BUSINESS CYCLE

introduction

Have you heard about recession or great depression ? financial

crisis or economic crisis?
What kind of impact it can have on businesses?
Can Government do something to control it?
Is it possible to prevent crisis/depression ?
 Expansions and Recessions in U.S.

Period of Expansion Length (in months) Period of Recession Length (in months)

Oct.1949-Jul.1953 44 Jul. 1953 – May 1954 10

May 1954-Aug. 1957 39 Aug. 1957 – Apr. 1958 9
Apr. 1958-Apr. 1960 24 Apr. 1960 – Feb. 1961 10
Feb. 1961- Dec. 1969 105 Dec. 1969 – Nov. 1970 10

Nov. 1970- Nov. 1973 36 Nov. 1973 – Mar. 1975 16

Mar. 1975- Jan. 1980 58 Jan. 1980 – Jul. 1980 6

Jul. 1980- Jul. 1981 12 Jul. 1981 – Nov. 1982 16
Nov. 1982- Jul. 1990 92 Jul. 1990 – Mar. 1991 9
Mar. 1991- Mar. 2001 120 Mar. 2001 – Nov. 2001 8

Nov. 2007 - Nov 2007 18

http://www.aaoifi.com/media/document/work1461.pdf
 What is a business cycle?

 The economic history of the free market capitalist countries has shown that the period of
economic prosperity or expansion alternates with the period of contraction or recession.
 These alternating periods of expansion and contraction in economic activity has been called
business cycles. They are also known as trade cycles.
 J.M. Keynes writes, “A trade cycle is composed of periods of good trade characterized by rising
prices and low unemployment percentages with periods of bad trade characterized by falling
prices and high unemployment percentages.”
 They are recurrent and irregular fashion.
 Phases/stages of Business cycle

A typical cycle is generally divided into five phases

1. Depression
2. Recovery
3. Prosperity/Full employment
4. Boom/peak
5. Recession
 1. Depression

Recession merges into depression when there is a general decline in economic activity.
 There is considerable reduction in the production of goods and services, employment, income,
demand and prices.
 The general decline in economic activity leads to a fall in bank deposits.
 When credit expansion stops, even business community is not willing to borrow.
 Thus, a depression is characterized by mass unemployment – general fall in prices, wages,
profits, interest rate, consumption expenditure, investment –
 Bank loans and advances falling – factories close down – capital goods industries are also
closed down.
 During this phase, there will be pessimism leading to closing down of business firms.
 1. Depression
●
Decline in Production of Goods and Services
Reduction in Growth ●
Reduction in the Income

Unemployment

No Money
●

Reduction in the Demand, so prices that further leads to reduction in

●

Supply

Businesses are not willing to borrow- reduction in bank deposits and

Pessimism
●

interest rates
●
Less Investment, shrinking credit, mass unemployment, closing down
 2. Recovery

Recovery denotes the turning point of business cycle from depression to prosperity.
 There is a slow rise in output, employment, income and price – demand for
commodities go up steadily.
 There is increase in investment – bank and financial institutions are also willing to
grant loans and advances.
 Pessimism gives way to optimism.
 The process of recovery becomes combative and leads to prosperity.
  The recovery may be initiated by the following factors –

1. Government expenditure.
2. Changes in production techniques.
3. Investment in new regions.
4. Exploitation in new sources of energy etc.
5. New innovations
6. Low production cost
 Recovery

New Rise in Employment

Investment Production Opportunities

New Rise in Employment

Investment Production Opportunities
 3. Prosperity/Full employment

 In this period, demand, output, employment and income are at a high level, they tend to raise
prices.
 But wages, salaries, interest rates, rentals and taxes do not rise in proportion to the rise in
prices.
 The gap between prices and cost increases - the margin of profit increases.
 The increase of profit and the prospect of its continuance commonly cause a rapid rise in stock
market values.
 The economy is engulfed in waves of optimism.
 Larger profit expectation further increase – investment which is helped by liberal bank credit.
 This leads to peak or boom.
 3. Prosperity/Full employment

wages, salaries, interest

demand, output, the margin of profit
rates, rentals and taxes do
employment and income increases so the stock
not rise in proportion to the
are at a high level prices
rise in prices
 4. Boom/Over full employment/inflation

 The prosperity phase does not stop at full employment. It gives way to the
emergence of a boom.
 Business optimism stimulates further investment.
 During the stage of full employment, the rise in investment can only mean
increased pressure for the available men and materials and hence rise in
wages and prices.
 The number of jobs exceed the number of workers available in the market.
 Such a situation is known as overfull employment.
 4. Boom/Over full employment/inflation

Marginal Efficiency of
Prices, wages, interest, Capital Higher Purchasing Power
profit (MEC)
 During this phase –

Prices, wages, interest, profit move in the upward direction.

