What are Business Cycles?

Phases, Types, Theory, Nature

What is the Business Cycle?

Business Cycle), also known as the economic cycle or trade cycle, is the fluctuations in economic
activities or rise and fall movement of gross domestic product (GDP) around its long-term growth
trend.

No era can stay forever. The economy too does not enjoy same periods all the time. Due to its dynamic
nature, it moves through various phases.

The change in business activities due to fluctuations in economic activities over a period of time is known
as a business cycle. Business cycle are also called trade cycle or economic cycle. Business Cycle can also
help you make better financial decisions.
The economic activities of a country include total output, income level, prices of products and services,
employment, and rate of consumption. All these activities are interrelated; if one activity changes, the rest
of them also change.

Business Cycle Definition

Arthur F. Burns and Wesley C. Mitchel defined business cycle definition as

Business cycle are a type of fluctuation found in the aggregate economic activity of nations
that organize their work mainly in business enterprises: a cycle consists of expansions
occurring at about the same time in many economic activities, followed by similarly
general recessions, contractions, and revivals which merge into the expansion phase of the
next cycle; in duration, business cycle vary from more than one year to ten or twelve
years; they are not divisible into shorter cycle of similar characteristics with amplitudes
approximating their own.

— Arthur F. Burns & Wesley C. Mitchel

Phases of Business Cycle

Let us discuss Phases of Business Cycle are:

1. Expansion
2. Peak
3. Contraction
4. Trough
Expansion

Expansion is the first phase of a business cycle. It is often referred to as the growth phase.

In the expansion phase, there is an increase in various economic factors, such as production, employment,
output, wages, profits, demand and supply of products, and sales. During this phase, the focus of
organisations remains on increasing the demand for their products/services in the market.

The expansion phase is characterised by:

Increase in demand Growth in income Rise in competition Rise in advertising

Creation of new policies Development of brand loyalty

In this phase, debtors are generally in a good financial condition to repay their debts; therefore, creditors
lend money at higher interest rates. This leads to an increase in the flow of money.

In the expansion phase, due to increase in investment opportunities, idle funds of organisations or
individuals are utilised for various investment purposes. The expansion phase continues till economic
conditions are favourable.

Peak

Peak is the next phase after expansion. In this phase, a business reaches at the highest level and the profits
are stable. Moreover, organisations make plans for further expansion.

Peak phase is marked by the following features:

High demand and supply

High revenue and market share Reduced advertising
Strong brand image

In the peak phase, the economic factors, such as production, profit, sales, and employment, are higher but do
not increase further.

Contraction

An organisation after being at the peak for a period of time begins to decline and enters the phase of
contraction. This phase is also known as a recession.

An organisation can be in this phase due to various reasons, such as a change in government policies, rise in
the level of competition, unfavourable economic conditions, and labour problems. Due to these problems,
the organisation begins to experience a loss of market share.

The important features of the contraction phase are:

Reduced demand
Loss in sales and revenue

Increased competition

Trough

In Trough phase, an organisation suffers heavy losses and falls at the lowest point. At this stage, both profits
and demand reduce. The organisation also loses its competitive position.

The main features of this phase are:

Lowest income Loss of customers

Adoption of measures for cost-cutting and reduction
Heavy fall in market share

In this phase, the growth rate of an economy becomes negative. In addition, in trough phase, there is a rapid
decline in national income and expenditure.

After studying the business cycle, it is important to study the nature of business cycle

Nature of Business Cycle

The nature of business cycle helps the organisation to be prepared for facing uncertainties of the business
environment.

1. Cyclical nature
2. General nature

Cyclical nature

This is the periodic nature of a business cycle. Periodicity signifies the occurrence of business cycle at
regular intervals of time. However, periods of intervals are different for different business cycle . There is a
general consensus that a normal business cycle can take 7 to 10 years to complete.

General nature

The general nature of a business cycle states that any change in an organization affects all other
organizations too in the industry. Thus, general nature regards the business world as a single economic unit.

For example, depression moves from one organization to the other and spread throughout the industry. The
general nature is also known as synchronism.

