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Chapter 18

Business Cycles
Lecture Plan
 Introduction
 Phases of Business Cycles
 Concepts of Multiplier and Accelerator
 Interaction of Multiplier and Accelerator
 Causes of Business Cycles
 Keynes’ Theory
 Multiplier-Accelerator Interaction
 Hicks’ Theory
 Real Business Cycle Theory
 Effects of Business Cycles
 Controlling Business Cycles
 Monetary Measures
 Fiscal Measures
Chapter Objectives

 To examine the intricacies of business cycles,


causes of such cycles, and their effects.
 To develop a critical understanding of the
various theories on business cycles.
 To understand the dimensions of concepts of
and linkages between multiplier and accelerator.
 To comprehend the measures of controlling
business cycles.
Business Cycle

 Shows the periodic up and down movements in


economic activities.
 Economic activities measured in terms of
production, employment and income move in a
cyclical manner over a period of time.
 Cyclical movement is characterized by
alternative waves of expansion and contraction.
 Associated with alternate periods of prosperity
and depression.
Characteristics of Business Cycles
 Periodicity
 Wavelike movements in income and employment occur at
intervals of 6 to 12 years.
 Gap between two cycles is not regular or predictable with
certainty.
 Synchronism
 Impact is all embracing, i.e. large sections of the economy
experience the same phase.
 Happens because of interdependence of various sectors of the
economy.
 Self Reinforcing
 Due to interdependence in the economy, cyclical movements
faced by one sector spread to other sectors in the economy; and
from one economy to other economies.
 Thus the upward swing of the cycle is reinforced for further
upward movement and vice versa.
Phases of Business Cycle
Pea G
GNP Ck D Expan Four phases:
(%) sion G
Expans Expansion, B to C

ion
Peak, (Boom) C to D
Contra E F
Contraction E to F
G ction
A B (recession),
Contra
ction Troug Trough A to B
h Time Unit (depression)
(years)
• Time gap between two bouts of trough (from B to E) or peaks (from
D to G) can vary between 6 to 12 years.
• For 3 to 5 years, the economy experiences growth, then for another
3 to 5 years, it faces contraction or recession.
• GG’ is the steady growth line, to show that the general trend is that
of growth.
Phases of Business Cycle
Contd.

 Expansion: when all macro economic variables like


output, employment, income and consumption increase.
 Prices move up, money supply increases, self reinforcing feature of
business cycle pushes the economy upward.
 Peak: the highest point of growth; referred to as boom.
 Stage beyond which no further expansion is possible,
 Sees the downward turning point.
 Contraction: means the slowing down process of all
economic activities.
 Trough: the lowest ebb of economic cycle.
 Followed by the next turning point in the cycle, when new growth
process starts afresh.
Concepts of Multiplier and Accelerator
Keynesian Multiplier
 Referred to as autonomous expenditure multiplier or investment multiplier.
 Depicts the relationship between changes in national income due to
change in autonomous investment.
 Income Function: Y=C+I=E
 Consumption is a linear function of national income:
where (>0) is autonomous consumption. C = C + cY
Marginal
C propensity to consume (MPC) is the measure of effect of change
in total income on the keenness of people to spend on consumption.
As Y increases C increases, but increase in C < increase in Y.
dC
Marginal Propensity to =Save (MPS) is a measure of the effect of change in
MPC
dY
total income on the keenness of people to save.

