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Unit-5

Points to be covered
        Business Cycle and different phases Theories of Business Cycle Inflation and limit of inflation Methods of measuring inflation Types of Inflation Effects of inflation Cost push and Demand Pull Inflation Inflation and economic growth

What is business cycle?  Business cycle refers to the fluctuations in economic activity that occur in a regular time sequence in all capitalist societies. .

Phases of Business Cycles Steady Growth Line Growth Rates O Time .

capital etc Consumer Resistance gets momentum Supply Exceeds Demands . consumers. Inputs gets costlier Increase in Demand Halts Rise in output.Prosperity Phase of The Business Cycles PROSPERITY Expansion Peak Recession (The Turning Point) Multiplier Effect Input falls short of demand.

Expenditure. Additional Investments pushes consumptions .Depression Phase of The Business Cycles Depression Trough Recovery Growth Rate is negative Renovation Programs Decline of National Income. Employment etc.

Theories of Business Cycle Pure Monetary Hick’s Theory Monetary OverInvestment Trade Cycle Theories Schumpeter’s Innovation MultiplierAccelerator Interaction .

Critical Evaluation • Non-Monetary factors play a crucial role in altering the course of economic activities e.The Pure Monetary Theory Theory • Business Cycle is caused by fluctuations in monetary and credit market. • All changes in levels of economic activities is due to changes in cash flows. • Monetary factors are not able to completely explain the turning points. . • When credit expansion gets halted downswing sets in. • Principal factor which effect money supply is credit mechanism where banks expand credit facility up to a point. cost structure etc.g. • Future business prospects and marginal efficiency of capital plays an important factor in business decision making.: aggregate demand.

. cost of capital etc. .Monetary Over-Investment Theory Critical Evaluation Desired Investment Actual Investment • When market rate of interest is lower than the natural rate credit flows to the capital goods industries only under full employment. • Ignores important factors such as businessman’s expectation. • Undue emphasis on the imbalance between the investment in capital and consumer goods industries.

Schumpeter’s Theory of Innovation Business cycles are almost exclusively the result of Initial impact of innovation results in credit and borrowings from the bank which reduces money supply and recession sets in Subsequent waves are created due to speculation. Not much different from Over-Investment theory except for the cause of variation 3. Wave of expansion causes further investment which in long run will cause prices to fall and thus depression starts 1. Does not consider other important factors First Approximation Second Approximation Critical Evaluation . Most arguments based on sociological than economic factors and so non-testable 2.

Far too simple 2. No government activity and no foreign trade Critical Evaluation 1. One-year lag in increase in consumption and investment demand 4. Assumptions 1. One-year lag in consumption 3. not considered 3. e. producer’s expectation. Other factors.g.Multiplier-Accelerator Interaction Theory Samuelson’s Model Autonomous investment is carried out by the firm which results in increased income (multiplier effect) and thus increase in demand for goods leading to derived investment to increase output. Constancy of capital/output ratio 4. No excess production capacity 2. Cyclic patterns do not confirm to real world .. change in preferences etc. This again causes increase in demand.

Hicksian Theory of Trade Cycle Assumptions • Equilibrium rate of growth: Realized and natural growth are equal • Samuelson type of consumption function: Ct=aYt-1 • Autonomous investment as a function of current output • Ceiling and Bottom for the upswing and downswing Critical Evaluation • Does not provide for linear consumption function and constant multiplier • Assumption of constancy of multiplier is skeptical • Seems to be an abstract formulation .

Inflation Inflation means ‘persistent’ and appreciable increase in general level of prices over a period of time Inflation is Desirable because Accepted Level Keeping economic outlook optimistic and helping production and employment 1-2% in developed countries 4-6% in less developed countries Promoting mobilization of resources by inflationary method of financing .

PINt-1 = ×100 PINt-1 Change in GNP Deflator GNP Deflator Nominal GNP Real GNP .Methods of Measuring Inflation Change in Price Index Numbers (PIN) Rate of Inflation PINt .

Types of Inflation .

Effects of Inflation Effects on Production and Growth Time Lag Redistributes income in favour of higher income groups Effects on Employment Increases Employment Affects growth adversely Effects on Income Distribution Wage earners are hurt Producers gain Fixed Income groups are adversely effected Borrowers gain Lenders loose Government gains Effects on Distribution of Wealth Redistribution in favour of rich .

Modern Theories of Inflation Demand Pull Theory Cost Push Theory .

expenditure .Demand Pull Inflation Caused by increase in aggregate Income increases much faster than aggregate supply Monetary Factors Increase in Money Supply Decline in Interest Rate Increase in Investment and Income level Increase in Aggregate Demand Real Factors Downward shift of saving or import function Upward shift in investment or export function Cut in taxes Increase in govt.

Cost-Push Inflation Caused by monopolistic forces of the societies like labour unions and cartels .

Policy Measures to Control Inflation • Bank Rate Policy • Variable Reserve Ratio • Open Market Operations • Taxation • Gove rnment Expe nditure • Publ ic Borr owings Monetary Policy Fiscal Policy Indexation • Adjusting monetary income to minimize undue gain or s los Price and Wage Control il prices • Reta arefixed ge Freeze • Wa .