Chapter Five: Business Cycles

An economy experiences fluctuations in the level of economic

activity through fluctuations in macroeconomic variables. At
times, consumption, investment, employment, output, etc., rise
and at other times these macroeconomic variables fall. Such
fluctuations in macroeconomic variables are known as business
cycles. An economy exhibits alternating periods of prosperity or
boom and depression. Such movements are similar to wave-like
movements that are rather regular and steady but not random.

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 characterised
by falling prices and high unemployment percentages.”

Characteristics of Business Cycles:

Cyclical pattern: Expansions and contractions with turning

points of the business cycle (peak and trough) - A Business Cycle
exhibits a wave-like movement having regularity and recognized
patterns repetitive in character.

Fluctuations of aggregate economic activity: Almost all sectors

of the economy are affected by the cyclical movements. Most of
the sectors move together in the same direction. During
prosperity, most of the sectors or industries experience an
increase in output and during recession they experience a fall in
output.

Investment goods industries fluctuate more than the consumer

goods industries. Industries producing consumer durable goods
generally experience greater fluctuations than sectors producing
non-durable goods. Further, fluctuations in the service sector
are insignificant in comparison with both capital goods and
consumer goods industries.

Recurrent but not periodic: Periodicity of a trade cycle is not

uniform, though fluctuations are something in the range of five
to ten years from peak to peak. Every cycle exhibits similarities
in its nature and direction though no two cycles are exactly the
same. In the words of Samuelson: “No two business cycles are
quite the same. Yet they have much in common. Though not
identical twins, they are recognisable as belonging to the same
family.”

Phases of a Business Cycle:

A typical business cycle has two phases expansion phase or

upswing or peak and contraction phase or downswing or trough.
The upswing or expansion phase exhibits a more rapid growth
of economic activity than the long run trend growth rate. At
some point, economic activity reaches its upper turning point
and the downswing of the cycle begins. In the contraction
phase, economic activity declines.

At some time, economic activity reaches its lower turning point

and expansion begins. Starting from a lower turning point, a
cycle experiences the phase of recovery and after some time it
reaches the upper turning point the peak. But, continuous
prosperity can never occur and the process of downhill starts. In
this contraction phase, a cycle exhibits first a recession and then
finally reaches the bottom—the depression.

A Business Cycle has four phases: (i) depression, (ii) revival, (iii)
boom, and (iv) recession.
The period of a cycle, i.e., the length of time required for the
completion of one complete cycle, is measured from peak to
peak (P to P’) and from trough to trough (from D to D’).

1. Depression or Trough: The depression or trough is the

bottom of a cycle where economic activity remains at a very low
level. Income, employment, output, price level, etc. go down. A
depression is generally characterised by high unemployment of
labour and capital and a low level of consumer demand in
relation to the economy’s capacity to produce. This deficiency in
demand forces firms to cut back production and lay-off workers.

There develops a substantial amount of unused productive

capacity in the economy. Even by lowering down the interest
rates, financial institutions do not find enough borrowers.
Profits may even become negative. Firms become hesitant in
making fresh investments. Thus, there is air of pessimism in the
entire economy and the economy experience the phase of
depression.
2. Recovery: Since trough is not a permanent phenomenon, an
economy experiences expansion and, therefore, the process of
recovery starts.
During depression some machines wear out completely and
ultimately become useless. For their survival, businessmen
replace old and worn-out machinery. Thus, spending spree
starts which gives an optimistic signal to the economy.
Industries begin to rise and expectations tend to become more
favourable. Pessimism makes room for optimism and additional
and fresh investment leads to a rise in production.
Increased production leads to an increase in demand for inputs.
Employment of more labour and capital causes economic
activity to rise. Further, low interest rates charged by banks in
the early years of recovery phase act as an incentive to
producers to borrow money. Thus, investment rises. Now plants
get utilised in a better way. General price levels starts rising. The
recovery phase, however, gets gradually cumulative and
income, employment, profit, price, etc., start increasing.

3. Prosperity: Once the forces of revival get strengthened the

level of economic activity tends to reach the highest point—the
peak. A peak is the top of a cycle. The peak is characterised by
an all-round optimism in the economy—income, employment,
output, and price level tend to rise. Meanwhile, a rise in
aggregate demand and cost leads to a rise in both investment
and price level. But once the economy reaches the level of full
employment, additional investment will not cause economic
activity to rise.

On the other hand, demand, price level, and cost of production

will rise. During prosperity, existing capacity of plants is
overutilised. Labour and raw material shortages develop.
Scarcity of resources leads to rising cost. Aggregate demand
now outstrips aggregate supply. Businessmen now come to
learn that they have overstepped the limit. High optimism now
gives birth to pessimism. This ultimately slows down the
economic expansion and paves the way for contraction.