MPC + MPS =1. Since 0< MPC<1, 0<MPS= (1-c)<1


dS
MPS =
dY
Multiplier

 A multiplier measures the


Y=E effect of certain amount of
capital investment on total
E = C + I'
Consumptio

Investment

E’ employment or total income or


E = C + c Y+ I total consumption.
n&

 Thus a change in income due


E C = C + cY
to change in investment is
dI given by the multiplier (k).
dY 1 1
k= = =
I =I d I 1 − mpc mps
O  Multiplier is the reciprocal of
National
dY=
1
dI Income marginal propensity to save.
1− c  Since 0<MPC<1, the multiplier
Multiplier Effect is always greater than one.
Accelerator
 Acceleration principle: Changes in the demand for consumer goods
bring about wider changes in the production of appropriate capital
goods.
 formulated by J. M. Clark.
 Accelerator measures the relationship between changes in
investment due to change in national income.
Assumptions
 Full utilization of the total stock of capital takes place keeping no
idle capacity.
 A fixed capital output ratio.
 Supply of capital stock is perfectly elastic.
 Increase in total output or income does not change in the structural
composition of aggregate output.
 If the optimum capital stock is more than the actual stock, more
investment needs to be pumped into the system.
Acceleration Principle
 Let v be the optimal stock of capital per unit flow of output at time
period t.
 Therefore, Kt = vYt where v is a positive constant and Kt is the
optimum capital stock required to produce an output
Yt at period t.
 For the time period (t-1) Kt − 1 = vYt − 1
 If the output in period t is more than output in period (t-1), then the
total capital stock is fully utilized.
 This induces the need for new investment (It ), which is defined as
the change in capital stock. Hence:
Kt − Kt − 1 = vYt − vYt − 1
∆ Kt = v(Yt − Yt − 1)
It = v(Yt − Yt − 1)
It = v∆Yt
∆ Kt
v =
∆ Yt
 The accelerator coefficient v is the incremental capital output ratio.
Interaction of Multiplier and Accelerator
 Formulated by the post Keynesian economists like Paul Samuelson
and others.
 Following figure shows the interaction of Multiplier and Accelerator

Increase in Increase in
income induced Magnified
Increase in through the investment increase in
autonomous multiplier through the aggregate
Investment output and
accelerator
1 income
dY = dI
1− c It = v∆ Yt
Causes of Business Cycles
Explanations given to explain economic cycles:
 Climatic changes such as sunspots that may cause
different moods.
 Psychological aspects of entrepreneurs and consumers,
such as moods of optimism and pessimism.
 Monetary phenomenon like changes in money supply,
rate of interest, etc.
 Economic factors, such as over investment, under
consumption and over savings.
 Shocks in the conditions under which producers supply
goods such as technological breakthroughs.
Keynes’ Theory
 Keynes is credited with presenting a systematic analysis of
role of investment in causing business cycles
 Economic fluctuations are due to changes in rate of
investment
 Rate of investment depends upon:
 rate of interest, which remains stable in the short run
 marginal efficiency of capital ( MEC).
 Keynes introduced the concept of ‘marginal efficiency of
capital’ (mec) to explain the expected rate of return on
investment.
 marginal efficiency of capital depends upon
 changes in prospective yield
 supply price of capital goods which does not change in the short run.
 Entrepreneurial expectations and the psychological aspect
of business that determine prospective yields.
Keynes’ Theory
Contd.

 With increase in entrepreneurial


expectations the marginal efficiency of
Rate of capital increases
Investment  Hence entrepreneurs make huge
investments (upward turning point)
 The multiplier starts its action, bringing
Marginal Rate of an increase in income, which is much
efficiency of Interest higher than increase in investment, this
capital is the multiplier effect.
 Expansion phase

