Business Cycle

ByManickarajRamkumar

DEFINITION• The business cycle or economic cycle refers to the

fluctuations of economic activity about its long term growth trend.

• The cycle involves shifts over time between periods of relatively rapid growth of output (recovery and prosperity), and periods of relative stagnation or decline (contraction or recession).

• These fluctuations are often measured using the real gross domestic product

• Perodic up’s and down’s movement in economic activity

BUSINESS CYCLE CURVE

STAGES OF BUSINESS CYCLE• Boom :

- Results from too much spending. - Economy experiences rapid inflation - Factors of production become expensive

• Recession :

- Results from too little spending. - GDP is falling - Demand in the economy will fall leading to closure of firms and unemployment

Slump :

- High level of unemployment. - Business will rapidly close down creating serious consequences for the economy

• Growth/Recovery :

- GDP is rising

- Unemployment is falling - Business are experiencing rising profits - ‘Feel good’ factor among the people as their incomes are rising

FEATURES OF BUSINESS CYCLE

• PERIODICITY:

Occurs in 6 to 12 years

The gap between two cycles is not certain

• SYNCHRONIZATION:

Interdependence of sectors leads to slowdown in one sector affects the other sector

• SELF ENFORCING:

Most critical features of business cycle

Cyclical movements in one sector spreads to other sector

TYPES OF BUSINESS CYCLE• The Short Kitchin Cycle :

It is also known as the minor cycle, which is of approximately 40 months duration

on the basis of on the basis of his research that a major cycle is composed of two or three minor cycles of 40 months research that a major cycle is composed of two or three minor cycles in 1923

• The Long Jugler Cycle :

This cycle is also known as the major cycle. It is defined “as the fluctuation of business activity between successive crises.”

This cycle is also known as the major cycle. It is defined “as the fluctuation of business activity between successive crises.”

• The Very Long Kondratieff Cycle :

In 1925, N.D. Kondratieff, the Russian economist, came to the conclusion that there are longer waves of cycles of more than 50 years duration, made of six Jugler cycles

A very long cycle has come to be known as the Kondratieff wave

Kuznets Cycle :

This cycle occurs in the intervel of 7 to 11 years

Post-World War II Recessions

Another Look at Expansions and Recessions

Changing nature of the Indian business cycle from 1950 - 2010• Our focus is to compare India's business cycle in the pre

1991 economy, with the post 1991 Indian economy, after the large scale liberalization reforms of 1991

COMPARISON OF INDIAN BUSINESS CYCLE BETWEEN POST REFORM AND PRE-REFORM

Introduction of trade cycle

• It is a cyclic process

• It refers to ups and downs in the level of economic activity

• It is a period during which trade expands then slow down and then expands again

• Time gap between two trough ( or peaks) will vary between 6 to 12 years

TERMS TO REMEMBER• Marginal Propensity to consume ( MPC ) :

It is the measure of change in total income on the keenness of people to spend on consumer goods

MPC = =

• Marginal propensity to save ( MPC )

It is measure of change in total income on keenness of people to save

MPS = =

TERMS TO REMEMBER• Multiplier :

A multiplier measures the effect of certain amount of capital investment on total employment or total income or total consumption

k =

Example :

If MPC (consume) = 2/3 ; MPS ( save) = 1/3 ; Multiplier = 3

If MPC (consume) = 1/3 ; MPS ( save) = 2/3 ; Multiplier = 1.5

If investment increases in a business, its growth will be high

TERMS TO REMEMBER• Accelerator :

Changes in demand for consumer goods bring about wider changes in the production of appropriate capital goods

Theories of trade cycle/business cycle Climatic or Sunspot theory

Keynes’ theory

Hick’s Theory

Hawtrey’s monetary theory

Innovation theory

Over-investment theory

Over-production theory

Sunspot theoryTrade cycles are caused by sun spots.

Sunspots appear on the face of the sun.

Almost at regular intervals of 10.4 years

SPOT APPEARS

SUN EMITS LESS HEAT

CROP YIELD WILL BE LOW

INCOME OF FARMER FALLS

LESS PURCHASING POWER

Drawback

• Based on only agro based theory

• Good or bad crop can only be one factor of depression or expansion but they cannot account for all the features

• The trade cycle occur at regular intervals of 10.4 years, while length of the trade cycle is 7 to 8 years

Keynes’ theory

• Deals with fluctuations in income, employment and money

• concept of Marginal Efficiency of Capital(MEC)

Example: buying of a machinery- how much return will we get in the coming years

MEC:- where price of capital=yield from capital

FACTORS• Rate of investment depends upon

Rate of interest

Marginal efficiency of capital

• Entrepreneurial expectations

Pessimistic

Optimistic

Rate of investment

Prospective yield

Marginal efficiency of

capital

Rate of interest

Entrepreneurial expectations

Supply price of capital

goods

Keynes’ theory• Govt expenditure helps the economy to recover

• Growth path cannot continue indefinitely. Excess inventory of capital goods brings pessimistic feelings in entrepreneurs who fear recession, which discourages further investment

