MANAGERIAL

ECONOMICS

MODULE V
 Business Cycle
Business cycle refers to the phenomenon of cyclical booms and depressions. In a business cycle,
there are wave like fluctuations in aggregate employment, income, output and price level.
Keynes defined business cycle as, ‘A trade cycle is composed of periods of good trade characterized by
rising prices and low unemployment percentages, altering with periods of bad trade characterized
by falling prices and high unemployment percentages.’
 Characteristics of Trade Cycle
 A business cycle is synchronic. When cyclical fluctuations start in one sector it spreads to other
sectors.
 In a trade cycle, a period of prosperity is followed by a period of depression. Hence trade cycle is a
wave like movement.
 Business cycle is recurrent and rhythmic; prosperity is followed by depression and vice versa.
  A trade cycle is asymmetrical. The prosperity phase is slow and gradual and the phase of depression
is rapid.
 The business cycle is not periodical. Some trade cycles last for three or four years, while others last for
six or eight or even more years.
 The impact of a trade cycle is differential. It affects different industries in different ways.
 A trade cycle is international in character. Through international trade, booms and depressions in one
country are passed to other countries.
 PHASES OF TRADE CYCLE
 Depression:
 During depression, the level of economic activity is extremely low.
 Real income production, employment, prices, profit etc. are falling.
 There are idle resources.
 Price is low leading to a fall in profit, interest and wages.
 All the sections of the people suffer.
 During this phase, there will be pessimism leading to closing down of business firms.
 Recovery:
 Recovery denotes the turning point of business cycle form depression to prosperity.
 In this phase, there is a slow rise in output, employment, income and price.
 Demand for commodities go up.
 There is increase in investment, bank loans and advances.
 Pessimism gives way to optimism.
 The process of revival and recovery becomes cumulative and leads to prosperity.
 PHASES OF TRADE CYCLE
 Prosperity:
 It is a state of affairs in which real income and employment are high.
 There are no idle resources.
 There is no wastage of materials.
 There is rise in wages, prices, profits and interest.
 Demand for bank loans increases.
 There is optimism everywhere. There is a general uptrend in business community.
 These boom conditions cannot last long because the forces of expansion are very weak. There are bottlenecks and shortages.
There may be scarcity of labour, raw material and other factors of production. Banks may stop their loans. These conditions lead
to recession.
 Recession:
 When the entrepreneurs realize their mistakes, they reduce investment, employment and production.
 Fall in employment leads to fall in income, expenditure, prices and profits.
 Optimism gives way to pessimism.
 Banks reduce their loans and advances.
 Business expansion stops.
 This state of recession ends in depression.
 Meaning of Exchange Rate
 A (foreign) exchange rate is the rate at which one currency is
exchanged for another.
 An exchange rate can be regarded as the price of one currency in
terms of another.
 An exchange rate is a ratio between two monies.
 If 5 UK pounds buy Indian goods worth Rs. 400 then pound-
rupee exchange rate becomes Rs. 80 = £1 respectively.
 If 5 US dollars buy Indian goods worth Rs. 250, then dollar-
rupee exchange rate becomes Rs. 50 = $1, respectively.
 Ex­change rate is usually quoted in terms of ru­pees per unit of
foreign currencies.
 Thus, an exchange rate indicates external purchasing power of
money.
 Theories of Exchange rate Determination