 MEC rises leading to business expansion.
 Business people borrow more and invest. This adds fuel to the fire. The tempo
of boom reaches new heights.
 There is higher output income and employment.
 There is higher purchasing power and the level of effective demand will reach
new heights.
 There is an atmosphere of “Over optimism” all round which results in over
investment.
 It is a symptom of the end of prosperity phase and the beginning of recession.
5. Recession – A turn form prosperity to Depression

Recession starts downward movement of economic activities from peak/boom.

 It is a state in which there is general deceleration in the economic activity
resulting in cuts in production and employment falling prices of stock market.
 Banking and financial institutional loans and advances beginning to decline.
 As a result profit margins decline further because costs starts overtaking prices.
 Recession may be mild/severe – it lead to a sudden explosive situation emanating
from banking system and stock markets.
 Such experience of the United States in 1873, 1893, 1907, 1933 and 2007.
 During this phase:

Down fall in the activities of stock exchange market.

 Failure of some business creates panic among businessmen.
 Loss of confidence.
 No new ventures are taken up.
 Bank curtails credit.
 Business expansion stops.
 New orders are cancelled and workers are laid off.
 Liquidity preference suddenly increases.
 Unemployment sets in the capital goods industries and with the passage of time it spreads to other
industries also.
 The unemployment multiplier begins to work in the downward direction.
 Characteristics of Business cycle

1. Business cycle is a part of the capitalist economy.

2. Cyclical fluctuations are wave – like movements.
3. Fluctuations are recurrent in nature
4. They are non-periodic or irregular – the peak/boom and depression do not occur at
regular intervals.
5. They occur in such aggregate variables as output, income, employment and prices.
6. Upswings and downswings are cumulative process in their effects.
7. They are not secular trends such as long-run growth or decline in economic
activity.
Indicators of business cycle

 1. GDP
 2. Fixed investment
 3. Net exports
 4. Unemployment rate
 5. Real earnings
 6. CPI
 Types or timings of indicators

 There are three timings in which these indicators lead to changes in the business cycle namely:
 1. Leading: are those indicators due to operation of which, changes in Business cycle happen. Change in
leading indicators bring immediate change in the business cycle.
 “the consumer confidence index, Industrial new order, personal consumption of manufacturing goods etc.”
 2. coincidental: are those indicators wherein the changes in indicators simultaneously bring changes in the
business cycle: GDP
 3. Lagging: are those indicators wherein there is a time lag between indicators change and business cycle
change.
 Unemployment as it increases after trough of the business & bottom peak of the business cycle.
 Causes of Business Cycles

1. External Factors
 sunspots, wars, revolutions, political events, gold discoveries, growth
rate of population, migrations, discoveries and innovations.

2. Internal Factors
 Bank Credit, Over-Saving or Under Consumption, Over-Investment,
Competition, Psychological Causes, Innovations.
 Causes of Business Cycles:

