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Business Cycle

Dr. Gopalakrishna B.V.


Faculty in MBA,
SDM College,
 Business cycle or trade cycle is a part of the
capitalistic economy.
 The business cycle refers to fluctuation in
economic activities such as levels of income,
employment, prices and output, occurs more or
less in regular time sequences.
 Business cycle is characterised by upward and
downward movement of economic activities.
 In a business cycle, there are wave-like
fluctuations in aggregate employment, income
output and price level.
Definitions
 Prof. Haberler’s defines “an alternation of periods of
prosperity and depression of good and bad trade”.
 J.M. Keynes “it composed of periods of good trade
characterised by rising prices and low employment
percentage, altering with period of bad trade
characterised by falling prices and high
unemployment percentage”.
 Gordon’s define “business cycles consist of
recurring alternation of expansion and contraction in
aggregate economic activities in the economy”.
 Estey “cyclical fluctuations are characterised by
alternating waves of expansion and contraction”.
Characteristics of Business cycle

1. Business cycle is a part of the capitalist economy.


2. Cyclical fluctuations are wave – like movements.
3. Fluctuations are recurrent in nature
4. They are non-periodic or irregular – the peak and
troughs do not occur at regular intervals.
5. They occur in such aggregate variables as output,
income, employment and prices.
6. Upswings and downswings are cumulative process
in their effects.
7. They are not secular trends such as long-run growth
or decline in economic activity.
Phases/stages of Business cycle
 A typical cycle is generally divided into
five phases
1. Depression
2. Recovery
3. Full employment
4. Prosperity
5. Recession
1. Depression
 Recession merges into depression when there is a general
decline in economic activity.
 There is considerable reduction in the production of goods
and services, employment, income, demand and prices.
 The general decline in economic activity leads to a fall in
bank deposits.
 When credit expansion stops, even business community is
not willing to borrow.
 Thus, a depression is characterised by mass unemployment
– general fall in prices, wages, profits, interest rate,
consumption expenditure, investment – bank loans and
advances falling – factories close down – capital goods
industries are also closed down.
 During this phase, there will be pessimism leading to
closing down of business firms.
2. Recovery
 Recovery denotes the turning point of business
cycle from depression to prosperity.
 There is a slow rise in output, employment, income
and price – demand for commodities go up
steadily.
 There is increase in investment – bank and
financial institutions are also willing to granting
loans and advances.
 Pessimism gives way to optimism.
 The process of recovery becomes combative and
leads to prosperity.
3. Prosperity
 In this period, demand, output, employment and
income are at a high level, they tend to raise prices.
 But wages, salaries, interest rates, rentals and
taxes do not rise in proportion to the rise in prices.
 The gap between prices and cost increases - the
margin of profit increases.
 The increase of profit and the prospect of its
continuance commonly cause a rapid rise in stock
market values.
 The economy is engulfed in waves of optimism.
 Larger profit expectation further increase –
investment which is helped by liberal bank credit.
 This leads to peak or boom.
4. Recession
 Recession starts downward movement of economic
activities from peak/boom.
 It is a state in which there is general deceleration in the
economic activity resulting in cuts in production and
employment falling prices of stock market.
 Banking and financial institutional loans and advances
beginning to decline.
 As a result profit margins decline further because costs
starts overtaking prices.
 Recession may be mild/severe – it lead to a sudden
explosive situation emanating from banking system and
stock markets.
 Such experience of the United States in 1873, 1893,
1907, 1933 and 2007.
Expansions and Recessions in US
Period of Expansion Length (in months) Period of Recession Length (in months)