Supply price  Abundance of capital goods reduces


Prospective
of Capital marginal efficiency of capital, which
yield discourages further investment.
goods
 Downward turning point)
Entrepreneurial  Reverse action of multiplier.
expectations
Hicks’s Theory
 Hicks demonstrated through mathematical models how the
interaction of multiplier and accelerator could bring several
types of fluctuations in total output.
 There is a full employment ceiling beyond which the economy
may not grow.
 In Hicksian model, three concepts play important role:
 Warranted rate of growth
 Sustains itself in congruity with the equilibrium of saving and
investment
 Autonomous and Induced investment
 Autonomous investment includes public investment, investment
which occurs in direct response to inventions, and other long range
investment.
 Induced investment depends upon changes in the level of output or
income; thus it is a function of an economy’s growth rate.
 Multiplier and accelerator
 Fundamental causation of the trade cycle is in the multiplier
accelerator relationship
Hicks’s Theory Contd.
F’ 4 levels of economic activity:
GNP
(%) S T •AA’ is determined by autonomous
E’ investment.
F •LL’ is the floor line which shows
L’ income level determined by
E R M N autonomous investment and multiplier.
A’ •EE’ is the equilibrium path of income
L and output.
•FF’ is the full employment ceiling,
A where all the productive resources are
O fully utilized in gainful activity.
Time (years)
 At R on EE’, an outburst of investment via the multiplier accelerator interaction,
pushes the economy to S on FF’, RS shows the expansion phase.
 The economy crawls at FF’ from S to T. Rate of growth of output between RS
and ST is very different this results in downward turning point at point T.
 This slackening of growth rate causes a fall in induced investment, the economy
slides further down to LL’ line, TM is the contraction phase.
 Economy crawls at LL’ from M to N. Process of recovery starts between M and
N; autonomous investment is greater than declining investment prior to M.
Acceleration effect operates again. The cycle will be repeated.
Hicks’s Theory:Multiplier Accelerator
Interaction Contd.

