BEE (2019-20) Handout-05

Business Cycles

Business Cycles: Meaning and Phases

 Business cycles refer to alternating periods of expansion and contraction in the real GDP of the economy termed as
phases of prosperity and depression or booms and slumps.
 These periodic booms (periods of prosperity) and slumps (periods of slowdown/recession) are characterized by
fluctuations in key economic magnitudes of the macro economy, namely national output, income, investment, prices
(including stock prices and housing prices), wages, bank credit, interest rates etc.
 The two most severe business cycles being the Great Depression of 1930s and the global recession of 2008-09. The
business cycles repeatedly occur after short or long periods of time, but can be controlled by the government.
However the ability to control the business cycles is limited.
 Business cycles can be divided into four phases - expansion, peak, recession and trough

 Expansionary Phase – this period is characterized by high growth rate of national output. There is high growth
in per capita income, investment and employment, sales, profit and rise in standard of living. However, there
may be presence of high inflation during this period with rapid increase in wholesale and retail prices.
 Peak- the phase of expansion culminates in peak, which is the upper turning point of the business cycle.
 Recessionary Phase – recessionary period is initiated by slackening in the expansion rate of the economy
termed as a slowdown. The growth rate may eventually decline to zero or even become negative and is termed
as a recession, which is characterized by downward slide in economic activities. There is contraction in national
output, employment, investment, sales, profits, bank credit, prices and standard of living. A recession which is
large both in scale and duration is termed as a depression.
 Trough – a trough is the lower turning point of the business cycle when the recession ends and a stage of
recovery starts. The real GDP again starts expanding although at a low rate leading to a phase of expansion with
high growth rate

Causes of Business Cycles:

 The primary source of business cycles is fluctuations in aggregate demand (demand shock). Aggregate demand
is the total or aggregate quantity of output that is bought at a particular price level in the economy. It consists of
consumption, investment, government purchases and net exports. Aggregate demand may fluctuate as a result of
exogenous economic events such as changes in business confidence, stock market bubbles, housing bubble etc
or as a result of policy variables as changes in interest rates.
 Fluctuation in aggregate demand can be of two types-
o An increase in aggregate demand: This will lead to a phase of expansion in the economic magnitudes
as national output and employment. This phase is accompanied by rising inflation as the aggregate
demand is excessive in relation to the national output. A rapid increase in aggregate demand leads to a
rapid expansion of national output. If the rate of increase in aggregate demand slackens, it leads to a
phase of slowdown.
o A decrease in aggregate demand - This will lead to a contraction in the economic magnitudes as
national output and employment, leading to a recession. This phase is accompanied by deflation as the
aggregate demand falls short of the national output. In other words there is overproduction and
accumulation of inventory.
 Fluctuation in business activity may also take place as a result of fluctuations in aggregate supply. Aggregate
supply is the total or aggregate quantity of output that is supplied at a particular price level in the economy.
o A decrease in the aggregate supply leads to a situation in which the aggregate supply decreases and
therefore falls short of the aggregate demand in the economy. A negative supply shock may be caused
due to increase in prices of key economic inputs, natural calamities, wars etc. This is a situation of
falling national output with rising prices and is termed as stagflation ( i.e., stagnation + inflation)
o An increase in aggregate supply leads to rapid economic growth with declining prices. This may be
caused by improvements in technology.
Business Cycles in India:
The growth rate cycles of real GDP of India since Q1of 2012-13 is as under:

10.0
9.0
8.0
7.0
Growth Rate (%)

6.0
5.0
4.0
3.0
2.0
1.0
0.0

Q1
Q2
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4

Q3
Q4
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4
Q1
2012-13 2013-14 2014-15 2015-16 2016-17 2017-18 2018-19

The Global Recession of 2008:

The global recession originated in US in later half of 2008 and spread to almost all major economies of the world. The
economic crisis was caused due to burst of housing boom. The housing boom was caused primarily due to excessive
housing loans granted by banks which increased the demand for houses. The prices of houses shot up. The housing boom
later collapsed because supply of houses far exceeded the demand of houses leading to sharp decline in housing prices by
about 50%. Due to sharp decline in value of their houses, the owners started selling their houses to minimize losses. The
subprime borrowers defaulted on loan repayments. Consequently banks failed to recover their money and most US banks
started failing by 2008.This is therefore also known as the subprime crisis / financial crisis of 2008. Thus decline in both
consumption and investment lead to the recession.

Contra-cyclical Stabilisation Policies:

 Stabilization polices can affect output and control economic crisis occurring in the economy, in the form of either
recession or inflation. Stabilisation policies are of two types – contractionary policies are used to control inflation
while expansionary policies are used to cure slowdown/ recession.
o Monetary Policy-
 Contractionary monetary policy- money supply is decreased /policy rates are increased.
 Expansionary monetary policy-money supply is increased/policy rates are decreased.
o Fiscal policy-
 Contractionary Fiscal Policy- government expenditure is decreased /tax rates are increased.
 Expansionary Fiscal Policy- government expenditure is increased /tax rates are decreased.

 Stagflation and Policy Trade off: Control of stagflation is difficult because if expansionary policy is used to expand
GDP, it will fuel inflation further in the economy, while if contractionary policy is used to control inflation, it will
have adverse effect on GDP growth. Thus, if inflation is controlled growth suffers and if growth is encouraged,
inflation rises. This is known as growth - inflation trade off.