Theories of
Exchange rate
Determination

Mint Parity Purchasing Power Balance of

Theory Parity Theory Payment Theory
 Purchasing Power Parity Theory

 The purchasing power parity theory was propounded by Professor Gustav Cassel of Sweden.
 According to this theory, rate of exchange between two countries depends upon the relative purchas­ing
power of their respective currencies. Such will be the rate which equates the two purchasing powers.
 For example, if a certain assortment of goods can be had for £1 in Britain and a similar assortment with Rs.
80 in India, then it is clear that the purchasing power of £ 1 in Britain is equal to the purchasing power of Rs.
80 in India. Thus, the rate of exchange, according to purchasing power parity theory, will be £1 = Rs. 80.
 Suppose in the USA 1$ purchases a given collection of commodities. In India, same
collection of goods cost 60 rupees. Then rate of exchange will tend to be $ 1 = 60
rupees.
 Now, suppose the price levels in the two countries remain the same but somehow
exchange rate moves to $1=61 rupees.
 This means that one US$ can purchase commodities worth more than 60 rupees. It
will pay people to convert dollars into rupees at this rate, ($1 = Rs. 61), purchase
the given collection of commodities in India for 60 rupees and sell them in U.S.A.
for one dollar again, making a profit of 1 rupee per dollar worth of transactions.
 This will create a large demand for rupees in the USA while supply thereof will be
less because very few people would export commodities from USA to India.
 The value of the rupee in terms of the dollar will move up until it will reach $1 =
60 rupees. At that point, imports from India will not give abnormal profits. $ 1 = 60
rupees and is called the purchasing power parity between the two countries.
 Thus while the value of the unit of one currency in terms of another currency is determined at
any particular time by the market conditions of demand and supply, in the long run the
exchange rate is determined by the relative values of the two currencies as indicated by their
respective purchasing powers over goods and services.
 In other words, the rate of exchange tends to rest at the point which expresses equality between
the respective purchasing powers of the two currencies. This point is called the purchasing
power parity.
 Thus, under a system of autonomous paper standards the exter­nal value of a currency is said to
depend ultimately on the domestic purchasing power of that currency relative to that of another
currency.
 In other words, exchange rates, under such a system, tend to be determined by the relative
purchasing power parities of different currencies in different countries.
 Criticism of PPP Theory
 Transport Costs: Goods that are unavailable locally must be imported, resulting in
transport costs. These costs include not only fuel but import duties as well. Imported
goods will consequently sell at a relatively higher price than do identical locally
sourced goods.
 Tax Differences: Government sales taxes such as the value added tax (VAT) can
spike prices in one country, relative to another.
 Government Intervention: Tariffs can dramatically augment the price of imported
goods, where the same products in other countries will be comparatively cheaper.
 Market Competition: Goods might be deliberately priced higher in a country. In
some cases, higher prices are because a company may have a competitive advantage
over other sellers. The company may have a monopoly or be part of a cartel of
companies that manipulate prices, keeping them artificially high.
 Fixed Exchange Rate
• A fixed exchange rate, sometimes called a pegged exchange rate, is a type
of exchange rate regime in which a currency’s value is fixed or pegged by a monetary
authority against the value of another currency, a basket of other currencies, or another
measure of value, such as gold.
• There are several ways countries maintain a fixed exchange rate. The purest form is
when its currency is pegged to a set value against a single currency.
• Alternatively, many countries fix a set value to a basket of currencies, instead of just
one currency. Other countries peg it to either a single currency or to a basket of
currencies, but then allow it to fluctuate within a range of the pegged currency.
Examples of Fixed Exchange Rate
 Merits of Fixed Exchange Rate
 Exchange Rate Stability: Exchange rate stability, it is said, is necessary for orderly devel­opment of
the international economy and rapid growth of world trade.
 Promotes Capital Movements: A stable currency does not involve any uncertainties about capi­tal
loss on account of changes in exchange rate. Therefore, fixed exchange rate system would attract
foreign capital investments.
 Prevents capital outflow: Flexible and unstable exchange rates may at times of diffi­cult economic
situation may encourage flight of capital. A stable exchange rate ensures that such capital outflow
would not occur.
 Prevents Speculation in foreign exchange market: the flexible and unstable exchange rate
encourages specu­lation in foreign exchange market. By eliminating speculation fixed exchange rate
system ensures stability in the exchange rate.
 Promotes economic integration of the world: A single common currency in a country which
promotes economic integration of a nation in the sense that it facilitates communication, trade and
free movement of finance be­tween different regions of a country.
 Demerits of Fixed Exchange Rate
 Under this system, countries with a large and persistent balance of payments deficits lose gold and other
foreign assets. This could not go on forever as evidently stock of gold and foreign currencies would have
run out. The country will have to devalue its currency. The devaluation has an inflationary potential.
 On the other hand, under the fixed exchange rates, the countries with a balance of payments surplus will
be providing its national currency and in return it will receive foreign currencies and assets such as US
dollar, pounds, gold. The increase in foreign assets would lead to the expansion in money supply which is
likely to create inflationary pressures in the economy.
 Flexible Exchange Rate

 Flexible exchange rates can be defined as exchange rates determined by global supply and demand of
currency.
 In other words, they are prices of foreign exchange determined by the market, that can rapidly change
due to supply and demand, and are not pegged nor controlled by central banks
  For example, one U.S. dollar might buy one British Pound today, but it might only buy 0.95 British
Pounds tomorrow. The value "floats."
 Merits of Flexible Exchange Rate
 Problems of Undervaluation and Overvaluation are Avoided: the flexible exchange system
works to ensure the equilibrium in the balance of payments. whenever there is surplus in the balance
of payments, the exchange rate will appreciate which will tend to reduce exports and raise imports.
This again will tend to automatically restore the balance of payments equilibrium.
  Promotes Growth of Multilateral Trade: Promotion of world trade under the flexible exchange
rates would not interfere in any way the adoption of policies to achieve domestic economic stability.
 Flexible Exchange Rates does not Necessarily Show Large Fluctuations: the problems of
undervalued or overvalued currency found under the fixed exchange rate regime are not found in the
flexible exchange rate system. changes in exchange rates will occur only when economic conditions
underlying demand for and supply of foreign currencies change. 
 It Ensures Individual Freedom: The system of floating exchange rate is advocated on the basis of
philosophy that Government should intervene in the economy as little as possible and the indi­viduals
should be left free to pursue their economic interests.
 It Frees the Government from Problems of Balance of Payments: floating exchange rates work
automatically to restore balance of payments equilibrium, the Government need not pay any
attention to the balance of payments. 
 Demerits of Flexible Exchange Rate
 Flexible Exchange Rates Create a Situation of Instability and Uncertainty: too frequent fluctuations in
exchange rate under it create uncertainty about the exact amount of receipts and payments in foreign
exchange transac­tions. This instability hampers foreign trade and capital movements between the countries.
 Dampening Effect on Foreign Trade: Under the flexible exchange rates, the price of for­eign exchange or
international value of the national currency is quite uncertain. As a result, they are unable to take proper
decisions regarding exports and imports of goods. Obviously, this has a damp­ening effect on the volume
and growth of foreign trade.
 Provides an Inflationary Bias to an Economy: Another shortcoming of the flexible, ex­change rates is
that they have an inflationary impact on the economy. It has been pointed out that whenever due to deficit
in balance of payments, the currency depreciates, the prices of imports go up. The higher prices of imported
materials raise the prices of industrial products and thus generate cost-push inflation.
 Fixed vs Flexible Exchange Rate System
BASIS FOR FLEXIBLE EXCHANGE
FIXED EXCHANGE RATE
COMPARISON RATE
Meaning Fixed exchange rate refers to Flexible exchange rate is a
a rate which the government rate that variate according to
sets and maintains at the same the market forces.
level.

Determined by Government or central bank Demand and Supply forces

Changes in currency price Devaluation and Revaluation Depreciation and

Appreciation
Speculation Takes place when there is Very common
rumor about change in
government policy.
Self-adjusting mechanism Operates through variation in Operates to remove external
supply of money, domestic instability by change in forex
interest rate and price. rate.