Accepted Level
Keeping economic outlook optimistic and helping production and employment

1-2% in developed countries 4-6% in less developed countries

Promoting mobilization of resources by inflationary method of financing

Methods of Measuring Inflation

Change in Price Index Numbers (PIN)

Rate of Inflation PINt - PINt-1 = 100 PINt-1

Change in GNP Deflator

GNP Deflator Nominal GNP Real GNP

Types of Inflation

Effects of Inflation
Effects on Production and Growth
Time Lag Redistributes income in favour of higher income groups

Effects on Employment
Increases Employment Affects growth adversely

Effects on Income Distribution

Wage earners are hurt Producers gain Fixed Income groups are adversely effected Borrowers gain Lenders loose Government gains

Effects on Distribution of Wealth

Redistribution in favour of rich

Modern Theories of Inflation

Demand Pull Theory

Cost Push Theory

Demand Pull Inflation

Caused by increase in aggregate Income increases much faster than aggregate supply

Monetary Factors
Increase in Money Supply Decline in Interest Rate Increase in Investment and Income level Increase in Aggregate Demand

Real Factors
Downward shift of saving or import function Upward shift in investment or export function Cut in taxes Increase in govt. expenditure

Cost-Push Inflation
Caused by monopolistic forces of the societies like labour unions and cartels

Policy Measures to Control Inflation

Bank Rate Policy Variable Reserve Ratio Open Market Operations Taxation Gove rnment Expe nditure Publ ic Borr owings

Monetary Policy

Fiscal Policy

Indexation
Adjusting monetary income to minimize undue gain or s los

Price and Wage Control

il prices Reta arefixed ge Freeze Wa