Oct.1949-Jul.1953 44 Jul. 1953 – May 1954 10

May 1954-Aug. 1957 39 Aug. 1957 – Apr. 1958 9

Apr. 1958-Apr. 1960 24 Apr. 1960 – Feb. 1961 10

Feb. 1961- Dec. 1969 105 Dec. 1969 – Nov. 1970 10

Nov. 1970- Nov. 1973 36 Nov. 1973 – Mar. 1975 16

Mar. 1975- Jan. 1980 58 Jan. 1980 – Jul. 1980 6

Jul. 1980- Jul. 1981 12 Jul. 1981 – Nov. 1982 16

Nov. 1982- Jul. 1990 92 Jul. 1990 – Mar. 1991 9

Mar. 1991- Mar. 2001 120 Mar. 2001 – Nov. 2001 8

Nov. 2007
Theories of Business cycles

1. Hawtrey’s monetary theory


2. Hayek’s monetary over investment theory
3. Schumpeter’s innovations theory
4. The psychological theory
5. The Cobweb theory
6. J.M. Keynes business theory
7. Samuelson’s model of business cycle
8. Hick’s theory of business cycle
1. Hawtrey’s monetary theory

 According to Prof. R.G. Hawtrey – business


cycle is a purely monetary phenomenon.
 It is changes in the flow of monetary demand on
the part of businessmen that lead to prosperity
and depression in the economy.
 The cyclical fluctuations are caused by
expansion and contraction of bank credit which,
in turn lead to variations in the flow of monetary
demand on the part of producers and traders.
 Credit is expanded or reduced by the banking
system by lowering or raising the rate of interest
or purchasing or selling securities to merchants.
 This increases or decreases the flow of money in
the economy and thus brings about prosperity or
depression.
 Expansion phase – bank credit increases –
lending rate of interest falling – encourages to
borrower to borrow money in large scale – rate of
interest will decline – credit become cheap –
stocks/inventories – peak/boom
 Contraction phase – bank credit decreases –
lending rate of interest increases – borrower
reduces loans – cost of loans become costlier –
production falls etc.
2. Hayek’s monetary over – investment theory

 F.A. Hayek’s formulated monetary over-


investment theory of trade cycle.
 He explained his theory on the basis of
distinction between the natural interest rate and
market interest rate.
 The natural rate of interest is that rate at which
the demand for learnable funds equal the supply
of voluntary savings (loans = savings)
 Market rate of interest is the money rate at which
prevails in the market and is determined by the
demand and supply of money.
 According to Hayek as long as the natural rate of
interest are equals the market rate of interest – the
economy in the state of equilibrium and full
employment existence – no places for trade cycle.
 The trade cycles in the economy are caused by
inequality between market rate of interest and natural
rate of interest.
 When the market interest rate is less than the natural
rate, there is prosperity in the economy.
 On the other hand, when the market interest is more
than the natural rate, the economy is in depression.
3. Schumpeter’s innovations theory
 The innovations theory of trade cycles is associated with
the name of Joseph Schumpeter.
 According to him, innovations in the structure of an
economy are the source of economic fluctuations.
 Trade cycles are the outcome of economic development
in a capitalist society.
 Schumpter approach involves two stages –
• First stage – deals with initial impact of innovation
• Second stage – follows through reactions to the original impact
of innovation.
 When the economy is in equilibrium where every factor
fully employed – cost = receipts – product price =
average and marginal cost – profit and interest are zero
– no savings and investments – circular flow.
 Schumpeter theory starts with the breaking up of the
circular flow by an innovation in the form of a new
product by entrepreneur for earning profits.
Schumpeter’s innovations theory…….
An innovation may consists of –
1. The introduction of a new product
2. The introduction of a new method of production
3. The opening up of a new market
4. New sources of raw-materials or semi-manufactured
goods and
5. New organizations of an industry.
 Changes in technology and expansion of bank
credit.
 Trade cycle starts with equilibrium.

Upward movement from equilibrium are prosperity
and recession.