 External Factors: The external factors emphasize the causes of business cycles in the fluctuations of something
outside the economic system.
 Such external factors are sunspots, wars, revolutions, political events, gold discoveries, growth rate of population,
migrations, discoveries and innovations.
 These outside factors change the level of national income by affecting either the investment or consumption
component of aggregate demand. For example, a drought that destroys many crops due to sunspots may reduce the
quantity of goods produced in the country and adversely affect both consumption and investment.
 An innovation by opening the door to new markets, raw materials, products and production processes encourages
new investments in plant and equipment. Inventions of railroads, electricity, telephone, automobiles, TVs,
computers, etc. have led to the burst of investments in both capital and consumer goods from time to time.
 Discoveries of gold, oil and natural resources have led to large scale investments. Similarly, population expansion
and migrations are the causes of huge investments in both housing and other infrastructure and consumer durables.
 Internal Factors: Haberler divides the internal factors into monetary and non-monetary
 1. Bank Credit: Hawtrey, Friedman and other monetarists regard business cycles as “a purely monetary phenomenon”.
According to Hawtrey, cyclical fluctuations are caused by expansion and contraction of bank credit. These in, turn, lead to
changes in the demand for money on the part of producers and traders.
 Bank credit is the principal means of payment. Credit is expanded or reduced by the banks by lowering or raising the rate of
interest or by purchasing and selling of securities to traders. This increases or decreases the supply of money in the economy.
An increase in the money supply brings about prosperity and a decrease in the money supply leads to depression.
 2. Over-Saving or Under Consumption: According to economists like Hobson, Foster and Douglas, business cycles are
caused by over saving or under-consumption. They argue that wide disparities of income and wealth lead to depression in the
country.
 The rich people are not able to spend their entire income. So they save more and invest more in producing consumer goods.
On the other hand, the poor people have low incomes or wages. This leads to fall in demand and as result depression.
 3. Over-Investment:
 Hayek Spiethoff, Cassel and Robertson find the root cause of business cycles in over­investment. According to Hayek, it is
bank loans which lead to over-investment in capital goods industries relative to consumer goods industries that ultimately
brings depression in the economy.
 When the total money supply exceeds the amount of voluntary savings, it leads to increase in the investment activity and
ultimately to a boom. But banks cannot continue to give credit for long due to the shortage of voluntary savings. As a result,
production will decline which will bring about a depression. Thus it is over-investment in the capital goods industries which
is the cause of a boom and a depression.
 4. Competition: According to Chapman, the main cause of business cycles is the existence of competition in an economy
which leads to over-production and ultimately to a crisis (depression). Under competitive conditions, firms produce in
anticipation of demand.
 Competition among producers to hire more factors raises their prices. Thus costs rise which raise the prices of products.
Demand falls which eventually leads to fall in prices and to a depression.
 5. Psychological Causes
 According to Pigou, the alternating waves of “over optimism” and “over pessimism” are the
sole causes of the industrial fluctuations. He traces cyclical fluctuations to the tendency of
businessmen to react excessively to the changing conditions of the economy. It is this tendency
that causes alternating periods of over-production and under-production.
 6. Innovations:
 According to Schumpeter, innovations in the structure of an economy are the source of
economic fluctuations. To him, “the cause of depression is prosperity.” The boom consists in
the carrying out of innovations in the industrial and commercial fields. The cyclical upswing is
set in motion when an innovator starts making investment in his innovation of a new product.
 Measures to Control Business Cycles or
Stabilization Policies

 Economic stabilization is one of the main remedies to effective control of

business cycle.
 Economic stabilizations is not merely confined to single sector of an economy
but embraces all the sectors.
 There are three ways by which a business cycle can be controlled.
1. Monetary Policy
2. Fiscal Policy
3. Automatic Stabilizers
 1. Monetary Policy

 Monetary policy as a method to control business fluctuations is operated by the

central bank of a country. The central bank adopts a number of methods to
control the quantity and quality of credit.
 To control the expansion of money supply during a boom, it raises its bank rate,
sells securities in the open market, raises the reserve ratio, and adopts a number
of selective credit control measures such as raising margin requirements and
regulating consumer credit.
 To control a recession or depression, the central bank follows an easy or cheap
monetary policy by increasing the reserves of commercial banks. It reduces the
bank rate and interest rates of banks
 2. Fiscal Policy:

 Monetary policy alone is not capable of controlling business cycles. It should, therefore, be
supplemented by compensatory fiscal policy.
 During a boom, the government tries to reduce unnecessary expenditure on non-development
activities in order to reduce its demand for goods and services. But it is difficult to cut
government expenditure. Therefore, this measure is supplemented by taxation.
 The government also follows the policy of having a surplus budget when the government
revenues exceed expenditures. This is done by increasing the tax rates or reduction in
government expenditure or both.
 Another fiscal measure which is usually adopted is to borrow more from the public which has
the effect of reducing the money supply with the public. Further, the repayment of public debt
should be stopped and postponed to some future date when the economy stabilizes.
 Policy during Depression:
 During a depression, the government increases public expenditure, reduces
taxes and adopts a budget deficit policy.
 These measures tend to raise aggregate demand, output, income, employment
and prices. An increase in public expenditure increases the aggregate demand
for goods and services and leads to increase in income.
 3. Direct Controls:
 The aim of direct controls is to ensure proper allocation of resources for the
purpose of price stability. They are meant to affect strategic points of the
economy.
 They affect particular consumers and producers. They are in the form of
rationing licensing, price and wage controls, export duties, exchange controls,
quotas, monopoly control, etc.
 Conclusions

 Of the various instruments of stabilizations policy, no single method is sufficient

to control cyclical fluctuations. Therefore, all methods should be used
simultaneously.
 This is because monetary policy is easy to apply but less effective while fiscal
measures and direct controls are difficult to operate but are more effective.
 Since cyclical fluctuations are inherent in the capitalist system, they cannot be
eliminated completely. Some fluctuations may be beneficial for economic growth
and others may be undesirable.
 Stabilization policy should, therefore, control undesirable fluctuations.
India's growth likely reached a trough in June quarter; recovery cycle to be
elongated: UBS

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