Business Cycles & Theories of Business Cycles Introduction

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The Predominantly private enterprise economies have over the last one century, faced fairly regular fluctuations in the level of economic activity. Between two world wars, these fluctuations are recurrent and are for five to eight years. Since 1945 onwards, fluctuations have been much less marked mainly because of the counter cyclical policies adopted by the governments. These periodical fluctuations in aggregate economic activity particularly in employment, output, income, Prices etc., which occur with a certain regularity have been named as “ Trade or Business Cycles”. According to Keynes “ A Trade cycle is composed of periods of good trade characterized by rising prices and low unemployment alternating with periods of bad trade charcterised by falling prices and high unemployment.” Business Cycles are visible in Business activity. There are different phases in business cycles. According to Schumpeter, there are FOUR phases in the Business. They are: a) b) c) d) The prosperity Phase The Recession Phase The Depression Phase The Recovery Phase

This BS is just a combination of the two Phases of the above normal activity and below normal activity.

In figure, first half of the cycle is divided into two phases viz the prosperity and Recession characterized by increases in the level of employment and the employment on the decline respectively. When the economy reaches Point ‘B’ the second half of the cycle starts with depression characterized by decline in employment and recovery by increase in employment.

Hicksian Theory of Trade Cycle:
This theory is also called as interaction multiplier and Accelerator. This theory is designed to focus some crucial factors in growth trends and cyclical fluctuations. Multiplier shows the effect of the change in ‘autonomous Investment’ on Income and employment and accelerator shows the effect of a change in consumption or output on Induced Investment. The leverage effect of an initial increase in expenditure upon National Income is not either exclusively due to multiplier and Accelerator. It must be attributed to the combined interaction of two.

In figure, Line ‘AA’ representing autonomous Investment. Given the MPC, the simple multiplier is determined. Then the multiplier and autonomous investment together determine the equilibrium level of national income, shown by the line ‘LL’ Hicks call it as the floor.

Hicks also include induced investment which creates increase in income. When induced investment is present, the super multiplier goes to work. The line ‘EE’ shows the equilibrium time path of national income determined by induced investment and the super multiplier. Finally the Line ‘FF’ is the full employment ceiling which shows the maximum national output of nay period of time.

At the outset, there is full employment ceiling that sets a maximum on national income. There is also a minimum or a floor determined by the Keynesian multiplier and the level of ‘Ia’. The economy bounces back and forth between the ceiling and the floor. This general trend given by the upward slope of ‘Ia’ curve, the interaction of these two forces, gives the Hicks Business Cycles. The Innovative Theory of Trade Cycles: The fundamental cause of fluctuations according to Schumpeter is the periodic bursts of Innovational activity. There is a difference between Inventions and Innovations. While the former involve the discovery of novelties. Innovations consists in the commercial exploitation of new techniques, new methods. Thus innovations are essentially un-periodic and discontinuous and bring in wave like movements in investments, production, employment and income. Now let us see different phases of trade cycles in view of Schumpeter: We start from the position of equilibrium in the economy, where there is no unemployment. Only a few among the entrepreneurs have the intelligence and capacity to make the commercial application of the new possibilities with the use of bank credit. New plants, equipments installed and the construction activity is on increase result in expansion of investment then savings > Investment lead to establishment of new firms. These firms will involve in the bidding up of factor prices which pushes up prices result in more profits, more optimism causes to Boom. The peak of expansion is characterized by the innovators ceasing to innovate, but production will continue and competition between old and new entrepreneurs leads to decline in profits and prices. Ultimately crisis or recession/depression takes place. So Schumpeter himself regards depression as a reaction of earlier Boom.

Schumpeter points out that the deflationary forces generated by depression are gradually off set by other forces, one of which he terms as the ‘diffusion effects’. This is the effect of individual events like bankruptcies, shut downs and collapses of individual markets upon general economic activity. As the bankruptcies, unemployment spread, their impact decreases at an increasingly diminished rate. Another offsetting force Schumpeter calls as ‘depression business’ means that the collapse of some firms will enable the remaining firms to expand their business in the additional spheres which were being catered to by outgoing firms. Thus while there may be losses/liquidations in some sectors, there may be at the same time, gains/expansions in others. These off setting influences may have a restorative effect means recovery. ========The End========

Controlling Business Cycles

1) Monetary Remedies: Economists, who believe that monetary causes underlie business cycles, suggest that banking policy should be directed as to eliminate variations in the volume of credit and to maintain rate of interest. In other words use quantitative tools. Keynes argues that BC are not due to monetary causes but of fluctuations in the MEC. So it can be eliminated by securing full employment through a judicious policy of investment. 2) Increasing of Buying Power:

Hobson suggests that raising wage rates in time of Boom so that a greater part of the income may go to labor. He also recommends reduction of inequality in wealth.

3) Direct Controls: Government undertakes certain direct control methods such as: Price control; Price support and Rationing; In order to check Boom, price control to be adopted but during a normal time it will not work. One of the other methods is; Un-employment insurance has been prescribed as an effective method of controlling depression and un-employment. 4) Stabilizers: Stabilization prevents inflationary and deflationary gaps and aims at achieving moderate business cycles and full employment. Methods of stabilization are: Automatic or involuntary; Planned or Voluntary

Within The first group are changes in tax receipts, un-employ compensations etc., within the second group are fiscal and monetary policy 5) Forecasting: This is a method of measuring the upswings and down swings so that Cyclical fluctuations can be counteracted.

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