Downward movement equilibrium to depression and
revival.
4. The Psychological theory
 The psychological theory of business cycle has been
developed by Prof. A.C. Pigou.
 He explain the phenomenon of business cycle on the
basis of changes in the psychology of industrialists
and businessmen.
 According to Pigou, expectations (optimistic and
pessimism) originated from some real factors such as
good harvests, wars, natural calamities, industrial
disputes, innovation etc.
 The cause of business cycle into two categories 1.
inpulses 2. conditions.
1. Inpulses – refers to those causes which set a process in
motion
2. Conditions – the vehicles through which the process passes
and upon which the impulses act.
5. The Cobweb theory
 The cobweb theory of business cycles was
advocated by Prof. Schultz in 1930, latter it
was fully developed by Prof. Kaldar,
Tinbergen and Ricci.
 The cobweb model is used to explain the
dynamics of demand, supply and price over
long period of time.
 The movement of up and down of prices and
output of the commodities causes for
business cycle.
6. Keynes theory of trade cycle
 Keynes does not develop a complete and pure
trade cycle.
 According to Keynes effective demand will
influence on fluctuations in economic activities.
 These effective demand consist of aggregate
demand function and aggregate supply function.
 Aggregate demand function consists –
consumption and investment expenditure.
 Aggregate effective demand determines the
level of income and employment.
 Keynes believes that consumption expenditure
(short period) is stable and it is fluctuation in
investment expenditure which is responsible
for changes in output, income and
employment.
 Investment depends on rate of interest and
marginal efficiency of capital.
 Since rate of interest is more or less stable
marginal efficiency of capital determines the
level of investment.
 These MEC depends on two factors such as
perspective yield and supply price of the
capital asset.
Keynes theory of trade cycle……

 An increase in MEC will create more


employment, output and income leads to
prosperity.
 On the other hand, a decline in MEC leads to
unemployment and fall in income and output,
this result – depression.
 During the period of expansion businessmen are
optimistic – where MEC is rapidly increases – so
entrepreneurs undertake new investment – the
process of expansion goes on till boom is
reached.
 While, on the other hand, if MEC is falling
– profits level are also falling – price of
raw-material equipment cost falls – wages
also go down – this leads to depression.
 Keynes explain business cycle with
reference to two kinds of turning points
 Upper turning point – consists of
recovery and boom/peak.
 Lower turning point – depression and
recovery etc.
Control of Business Cycle
 Economic statilisation is one of the main
remedies to effective control of business cycle.
 Economic stabilizations is not merely confined
to single sector of an economy but embraces
all the sectors.
 There are three ways by which a business
cycle can be controlled.
1. Monetary Policy
2. Fiscal Policy
3. Automatic Stabilisers
1. Monetary policy
 Monetary policy as a method to control business
fluctuations is operated by the central bank of country.
 Monetary policy mainly concerned with money supply,
bank credit and interest rates.
 The central bank can adopts a number of methods to
control the business cycle with the help of quantitative
and qualitative credit control.
 Dear money policy – during boom/peak it raises its
bank rate policy, sells securities in the open market
operation and raises the cash reserve ratio and adopts
number of selective credit control.
 Cheap money policy – during recession/depression –
reduces the bank rate policy and interest rates of banks
– and also buys securities in the open market, reduces
cash reserve ratio etc.
2. Fiscal policy
 Monetary policy alone cannot check business cycle.
Therefore, economists like JM Keynes and Hansen &
many others have recommended that fiscal policy can be
bring about stabilisation of business cycle.
 Fiscal policy is a policy of government which is
concerned with public expenditure, taxation and public
borrowing.
 These three instruments have to be effectively utilised to
control the severity of boom and depression.
 During the period of recession and depression,
government should reduces taxation substantially,
increases of public expenditure – public works – social
and economic infrastructure. Repayment of loans to
public - deficit budgeting
 In times of boom, government should raises tax rates,
levy new taxes, reduces public spending and public
borrowing – following surplus budgeting
3. Automatic Stabilisers
 When economics fluctuation takes place in
the economy, the available monetary
policy and fiscal tools cannot be geared
quickly to set right the imbalance. Then
automatic stabilizers become the
prominence.
 Automatic stabilizers should be used as
supplemented with fiscal and monetary
policies.
 Automatic stabilizers are also called as
built-in-stabilizers – it is proportion to the
rise and fall of economic activity.
 The progressive taxation and unemployment
insurance schemes are the two important tools
measures the automatic stabilizers in the
economy.
 During periods of prosperity or boom the
employers pay taxes more and withdrawing
unemployment benefits.
 While, during period of depression – government
allowed to provision of unemployment benefits,
and lowers the taxes and increasing public
expenditure.
 Thus, the flow of money is regulated
automatically from the people to the government
in times of both boom and depression.