4. Recession: Like depression, prosperity is not long-lasting. The

bubble of prosperity gradually dies down. A recession begins
when the economy reaches a peak of activity and ends when
the economy reaches its trough or depression. Between trough
and peak, the economy grows or expands. A recession is a
significant decline in economic activity spread across the
economy lasting more than a few months, normally visible in
production, employment, real income and other indications.
During this phase, the demand of firms and households for
goods and services start to fall. No new industries are set up
while a few existing industries are wound up. Unsold goods pile
up because of low household demand. Profits of business firms
dwindle. Output and employment levels are reduced.
Eventually, this contracting economy hits the slump again. A
recession that is deep and long-lasting is called a depression
and, thus, the whole process restarts.

Cyclical behaviour of economic variables and Business Cycle

indicators:

Direction: Procyclical, Countercyclical or Acyclical variable

Timing: Leading, Coincident or Lagging variable.
Industrial Production is Procyclical and Coincident
Industrial production is pro-cyclical and coincident;
Both consumption and investment are pro-cyclical with
investment more sensitive than consumption to the business
cycle, as durable goods are a larger fraction of investment than
of consumption;
Capacity utilization is procyclcial;
Employment is procyclical and coincident; the unemployment
rate is countercyclical;
Inflation rate is pro-cyclical and lags the business cycle (it tends
to build up during an expansion and fall after the cyclical peak);
Short-term nominal interest rate is procyclical and lagging;
Corporate profits are very pro-cyclical as they tend to increase
during booms and strongly fall during recessions.

Samuelson’s Model of Multiplier- Accelerator Interaction:

Samuelson’s model of multiplier accelerator interaction was the

first model that represents interaction between these two
concepts. Samuelson described the way the multiplier and
accelerator interact with each other for generating income and
increasing consumption and demand of investment and also
how these two factors are responsible for creating economic
fluctuations.

Autonomous investment refers to the investment due to

exogenous factors, such as new product, production technique,
and market. On the other hand, derived investment refers to
the increase in the investment of capital goods produced due to
increase in the demand of consumer goods. When autonomous
investment occurs in an economy, the income level also
increases. This brought the role of multiplier into account. If the
income level increases, then the demand for consumer goods
also increases.
The induced consumption increases the demand of investment.
This is referred as derived investment. This marks the starting of
the acceleration process, which results in further increase in
income level.

Autonomous investment leads to multiplier effect that result in

derived investment. This is called acceleration of investment.
Derived investment would make the accelerator to come into
action. This is termed as multiplier-acceleration interaction.
Samuelson made certain assumptions for the explanation of
business cycles:
(i) Production capacity is limited and consumption takes
place after a gap of one year.
(ii) A gap of one year between the increase in consumption
and increase in the demand of investment.
(iii) No government activity and foreign trade in the
economy.

In the table, the process of income propagation through the

multiplier and accelerator interaction has been calculated where
(i) MPC = 0.5 and (ii) Acceleration Coefficient = 2.

In the first period there is an initial outlay of Rs. 10 crores, which

does not lead to any induced investment. Hence, the total rise
in national income in the first period is Rs.10 crores (being equal
to the initial outlay of Rs. 10 crores).
Since the MPC =0.5, induced consumption in the second period
is Rs.5 crores (shown in the column 3) and the acceleration
coefficient being 2, the induced investment in the second period
is Rs.10 crores, (shown in column 4) and the total leverage
effect (total increase in national income) is Rs.25 crores (shown
in column 5).
Similarly, in the third period increased consumption is Rs.12.50
crores and induced net investment of Rs.15 crores (being the
difference between 12.50 crores and 5 crores in column 3).
Thus, total income in the fourth period has reached the peak
level of Rs.41.25 crores, as a result of the combined multiplier
and acceleration effects i.e. through their interaction also called
Super Multiplier. Then, in the fifth period, the marginal income
increase starts falling off. It falls to rock bottom level of Rs.1.2
crores in the 8th period and then again starts rising in the 9th
period from Rs.2 crores to Rs.12 crores.

It goes up to Rs.26 crores in the 11th period, thereby completing

a cycle. If calculation goes on the multiplier-acceleration effects
in the various columns, it can be seen that the result is quite a
moderate type of recurring cycle which repeats itself
indefinitely.

In terms of equation:
Yt = Ct + It
Where, Yt = National income
Ct = Total consumption expenditure
It = Investment expenditure
t = Time period
According to the assumption that consumption takes place after
a gap of one year, the consumption function would be
represented as follows:
Ct = c Yt-1
Where, Yt-1 = Income for t-1 time period
c = ∆C/∆Y (multiplier propensity to consume)
Investment and consumption have a time lag of one year;
therefore, the investment function can be expressed a follows:
It = b (Ct –Ct-1)
Where, b = capital/output ratio (helps in determination of
acceleration)

By putting the value of Ct and It in the first equation of national

income, we get
Yt = c Yt-1 + b (Ct – Ct-1)
If Ct = c Yt-1, then Ct-1 = c Yt-2. Putting the value of Ct-1 in the
preceding equation, we get
Yt = c Yt-1 + b (c Yt-1 -c Yt-2)

With the help of preceding equation, the income level for past
and future can be determined if the values of c, b and income of
two preceding years are given.
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