BUSINESS CYCLE and INFLATION

BUSINESS CYCLE

Business conditions are never static. In some years, earning incomes is not so difficult for the resource owners, while in other years
conditions may be too harsh to even allow many businesses to survive. As has been experienced by world’s economies, output,
prices, interest rates and employment move up and down completing a business cycle that reflects periods of prosperity and
depression.

BUSINESS CYCLE
-to economists, the recurring ups and downs of real GDP. The terms cycles suggest that the ups and downs occurs systemically
perhaps even predictably.

THE NATURE OF BUSINESS CYCLE

 
Cycles are important features of nature. Trade activities are not exempt from the clutches of cycles. The expansion and
contraction of activities in many sectors of the economy betrays the existence of what is referred to as the business cycle.
Although business cycles occur one after the other, they are of different durations. Some lasts for two years, while others are
completed in ten years. Also, the negative effects of some cycles are more severe than others. The prosperity phase of one cycle, for
instance, may be longer than the prosperity phase of another cycle. The contraction (or the recession) phase of any cycle may be a
long process or one indicating an immediate decline in business activities. The expansion (or the recovery) phase may also be long or
short.

THEORIES OF BUSINESS CYCLE

For many countries, it has been observed that economic activities have not been constant. There have been always fluctuations
in the economy, or technological changes. In modern times, economists have noted the repetitive pattern, of peak, contraction,
recovery and expansion to be a regular cycle of about seven to ten years’ duration. However, there are some cycles which have longer
and shorter periods.
Several theories explain the changing behaviour of the economy. One economist even linked the business cycles to spots on the
sun, and another one claimed that what goes up must come down. In general, the theories of business cycles can be classified into two
categories:

Exogenous Theories. Forces outside the economic system create the business cycle. Examples of the forces are wars, political
developments, natural disasters, or major innovations.

Endogenous Theories. Forces within the economic system cause the fluctuations in the economy. Examples are accelerators,
multipliers, innovations, or monetary policies. An increase in aggregate demand results to a greater increase in investment.
Aggregate demand is composed of household consumption, business investment, and government expenditure. These three kinds of
expenditure create an economic expansion. Precisely, this is a situation which attracts more investments.

PHASES OF BUSINESS CYCLE

1. Prosperity- this is the peak of the business cycle. There is full employment, and the national output is at full capacity, or close to it.
Price level tends to increase due to increasing demand for goods and services.
2. Recession- the level is likely to decrease only if recession is of longer duration.

3. Depression- this is the valley of the business cycle. Under such condition, no private businessman is willing to invest because
demand for goods and services is also at its lowest point.

4. Recovery- during this stage, price level may increase.

 Prosperity Phase
 The prosperity phase is that part of the business cycle characterized by the following:
 High prices and great business activity
 Large profits for business firms
 Production is at full Capacity
 Increasing demand for many commodities
 Increasing demand for labor
 Increasing volume of sales
 Increasing volume of credit extensions by lenders
 Rising interest rates

 Recession Phase
When the economy has reached the peak of expansion and contraction begins to take shape, the crisis ore recession phase has already
started. When this happens, the following feature appears:
 The demand for goods decreases
 The margin of profits gradually shrinks
 The volume of sales decreases
 Trading slow down
 The production of goods is reduced
 The demand for labor, capital, and land decreases
 Prices go down
 The ability of business firms to meet their financial obligations is impaired
 Unemployment begins to bother labor
 No further extensions of credit or renewals of old loans are made by banks.

 Depression Phase
When the contraction of economic activities which began in the recession phase has reached its lowest level, the depression phase has
taken over. This phase is characterized by the following:

 Many business have ceased operations

 Profits are minimal, if it is still possible to make some
 Banks have plenty of idle funds
 Banks gradually reduced interest rates
 Credit starts to become available
 Unemployment is at its highest level
 Many unemployment are willing to work at lower wages
 The prices of raw materials and supplies are low

 Recovery Phase
The depression phase cannot continue indefinitely. As the prices of the various economic resources are low, some business firms that
have previously ceased operations will attempt to operate again. Those which stayed but reduced their outputs will now make
arrangements for normalizing production. As this happens, the following be noted:
 As the supply of commodities in the market gets exhausted, demand for these begin to be felt
 Optimism among business women slowly develops, prodding them to increase business activity
 The demand for labor increases, resulting to a decrease in unemployment
 The purchasing power of the people rises
 The low rates of interest will attract business borrowings
 Prices slowly rise
 These is an increase in production output
 Idle plants are used and plans for constructions of new ones are considered

Effect of Business Cycles – during bad economic times like recession and depression various sectors and individuals are affected in
different ways.

Economists cite several possible general sources of shocks that can cause business cycles.
Irregular innovation- significant new products or production methods, such as those associated with the railroad, automobile,
computer, and the Internet, can rapidly spread through the economy, sparking sizeable increases in investment, consumption, output.

Productivity changes-when productivity-output- per unit of input-unexpectedly Increases, the economy booms; when productivity
unexpectedly decreases, the economy recedes.

Monetary factors- some economists see business cycles as purely Monetary Phenomena. When a nation’s central bank shocks the
economy by creating more money than people were expecting, an inflationary boom in output occurs.

Political events-unexpected political events, such as peace treaties, new wars, or the 9/11 terrorist attacks, can create economic
opportunities or strains.

Financial instability-unexpected financial bubbles (rapid asset price increases) or burst (abrupt asset price decreases) can spill over to
the general economy by expanding or contracting lending, and boosting or eroding the confidence of consumers and businesses.

INFLATION

- We now turn to inflation, another aspect of macroeconomics instability.

- There is inflation when there is a rising general level of prices.

TYPES OF INFLATION

1.Demand-pull inflation-this type of inflation occurs when demand for goods and services exceeds supply. This is based on the law
of supply and demand.

2.Cost-push inflation-An increase in the cost of production results to an increase in prices.

Inflation - is a rise in the general level of prices. When inflation occurs, each dollar of income will buy fewer goods and services than
before. Inflation reduces the” purchasing power” of money. But inflation does not mean that all prices are rising. Even during periods
of rapid inflation, some prices may be relatively constant and others may even fall.

The rate of inflation- is equal to the percentage growth of CPI from one year to the next. For example, the CPI was 207.3 in 2007. Up
from 201.6 so the rate of inflation for 2007 is calculated as follows:

Rate of inflation= 207.3-201.6 x100=2.8%

201.6

Complexities-The real word is more complex than the distinction between demand-pull and cost-push inflation suggest .It is
difficult to distinguish between demand-pull inflation and cost-push inflation unless the original source of inflation is known.

Core inflation- another complication relating to inflation (regardless of type) is noteworthy. Some price-flexible items within the
consumer price index, particularly, food and energy experience rapid changes in supply and demand and therefore considerable price
volatility from month to month and year to year.
 
Nominal income- is the number of dollar received as wages, rent, interest, or profit.
Real income- is a measure of the amount of goods and services nominal income can buy, it is the purchasing power of nominal
income, or income adjusted for inflation. That is,
Real income= nominal income
 Price index (in hundredths)

Fixed-income Receivers- people whose incomes are fixed see their real incomes fall when inflation occurs.

Savers- unanticipated inflation hurts savers. As prices rise, the real value, or purchasing power, of an accumulation of savings
deteriorates.

Creditors- unanticipated inflation harms creditors (lender).

Anticipated Inflation- the redistributing effects of inflation are less severs or are eliminated altogether if people anticipate inflation
and can adjust their nominal incomes to reflect the expected price- level rises.