Business Cycles

Business Cycle

 Shows the periodic up and down movements in

economic activities.
 Economic activities measured in terms of
production, employment and income move in a
cyclical manner over a period of time.
 Cyclical movement is characterized by
alternative waves of expansion and contraction.
 Associated with alternate periods of prosperity
and depression.
 Characteristics of Business Cycles
 Periodicity
 Wavelike movements in income and employment occur at
intervals of 6 to 12 years.
 Gap between two cycles is not regular or predictable with
certainty.
 Synchronism
 Impact is all embracing, i.e. large sections of the economy
experience the same phase.
 Happens because of interdependence of various sectors of the
economy.
 Self Reinforcing
 Due to interdependence in the economy, cyclical movements
faced by one sector spread to other sectors in the economy; and
from one economy to other economies.
 Thus the upward swing of the cycle is reinforced for further
upward movement and vice versa.
 Phases of Business Cycle
Peak Four phases:
GNP Expansion
C D G’ Expansion, B to C
(%)
Expansion and From F
Peak, (Boom) C to D
Contraction
E F
G Slump Contraction D to E
Contraction A B (recession),
Trough Trough (Slump/
Time Unit depression) A to B and
(years) E to F
• Time gap between two bouts of trough (from B to E) or peaks (from
D to G) can vary between 6 to 12 years.
• For 3 to 5 years, the economy experiences growth, then for another
3 to 5 years, it faces contraction or recession.
• GG’ is the steady growth line, to show that the general trend is that
of growth.
 Phases of Business Cycle
Contd.

 Expansion: when all macro economic variables like

output, employment, income and consumption
increase.
 Prices move up, money supply increases, self reinforcing
feature of business cycle pushes the economy upward.
 Peak: the highest point of growth; referred to as boom.
 Stage beyond which no further expansion is possible,
 Sees the downward turning point.
 Contraction/Recession: means the slowing down
process of all economic activities.
 Trough or Slump: the lowest ebb of economic cycle.
 Followed by the next turning point in the cycle, when new
growth process starts afresh.
 What is recession?
• Recession is a decline in a country's gross domestic
product growth for two or more consecutive quarters of a
year.
• A recession is also preceded by several quarters of
slowing down.
• An economy which grows over a period of time tends to
slow down the growth as a part of the normal economic
cycle.
• A recession normally takes place when
– consumers lose confidence in the growth of the
economy and spend less.
– Investors spend less as they fear stocks values will
fall and thus stock markets fall on negative sentiment.
 Causes of Business Cycles
Earlier Explanations of economic cycles:
 Climatic changes such as sunspots that may cause
different moods.
 Psychological aspects of entrepreneurs and consumers,
such as moods of optimism and pessimism.
 Monetary phenomenon like changes in money supply,
rate of interest, etc.
 Economic factors, such as over investment, under
consumption and over savings.
 Shocks in the conditions under which producers supply
goods such as technological breakthroughs.
 Keynes’ Theory
 Keynes is credited with presenting a
systematic analysis of factors causing
business cycles.
 Economic fluctuations are due to changes in
rate of investment
 Rate of investment depends upon:
1. rate of interest, which remains stable in the
short run
2. marginal efficiency of capital ( MEC).
 Keynes’ Theory
 Keynes introduced the concept of ‘marginal
efficiency of capital’ (mec) to explain the
expected rate of return on investment.
 marginal efficiency of capital depends upon
1. changes in prospective yield
2. supply price of capital
 Entrepreneurial expectations and the
psychological aspect of business determine
prospective yields.
• Supply price of capital goods does not change
in the short run.
 Keynes’ Theory
Contd.

 With increase in entrepreneurial

Rate of expectations the marginal efficiency
Investment of capital increases
 Hence entrepreneurs make huge
investments (upward turning
Marginal Rate of point)
efficiency of Interest  The multiplier starts its action,
capital bringing an increase in income,
which is much higher than increase
in investment, this is the multiplier
Prospective Supply price effect.
yield of Capital  Expansion phase
goods  Abundance of capital goods reduces
marginal efficiency of capital, which
Entrepreneurial discourages further investment.
expectations
 Downward turning point
 Reverse action of multiplier.
 Hicks’s Theory

 Hicks demonstrated through mathematical models

how the interaction of multiplier and accelerator
could bring several types of fluctuations in total
output.
 There is a full employment ceiling beyond which the
economy may not grow.
 In Hicksian model, three concepts play important
role:
 Warranted rate of growth
 Autonomous and Induced investment
 Multiplier and accelerator
 Hicks’s Theory
 In Hicksian model, three concepts play important role:
 Warranted rate of growth
 Sustains itself in congruity with the equilibrium of saving and
investment
 Autonomous and Induced investment
 Autonomous investment includes public investment, investment
which occurs in direct response to inventions, and other long range
investment.
 Induced investment depends upon changes in the level of output or
income; thus it is a function of an economy’s growth rate.
 Interaction of Multiplier and accelerator
 Fundamental causation of the trade cycle is in the multiplier
accelerator relationship
 Multiplier increases national income by a certain proportion (1/MPS)
due to increase in investment
 Increase in investment increases national income accelerator times
 The process continues
 Hicks’s Theory:Multiplier Accelerator
Interaction Contd.