Period Autonomous Induced Induced Increase in Business


(1) Investment Consumption Investment Income Cycle Phase
(2) (3) (4) (5) =(2+3+4)
1 100 0 0 10Expansion
2 100 67 134 301
3 100 200 266 566
4 100 378 356 834
5 100 556 356 1012
6 100 675 238 1013Full
employment
7 100 518 20 778Contraction
8 100 346 -100 518
9 100 230 -100 346
Assumptions
 Autonomous investment in the economy is Rs. 100 million
 MPC is 2/3 and accelerator is 2.
Hicks’s Theory: Basic Assumptions Contd.
 The economy is progressive, in which autonomous investment is increasing
at a regular rate.
 The saving and investment coefficients are distributed over time, so that any
upward movement from the equilibrium path results in displacement from
equilibrium, though it may be lagged.
 Production cannot exceed the full employment ceiling.
 Working of the accelerator in an economy on the downswing is different from
its working while the economy is in the upswing.
 There are fixed values for the multiplier and the accelerator throughout the
different phases of a cycle.
 Disinvestment cannot exceed depreciation because transformation of
accelerator in the downsizing provides indirect constraints.
Real Business Cycle Theory
 Explored by John Muth (1961) and others.
 The ups and downs are caused by technology or other similar shocks
to the supply side of the economy.
 Highlights the importance of supply side of business.
 Reflects the outcome of rational decisions made by many individuals.
 Postulates that:
 A boom will occur with an invention of a productivity increasing device,
entrepreneurs increase investment, expand output and employ more
people.
 A recession will occur with new advances lacking, or productivity low, and
at that point employers rationally choose not to produce as much.
 Although booms are nicer than recessions, but there is no need to
react to either, as they represent the best use of the opportunities
available.
 The theory has not attracted much empirical support.
Effects of Business Cycles
During Expansion
 High growth: large investments, increase in employment, income and
expenditure
 Inflation: Increase in investment forces more money supply in the
system, demand for factor inputs increases, hence their prices increase
which increases cost of production. So wages and prices of goods also
increase.
 Severe Competition: Firms resort to large amount of non productive
expenditure on advertisements and publicity.
During Recession
 Unemployment, excessive inventory, below capacity operations and
liquidation of firms.
 Excess inventory: Those firms which had produced in abundance during
expansion phase face the problem of maintaining unsold items.
 Retrenchment: in order to reduce investment, recession phase is
marked by large scale retrenchment.
Controlling Business Cycles
At Firm Level
 Precautionary Measures: to be taken at the time of
expansion
 Investments: deter from investing huge amount of funds in
fixed assets.
 Inventory: should not create large inventory of raw material or
finished goods.
 Products: diversify in different markets and different products,
so that risk is diversified.
 Curative Measures: to be taken at the time of
recession
 Pricing: Flexibility should be the right strategy, so that during
recession prices may be adjusted to increase demand without
eating away the margins.
Controlling Business Cycles
At Government Level
 Monetary Measures: Central bank uses methods of credit control.
 Rediscount rate:
 Expansion: increase the rediscount rate to curb money supply
 Recession: reduce the rate to increase money supply.
 Reserve ratios:
 Expansion: the ratios are increased so that banks are left with less
cash to be extended as credit
 Recession: the ratios are decreased so that banks can extend easy
credit.
 Two major reserve ratios are SLR and CRR
 Open market operations:
 Expansion: sells securities and takes away disposable income from
people.
 Recession: buys securities to give more in the hands of people
 Selective credit control:
 Banks are advised to extend credit to certain areas, while restrict to
certain other areas.
Controlling Business Cycles
Contd.
 Fiscal Measures
 Public expenditure
 Expansion: Government reduces expenditure to curtail
demand
 Recession: Government increases expenditure on various
activities like health, transport, communication, etc., thus
income of individuals increases; this in turn increases
aggregate demand.
 Public revenue
 Expansion: An increase in taxes takes away portion of
people’s money income and thus brings down aggregate
demand.
 Recession: It is desirable that governments reduce taxes.
 An appropriate combination of these measures is adopted
after thorough examination of the causes of business cycles.
Summary
• Business cycle is the periodic up and down movement in economic activities,
measured in terms of production, employment and income move in a cyclical
manner over a period of time.
• It is characterized by alternative waves of expansion and contraction, and is
associated with alternate periods of prosperity and depression.
• It has three basic characteristics: periodicity, synchronism and self reinforcing.
• It can be studied in four phases: expansion, peak, contraction (recession),
trough (depression) and two turning points, upward and downward.
• Expansion is a phase when all macro economic variables like output,
employment, income and consumption increase. Peak or boom is the stage
beyond which no further expansion is possible, and it sees the downward
turning point.
• Contraction implies slowing down of all economic activities; it marks the onset of
recession. Slump or depression is the lowest ebb of economic cycle, followed by
the next turning point in the cycle, when new growth process starts afresh.
• Keynes proposed that economic fluctuations are basically due to changes in
rate of investment, which depends upon two factors: rate of interest and
marginal efficiency of capital.
• Hicks combined the approaches of Keynes, Samuelson, Harrod and Domar, and
demonstrated through mathematical models how the interaction of multiplier and
accelerator could bring several types of fluctuations in total output.
Summary
• According to Hicks, the interaction between multiplier and accelerator fabricates economic
fluctuation around the warranted rate of growth.
• The real business cycle theory associates business cycles with rational expectations,
and proposes that the ups and downs are caused by technology or other similar shocks to
the supply side of the economy.
• Inflation is a necessary evil that comes with expansion; it is a by product of growth and
expansion. Therefore governments are busy controlling inflation during expansion phase.
• Recession is unwarranted and creates negative implications for the economy; during this
phase, the basic problems that occur are that of unemployment, excessive inventory,
below capacity operations and liquidation of firms.
• Business cycles create problem for the economy. Hence governments constantly keep a
watch on macro variables so as to contain either over heating or over dampening of
economic activities. Measures to control business cycles can be categorized as
preventive and curative measures.
• Not only governments but also the corporate sector plays a vital role in taking such
measures which help reducing the ill effect of cycles. At government level these can be
categorized into monetary and fiscal measures.
• In the expansion phase firms, which take preventive measures remain in competition.
Similarly firms should plan in such a way that their losses during recession are minimized.
• Just as preventive measures are taken during expansion phase, similarly corrective
measures are taken during recession phase.

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