Types of Business Cycle

Following the writings of Prof .James Arthur and Schumpeter, we can classify business cycle into three
types based on the underlying time period of existence of the cycle as follows:
1. Short Kitchin Cycle
2. Longer Juglar cycle
3. Very long Kondratieff Wave

Short Kitchin Cycle (very short or minor period of the cycle, approximately 40 months duration)
Longer Juglar cycle (major cycles, composed of three minor cycles and of the duration of 10 years or so)

Very long Kondratieff Wave (very long waves of cycle, made up of six major cycles and takes more than
60 years to run its course of duration)

Business Cycle Theory

A business cycle is a complex phenomenon which is common to every economic system. Several theories
of business cycle have been propounded from time to time to explain the causes of business cycle.
Business Cycle Theory are:

1. Hawtrey Monetary Theory monetary-theory)

2. Innovation Theory
3. Keynesian theory
4. Hicks Theory
5. Samuelson theory

Hawtrey Monetary Theory

Hawtray was of opinion that in depression monetary factors play a critical role. The main factor affecting the
flow of money and money supply is the credit position by the bank. He made the classical quantity theory of
money as the basis of his trade cycle theory.
According to him, both monetary and non-monetary factors also affect trade. His theory is basically the
product of the supply of money and expansion of credit. This expansion of credit and other money supply
instrument create a cumulative process of expansion which in return increase aggregate demand.

According to this theory the only cause of fluctuations in business is due to instability of bank credit. So it
can be concluded that Hawtray’s theory of business cycle is basically depend upon the money supply, bank
credits and rate of interests.

Criticism of this Business Cycle theory

 Hawtray neglected the role of non-monetary factors like prosperous agriculture, inventions, rate of
profit and stock of capital.
 It only concentrates on the supply of money.
 Increase in interest rates is not only due to economic prosperity but also due to other factors.
 Over-emphasis on the role of wholesalers.
 Too much confidence in monetary policy. vi. Neglect the role of expectations. vii. Incomplete theory
of trade cycles.

Innovation Theory

The innovation theory of business cycle is invented by an American Economist Joseph Schumpeter.
According to this theory, the main causes of business cycle are over-innovations.

He takes the meaning of innovation as the introduction and application of such techniques which can help in
increasing production by exploiting the existing resources, not by discoveries or inventions. Innovations are
always inspired by profits. Whenever innovations are introduced, it results into profitability then shared by
other producers and result in a decline in profitability.

Criticism of this Business Cycle theory

 Innovation fails to explain the period of boom and depression.

 Innovation may be major factor of investment and economic activities but not the complete process of
trade cycle.
 This theory is based on the assumption that every new innovation is financed by the banks and other
credit institutions but this cannot be taken as granted because banks finance only short-term loans and
investments.

Keynesian Theory

The theory suggests that fluctuations in business cycle can be explained by the perceptions on expected rate
of profit of the investors. In other words, the downswing in business cycle is caused by the collapse in the
marginal efficiency of capital, while revival of the economy is attributed to the optimistic perceptions on the
expected rate of profit.

Moreover, Keynesian multiplier theory establishes linkages between change in investment and change in
income and employment. However, the theory fails to explain the cumulative character both in the upswing
and downswing phases of business cycle and cyclical fluctuations in economic activity with the passage of
time.

Hicks Theory

Hicks extended the earlier multiplier-accelerator interaction theory by considering real world situation. In
reality, income and output do not tend to explode; rather they are located at a range specified by the upper
ceiling and lower floor determined by the autonomous investment.
In the theory, it is assumed that autonomous investment tends to grow at a constant percentage rate over the
long run, the acceleration co-efficient and multiplier co-efficient remain constant throughout the different
phases of the trade cycle, saving and investment co-efficient are such that upward movements take away
from equilibrium.

The actual output fails to adjust with the equilibrium growth path overtime. In fact, it has a tendency to run
above it and then below it, and thereby, constitute cyclical fluctuations overtime. This basic intuition can be
shown with the help of the following figure.

Criticism of this Business Cycle theory

 Wrong assumption of constant multiplier and acceleration co-efficient. Highly mechanical and
mathematical device.
 Wrong assumption of no-excess capacity. Full-employment ceiling is not independent.

Samuelson theory

According to this theory process of multiplier starts working when autonomous investment takes place in the
economy. With the autonomous investment income of the people rises and there is increase in the demand of
consumer goods. It directly affected the marginal propensity to consume.
If there is no excess production capacity in the existing industry then existing stock of capital would not be
adequate to produce consumer goods to meet the rising demand. Now in order to meet the consumer’s
requirements, producers will make new investment which is derived investment and the process of
acceleration principle comes into operation.

Then there is rise in income again which in the same manner continue the process of income propagation.
So, in this way multiplier and acceleration interact and make the income grow at faster rate than expected.
After reaching its peak, income comes down to bottom and again start rising.

Autonomous investment is incurred by the government with the objective of social welfare. It is also called
public investment. The autonomous investment is the investment which is done for the sake of new
inventions in techniques of production.

Derived investment is the investment undertaken in capital equipment which is induced by increase in
consumption.

Criticism of this Business Cycle theory

 This model only concentrates on the impact of the multiplier and acceleration and it ignored the role
of producer’s expectations, changing business requirements and consumers preferences etc.
 It is not practically possible to compute the fact of multiplier and acceleration principle.
 It has wrong assumption of constant capital output ratio.