Period Autonomous Induced Induced Increase in Business

(1) Investment Consumption Investment Income Cycle Phase
(2) (3) (4) (5) =(2+3+4)
1 100 0 0 100 Expansion
2 100 67 134 301
3 100 200 266 566
4 100 378 356 834
5 100 556 356 1012
6 100 675 238 1013 Full
employment
7 100 518 20 778 Contraction
8 100 346 -100 518
9 100 230 -100 346
Assumptions
 Autonomous investment in the economy is Rs. 100 million
 MPC is 2/3 and accelerator is 2.
 Hicks’s Theory
GNP F’ 4 levels of economic activity:
(%) •AA’ is determined by autonomous
S T investment.
E’
F •LL’ is the floor line which shows
L’ income level determined by
autonomous investment and
E R MN multiplier.
A’
•EE’ is the equilibrium path of income
L and output.
A •FF’ is the full employment ceiling,
where all the productive resources
O Time (years) are fully utilized in gainful activity.

• At R on EE’, an outburst of investment via the multiplier accelerator interaction,

pushes the economy to S on FF’, RS shows the expansion phase.
• Rate of growth of output between RS and ST is very different this results in
downward turning point at point T.
• This slackening of growth rate causes a fall in induced investment, the
economy slides to LL’ line, TM is the contraction/recession phase.
• Process of recovery starts between M and N; autonomous investment is
greater than declining investment prior to M.
• Acceleration effect operates again. The cycle will be repeated.
 Hicks’s Theory: Basic Assumptions Contd.

 The economy is progressive, in which autonomous

investment is increasing at a regular rate.
 Production cannot exceed the full employment ceiling.
 Working of the accelerator in an economy on the downswing
is different from its working while the economy is in the
upswing.
 There are fixed values for the multiplier and the accelerator
throughout the different phases of a cycle.
 Real Business Cycle Theory

 Explored by John Muth (1961) and others.

 Fluctuations and output and employment are the results of
a variety of real shocks that hit the economy
 Markets adjust to these shocks rapidly and always remain
in equilibrium
 The ups and downs are caused by technology or other
similar shocks to the supply side of the economy.
 Highlights the importance of supply side of business.
 Reflects the outcome of rational decisions made by many
individuals.
 Minimizes the role of nominal fluctuations and money.
 Real Business Cycle Theory
 Postulates that:
 A boom will occur with an invention of a productivity increasing
device, entrepreneurs increase investment, expand output and
employ more people.
 A recession will occur with new advances lacking, or productivity
low, and at that point employers rationally choose not to produce
as much.
 Although booms are nicer than recessions, but there is
no need to react to either, as they represent the best use
of the opportunities available.
 The theory has not attracted much empirical support.
 Effects of Business Cycles

During Expansion
 High growth: large investments, increase in
employment, income and expenditure
 Inflation: Increase in investment forces more
money supply in the system, demand for factor
inputs increases, hence their prices increase
which increases cost of production. So wages
and prices of goods also increase.
 Severe Competition: Firms resort to large
amount of non productive expenditure on
advertisements and publicity.
 Effects of Business Cycles
During Recession
 Excess inventory: Those firms which had
produced in abundance during expansion phase
face the problem of maintaining unsold items.
 Unemployment : in order to reduce investment,
recession phase is marked by large scale
retrenchment.
 Below capacity operations and liquidation of
firms.
 Controlling Business Cycles

At Firm Level
 Precautionary Measures: to be taken at
the time of expansion
 Investments: deter from investing huge
amount of funds in fixed assets.
 Inventory: should not create large inventory
of raw material or finished goods.
 Products: diversify in different markets and
different products, so that risk is diversified.
 Controlling Business Cycles
 Curative Measures: to be taken at the
time of recession
 Pricing: Flexibility should be the right
strategy, so that during recession prices may
be adjusted to increase demand without
eating away the margins.
 Costing: control wastages and reduce costs
 Controlling Business Cycles
At Government Level
 Monetary Measures:
 Rediscount rate:
 Expansion: increase the rediscount rate to curb
money supply
 Recession: reduce the rate to increase money
supply.
 Reserve ratios:
 Expansion: the ratios are increased so that banks
are left with less cash to be extended as credit
 Recession: the ratios are decreased so that banks
can extend easy credit.
 Controlling Business Cycles
 Open market operations:
 Expansion: sells securities and takes away
disposable income from people.
 Recession: buys securities to give more in the
hands of people
 Selective credit control:
 Banks are advised to extend credit to certain
areas, while restrict to certain other areas.
 Controlling Business Cycles

 Fiscal Measures
 Public expenditure
 Expansion: Government reduces expenditure to
curtail demand
 Recession: Government increases expenditure on
various activities like health, transport,
communication, etc., to increase income of
individuals; this in turn increases aggregate
demand.
 Controlling Business Cycles
 Public revenue
 Expansion: An increase in taxes takes away
portion of people’s money income and thus brings
down aggregate demand.
 Recession: It is desirable that governments
reduce taxes.
 An appropriate combination of these measures is
adopted after thorough examination of the causes of
business cycles.