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Business cycle

According to Keynes,” A trade cycle is composed of periods of


good trade characterised by rising prices and low unemployment
percentages, alternating with periods of bad trade characterized by
falling prices and high unemployment percentages.” Mitchell gives even
a more explicit idea of what a business cycle is when he says, “business
cycles are a type of fluctuations found in the aggregate economic
activity of nations that organise their word mainly in business
enterprises. A cycle consists of expansions occurring at about the same
time in many economic activities followed by similarly general
recessions, contractions, and revivals which merge into the expansions
phase of the next cycle; this sequence of change is recurrent but not
periodic…”

In short one can observe that:

(1) Business cycle at the wave-like fluctuations in economic activity as


reflected in the basic economic variables like employment, income,
output and price level.
(2) These fluctuations are cyclical in nature. One must distinguish
between secular trend, random fluctuations, seasonal changes and
cyclical fluctuations. The secular trend represents long run changes
in business activity which occur slowly and are spread over a
number of years. Such long-run changes are the result of factors like
improvement in production techniques, change in population, etc.
random fluctuations are a result of events like labour strike, power
cut, war, drought, flood, etc., which occur suddenly and are
unpredictable. Effect of these events on the economy is limited to
the period of occurrence of the event, as there is no regularity in
their occurrence. Thus, neither the secular trend nor the random
variations in economic activity can form the part of business cycle.
(3) The sequence of changes in business cycle (i.e., recovery,
prosperity, depression and recession)recur frequently and in a fairly
similar pattern.
(4) The rhythm or the periodicity between the cycles need not be
similar.
(5) Business cycles are a type of fluctuations found in the aggregate
economic activity and not in any single firm or industry. In fact, it
connotes the cyclical changes in overall economic environment
affecting all the business entities.

Characteristics of business cycles:


Knight discovered five distinguishing features of business cycles.
These are:

(1) Generally a ‘minor’ cycle has duration of 3 to 4 years. And, 2 or 3


of these cycles go to make up a ‘major’ cycle. Thus, the duration
between major cycles is 6 to 12 years.
(2) It has been empirically found that during a period of prosperity
the business activity is usually 10% to 25% above the long-term
trend, while during depressions it is 5% to 25% below the trend.
(3) Generally, prosperity takes twice as much time to develop as the
depression.
(4) The phases and their sequence is same in all cycles.
(5) It has been found that if the boom is high the succeeding
depression will also be severe. But this relationship may not hold
good in the reverse; that is, a severe depression need not be
followed by a high boom.

The above-mentioned characteristics are based on


actual observations. From a different point of view, we find some
additional characteristics of cycles, like:

(6) In every business cycle there are cyclical changes in the general
price level. But the beginning of prosperity, as also of depression,
is characterized by changes in the prices of stocks and shares,
which appear before any changes appear in the wholesale price of
in total production.
(7) After the changes in prices of stocks and shares, changes take
place in the wholesale prices and in the volume of production.
They appear before changes in the interest rate and wage rate
manifest themselves.
(8) Amongst the commodities, the prices of raw materials fall or rise
earlier than those of final goods.
(9) In general, the retail prices, to a certain extent, lag behind the
wholesale prices in both the prosperity and the depression.

Phases of business cycle:

A business cycle is typically divided into four phases: (1)


the recovery o revival of economic activity, (2) the prosperity or
expansion of the activity, (3) the recession or downturn in the
economic activity, and (4) the depression or contraction in the
economic activity. These phases of business cycle recur with some
sort of regularity and are uniform in case of different cycles.
(1) Recovery:
This is the phase of revival of demand for goods
and services. The economic activity as a whole increase slowly,
although the general prices start rising. The upward movement
of business activity is slow, production picks up, construction
activity is revived and there is a general rise in employment.
This is a period when the industrialists and the businessmen
repay the loans taken by them from the banks earlier and the
frozen stocks held by the banks are released. Stocks of goods
remain below the normal with the shopkeepers.
Banks are liberal in the matter of advances. The
prices recover and tend to reach the normal. The speed with
which the expansion of business activity takes place in
response to a given initial increase in investment, would
depend upon the multiplier effect.
The revival of demand for goods and services may
mainly be due to two reasons:
1. Change in business psychology in favour of optimism; and
2. Fresh public investments in development projects (which
are mainly motivated by non-profit considerations) which
create additional demand for goods and services.