• Example :

$100 million dam Project;

10,000 people employed (increases demand for consumer goods)

30,000 people in different sectors gets benefit whose combined income is say 250 million

Vice versa also happens

Hick’s Theory• Occurs due to interaction of multiplier and accelerator

• Super multiplier

• Upswing is the outcome of multiplier and accelerator

• downswing is the outcome of multiplier alone, since accelerator remains inactive

• Upper turning point is affected by elements like population, technology, capital stock

• At lower turning point there is increase in net investment, turning cycle upwards

Hick’s Theory• Warranted rate of growth : is the one that will sustain itself in

congruity with equilibrium of saving and investment

• Autonomous investment :

Direct response to invention

Long range investment

• Induced investment : Level of income

• Multiplier and Accelerator : Time Lag

Consumption of current year is a function of income of last year ( ex: buying a car) . With a lag of 1 year

Investment is function of output of same year

HAWTREY’S MONETARY THEORY• This trade 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

• He opines that non-monetary factors like strikes, floods, earthquakes, droughts, wars, etc. may at best cause a partial depression, but not a general depression.

HAWTREY’S MONETARY THEORY GROWTH PHASE

• The expanded phase of the trade cycle starts when banks increase credit facilities. 

• They are provided by the reducing the lending rate of interest and by purchasing securities

•  These encourage borrowings on the part of merchants and producers. This is because they are very sensitive to changes in the rate of interest. So when credit becomes cheap, they borrow from banks in order to increase their stocks or inventories.

•  For this, they place larger orders with producer who, in turn, employs more factors of production to meet the increasing demand. Consequently, money incomes of the owners of factors of production increase thereby increasing expenditure on goods. The merchants find their stocks being exhausted.

HAWTREY’S MONETARY THEORY• BOOM PHASE

• They place more orders with producers. This leads further increase in productive activity, in income, outlay, demand and a further depletion of stocks of merchants

• According to Hawtrey, “Increased activity means increased demand, and increased demand means increased activity. A vicious circle is set up, a cumulative expansion of productive activity.”

• As the cumulative process of expansion continues, producers quote higher and higher prices. Higher prices induce traders to borrow more in order to hold still larger stocks goods so as to earn more profits.

• Thus optimism encourages borrowing, borrowing increases sales, and sales raise optimism.

HAWTREY’S MONETARY THEORY RECESSION PHASE

• According to Hawtrey, prosperity cannot continue limitlessly. It comes to an end when banks stop credit expansion.

• Banks refuse to lend further because their cash funds are depleted and the money in circulation is absorbed in the form of cash holdings by consumers.

• Another factor is the export of gold to other countries when imports exceed exports as a result of high prices of domestic goods.

• These factors force the banks to raise interest rates and refuse to lend.

• Rather, they ask the business community to repay their loans. This starts the recessionary phase. In order to repay bank loans, businessmen start selling their stocks. This sets the process of falling prices. They also cancel orders with producers.

HAWTREY’S MONETARY THEORY SLUMP PHASE

• This, in turn, leads to reduction in the demand for factors of production. There is unemployment. Incomes fall.

• Falling demand, prices and incomes are the signals for depression. Unable to repay bank loans, some firms go into liquidation thus forcing banks to contract credit further. Thus the entire process becomes cumulative and the economy is forced in to depression.

• According to Hawtrey, the process of recovery is very slow and halting. As depression continues, traders repay bank loans by selling their stocks at whatever prices they can.

• As a result, money flows into the reserves of banks and funds increase with banks

Disadvantage• Trade cycle is not purely monetary phenomenon

• It is world wide phenomenon

Real business cycle• Business cycle are driven entirely by technology shocks

rather than by monetary or changes in expectations

• If there is an invention, productivity will increase and business people invest more on that. It leads to boom

• If there is lack of invention, the productivity will decrease

Innovation theory• Innovation can be of various types

1-new product

2-new market

3-niche market

4-new technology

5-new source of raw material

Innovation theory• Innovation leads to more production

• Ultimately increase in aggregate demand

• Further increase in income of business

Drawback of innovation theory The full employment assumption is unrealistic.

Bank is not the only source of finance for every innovation in business.

Many times the profits are ploughed back to finance innovations.

Innovation cannot be the sole cause of business cycle.

Over prod. theory• If economic system is capitalism,all the entrepreneurs

wants to produce goods which are profit making

• Leads to high competition because of entry of new firms

• Profit making possibility : high

• Due to over production activity, initially everything increases

Cont’d Thereafter as a result firms starts withdrawing resulting in

Less demand

Less income

Less production

Less labour

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