Business Cycle

Business Cycle: Meaning

Most of the capitalist countries that have
registered growth in their national income,
standard of living etc, do not show a steady
and smooth upward trend. For a certain time
all the indicators like income, consumption,
price level etc show a rising trend. After a
certain period the same indicators show a
falling trend.

Business Cycle: Meaning

The period of rising income, employment,
output etc. has been called expansion,
boom, upswing or prosperity.
The period of falling income, employment,
output etc has been called, contraction,
recession, downswing, depression.
These alternating periods of expansion
and contraction in economic activity
has been called business cycle.

Business Cycle
The Business Cycle allows people to
understand the direction the economy
(GDP) is going (growing or shrinking) and
plan accordingly.
The economy follows the Business Cycle
regularly.

Phases of the Business Cycle

Expansion (Growing)
Peak (Top)
Contraction (Shrinking)
Trough (Bottom)

Business Cycle
Peak

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Trough

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Peak

Expansion
During a period of expansion:
Wages increase
Low unemployment
People are optimistic and spending money
High demand for goods
Businesses start
Easy to get a bank loan
Businesses make profits and stock prices
increase

Peak
When the economic cycle peaks:
The economy stops growing (reached the top)
GDP reaches maximum
Businesses cant produce any more or hire
more people
Cycle begins to contract

Contraction
During a period of contraction:
Businesses cut back production and layoff
people
Unemployment increases
Number of jobs decline
People are pessimistic (negative) and stop
spending money
Banks stop lending money

Trough
When the economic cycle reaches a
trough:
Economy bottoms-out (reaches lowest point)
High unemployment and low spending
Stock prices drop

But, when we hit bottom, no where to go but

up!
UNLESS.

Recession/Depression
A prolonged contraction is called a
recession (contraction for over 6 months)
A recession of more than one year is
called a depression

What keeps the Business Cycle

Going?
4 variables cause changes in the
Business Cycle:
1. Business Investment

When the economy is expanding, sales and

profit keep rising, so companies invest in
new plants and equipment, creating new
jobs and more expansion. In contraction, the
opposite is true

What Keeps the Business Cycle

Going?
2. Interest Rates and Credit
Low interest rates, companies make new
investments, adding jobs. When interest
rates climb, investment dries up and less job
growth

3. Consumer Expectations
Forecasts of an expanding economy fuels more
spending, while fear of a recession
decreases consumer spending

What keeps the Business Cycle

Going?
4. External Shocks
External Shocks, such as disruptions of the oil
supply, wars, or natural disasters greatly
influence the output of the economy
Ex. 1992-2000 was the longest period of
expansion in U.S. history. Early in 2001,
signs of contraction appeared, though the
Bush administration denied it. The Sept. 11th
2001 terrorist attacks quickly caused the
business cycle to shift into a contraction.

Who Cares?????
Why should you care about the business
cycle and economy?
Lots of reasons!

Dont quit that job!

If the economy is going into a contraction,
jobs will become more scarce. If you quit,
you may not find another job!
But, if the economy is in a period of
expansion, jobs are readily available. It
may be a good time to switch careers.

Should I make a big purchase?

Only if you know that you wont lose your
job in a contraction. So, buy your house
during an expansion.
HOWEVER,
When the economy starts to slow down
(contraction), interest rates will decrease.
Wait to buy a house until the rates drop to
a low point, if you are sure you wont lose
your job.

Theories of Business cycle

Different theories are given to explain what
causes business cycle.
Hawtreys Theory
This is applicable in the case of country following
gold standard and it is monetary theory. Increase
in the quantity of money raises availability of
bank credit for investment. This is found when
rate of interest is low. The result is higher
demand, higher prices and over all expansion.
Demand for both domestic and imported goods
will rise. In case of trade deficit, there will be
gold outflow

Hawtreys theory
Expansion cannot continue for ever. Outflow of
gold will reduce supply of money and bank
credit. Result is rise in rate of interest and lesser
investment expenditure that will set in
contraction process.
Contraction also will not last for ever. Imports will
fall very much, resulting in trade surplus followed
by inflow of gold. This will again raise the supply
of money and expansion process in due course
of time.
It is concluded that rise and fall in the supply of
money is the basic cause of trade cycle,

Keynesian Theory of business cycle

Income, employment, output depend upon effective
demand (ED). If ED is high then investor will employ
greater amount of resources. On the other hand, if ED is
low, smaller amount of output is required, so we can say
that changes in ED will bring fluctuations in economic
activity.
During expansion phase, MEC is high. This raises
investment, income and employment that includes the
operation of multiplier. During this boom period MEC falls
due to 2 reasons: decline in the rate of MEC and rising
cost of capital.
So after reaching its highest level, contraction begins.

Keynesian Theory of business cycle

During the downturn, investment falls due to
falling MEC. This has cumulative effect on
income and employment. Multiplier operation will
be in reverse direction. This also cannot
continue for ever.
Revival depends on many factors like normal
rate of growth and length of life of capital goods.
More the rate of growth, shorter the depression
and shorter the life of capital goods, shorter the
duration of depression.
The basic cause of trade cycle is the changes in
MEC with respect to rate of interest.

Hicks Theory
According to Hicks, interaction between multiplier
and accelerator result in trade cycle. There are two
types of investment: autonomous and induced.
As per government policies autonomous
investment goes on increasing that causes
operation of multiplier and it results in rise in
income, employment and output. This encourages
induced investment particularly in the capital goods
sector, setting in the operation of accelerator.
Interaction of multiplier and accelerator results in
upswing in trade cycle.

Hicks Theory
Hicks has incorporated in his analysis the
role of buffers. On the one hand, he
introduces output ceiling when all the
given resources are fully employed and
prevent income and output to go beyond
it, and, on the other hand, he visualizes a
floor or the lower limit below which income
and output cannot go because some
autonomous investment is always taking
place.

Hicks Theory
Business cycle occurs over a rising trend of
income. There is an equilibrium rate of
growth over and below which the fluctuation
takes place. Due to operation of multiplier
and accelerator the income increases but
after reaching level of full employment it can
not rise further. It remains at that level for a
while after which it starts falling. Similarly,
after reaching the lowest level, it remains
there for some time and then starts rising
again.