(2) Prosperity:
During this phase there is a rapid cumulative
movement of prices, employment, income and production. The
prices and general business activity is above the normal. Total
output starts growing at a rapid pace due to higher investment and
employment. Prices of finished products rise faster than the
increase in wage-rate, raw material prices and interest rate.
Consequently, producers stand to gain.

The capital goods industry also, thus, experiences a sharp


upturn in its business activity. The peak of prosperity may lead to
over-optimism in business psychology resulting in over-full
employment of resources and raw material, and therefore, leading
to inflationary rise in prices. If it happens it signifies the end of
prosperity phase and the advent of recession in the very near
future. This phase of boom has inherent seeds of recession in the
form of structural constraints of the economy. These constraints are
three of the following

1. Limited availability of labour, raw material, etc. their excess


demand would result in a spiraling rise in their costs compared to the
commodity prices. This brings a decline in profit margins.

2. Excess pressure of demand on capital gives rise to rate of


demand

3. Consumption fails to rise due to increasing commodity prices and


stability in marginal propensity to consume beyond a point of income
increase. This results in piling up of inventories, due to sales lagging
behind production.
The effect of these forces becomes cumulative, thus,
forcing the businessman to be cautious, which after some time
turns into pessimism. Thus, the downturn of the cycle starts.

(3) Recession:
When the business cycle takes a downward turn
from the state of prosperity, the state of recession is said to
have set in. During the phase of prosperity, production
increases with every increase in commodity prices. As more
and more of unemployment labour, capital and raw material
are employed, interest rate, wages and other costs rise with
increasing rapidity.
Profit margins decline further because costs start
overtaking prices. Business psychology becomes depressed
and the boom bursts. There is a struggle for solvency among
the businessmen. Some firms close down while others reduce
production, leading to reduction in investment, employment,
income and demand. This process is cumulative.
There is a collapse of confidence. If not controlled
in the beginning by timely monetary and fiscal measures by
government which can sustain investment at a high level,
recession may give way to even a more grave situation, called
depression.
(4) Depression:
If unchecked, depression is a natural consequence of
the recessionary crisis. Gradually, the process of falling prices,
demand and employment gather momentum. Decrease in
price follows the same sequence as does the price increase in
case of the state of boom.
In this phase, general demand for goods and services
falls faster than the production of goods, though this is more in
case of capital goods than consumer goods.
In general, the bottom of depression is reached when
liquidation of accumulated stocks is completed. Depression is,
thus, characterized by low prices, idle funds with banks, mass
unemployment and slack trade.
The important features to be noted in this
connection are that the different phases follow each other in a
regular sequence; cycles continue one after another. Secondly,
the cycle shows fluctuations in total output and not of any
single commodity or a group of commodities. Lastly, within the
movement of total output, production of capital goods and
durable consumer goods reveal greater fluctuations than the
production of other goods. The main features of the four
phases of business cycle are represented in the form of a table.

The main six causes of business cycle are below:

1. Banking operations plays a vital role. By expanding and contracting


credit creation, changing discount rates, and the ratio between
deposits and cash reserves, the banks can change the volume of
money supply in the economy, and thus, contribute to the cyclical
phenomenon.
2. Changing in the proportion between capital goods and consumer
goods production in the economy can also lead to shortages or
surpluses in commodity supply in the short run. This results in
business cycles.
3. If the purchasing power does not correspond to the expansion or
contraction of production, the market suffers from maladjustments
and, therefore, cyclical fluctuations.
4. The profit mania of producer is also a contributory cause of the
business cycle. This makes the producer too optimistic. He is under
a constant illusion regarding the exact nature and volume of
demand.
5. The human psychology also contributes to the occurrence of
business cycle. Human psychology has a tendency to undergo
frequent changes almost in a cyclical manner-from exuberance to
depression. Optimism and pessimism ‘give birth to one another in
an endless chain’.
6. The cyclical changes in weather also contribute to the emergence of
trade cycles. This, in turn, affects the wage rate, cost of raw
material, etc., thereby contributing to the fluctuations in the
economic activity.

D.H. ROBERTSON’S FOREIGN TRADE MULTIPLIER


Let Y= income

V = home investment

X = exports

M = imports
p = proportion of income spent on home-produced consumption
goods.

q = proportion of income spent on [b] imports.

Then (1) Y = (F+X)/ (1-p) (Harrod’s equation.--Trade cycle).

(2) Y = [F+(X-M)]/ (1-p-q)

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