BUSINESS CYCLE

Meaning and Characteristics of Business Cycle.

Business cycle is also called Trade Cycle. The business is never steady. There are always ups& downs in economic activity. This cyclical movement both upwards and downwards are commonly called Trade Cycle. This is a wave like move in regular manner in business cycle .In business, there are flourishing activities which takes economy in prosperity and growth where as there are periods when there is recession which leads to decline in the employment, income and output. When the economy goes into downswing then there is a stage of recovery to reach a new boom.

Definition.

Keynes: Trade Cycle is composed of periods of good trade characterised by rising price and low unemployment percentage altering with periods of bad trade characterized by falling price and high unemployment percentage. To put it in simple words:-

Business Cycle is a fluctuation of the economy characterized by periods of prosperity followed by periods of depression.

Characteristics of Business Cycle:

The fluctuations are wave like movement and are recurrent in nature.

Business Cycle is characterized by waves of expansion and contraction but these are not only two phases of business cycle there are four phase of business cycle. – Expansion, Recession, Contraction and Revival or Recovery.

The movement from peak to trough and again trough to peak is not symmetrical. According to Keynes prosperity phase of business cycle comes to end fast but dip is gradual and slow.

Business Cycle is self generating. Every phase has germs of the next phase, that is expansion has the germs of the recession in it.

Phases of Business Cycle

After understanding what is business cycle and their characteristics we will take each phase of business cycle in details.

1. Prosperity or Expansion

This phase of business cycle is called the upswing. This phase is in the upper half of

the cycle which you can see in figure XI – 1.2 (1)To start with we will try to see how this phase begins. It starts from equilibrium position, when the demand increase the demand of raw material also increase and so the employment which again leads to increase in employment in other industry. As the consumption increases general employment also increases. The wages, salaries, interest rates, taxes and the cost do not increase in the same proportion and consequently profit margins go up. There is general feeling of optimism and production capacity of the economy is fully utilized. The rise general price is marked in this phase.In this phase, investment activity increases due to increase in demand for consumption goods. This optimistic sentiment can be seen in real estate and share market boom. Manufacturers pile up stock with improved prospects of increase in demand. This activity of producers increase in production is faster than consumption. But this process cannot be indefinitely continued. This phase ends and turns into phase of recession. The factors for recession to start are, when the gap between cost and price starts rising and the profit margin declines. This happens because of scarcity felt in different factor market and therefore the price of factors of production rises.

2. Recession:-

This is a turning period which is relatively shorter. But in this phase the production of consumer good do not decline immediately. The demand for consumer good falls with lag but the fall in demand for capital goods falls drastically. Producers cancel their future investment programmers so the demand for machinery decreases and therefore the capital goods manufacturing sectors responds more quickly. In this period over optimism gives way to over pessimism. All the investment seems unprofitable and so there is collapse of Marginal Efficiency of Capital. The employment situation gets bad as investment activity declines. This is referred as mild recession but when recession is severe it is called crisis.

3. Depression or Contraction:-

This phase is a phase of low economic activity. There is fall in production and employment throughout the economy. But it is not uniform in all sectors. The fall in demand for consumer good is less than the fall in demand for machines and equipments. During depression the expenditure on durable goods fall more than consumer goods, therefore the production and employment is affected in the sectors producing durable goods. Agriculture sectors are not much affected as it is necessary for subsistence. The producers and wholesalers start liquidating their inventories piling up during prosperity phase. This phase shows low a economic activity with fall in production, fall in employment and fall in general price level and the profit margins also. Producers are not interested to venture fresh investment as the MEC totally collapses. The price structure is distorted as some price galls little where as some goods the price vertically collapses making the income distribution worst and this prolongs the phase of depression. On the other hand not all the cost falls at a equal rate as wages and salaries tend to be sticky during this period due to trade unions and labour laws. Rents, interest rates and taxes come down slowly while price falls down continuously and cost rigidity wash away the profit margins for producer. Turning point of depression is trough is a very short period

but sometimes its for 3-5 years. e.g great depression of early 30s. After this, the recovery phase starts.

4. Recovery:- This phase is gradual. It starts when the price stops falling this is said to start when the pilled up stock is exhausted and supply reaches its. Now the producers start planning for production. This generates employment and income which again leads to demand for consumer goods. The MEC starts improving. This leads to correction of price and so also to the relationship between cost and price. The profit starts replacing losses and recovery gathers momentum. Rising price encourages companies towards new investment and projects. This phase of recovery takes the economy to the phase of prosperity. Thus is the cycle again ready to repeat itself.

THEORIES OF BUSINESS CYCLE:-

What are the factors that cause these fluctuations in business cycle? There are many theories proposed by various economists to explain the causes of business cycle. We will discuss some important theories of business cycle.

Schumpeter’s Innovation Theory:-

Joseph Schumpeter has explained the expansion and contraction through industrial innovation. Innovation - actual application of invention where as invention is discovery of something new. Invention converts into innovation. Here in this theory, the innovation can be introduction of new product, market source of raw material, opening of new market in business. An entrepreneur are innovators, he has knowledge to do something new, daring and foresight to go ahead of others and in this process he demands funds from banking system. Now we will examine how innovation causes business fluctuations. In this theory he says any innovation can move the economy to disequilibrium from equilibrium and this will continue till the new equilibrium position is reached. Here let us say the innovation is the introduction of a new product in a full employment economy. The new industry has to reward the existing factors of production heavily to attract them. The new industry is financed by bank credit. As the factor of new industry get higher rewards their purchasing power increases and the demand of old industry product increases, as the new product is yet to come in the market. Therefore the demand and production of old products increases. The old industry will now take credit from bank for expansion. In the mean while the new product comes to the market due to novelty, there is decrease in the demand for old products. The old industry starts cutting down on production, therefore the income to factors of production in decreases. As a result the demand for old and new product decreases. Due to more and more joblessness the vicious circle of deflation starts and the economy gets into downswing. So this theory says that the economic fluctuations due to innovation in the industry.

This theory was challenged and the limitations are-

The full employment assumption is unrealistic. Bank is not the only source of finance for every innovation in business. Many times the profits are ploughed back to finance innovations. Innovation cannot be the sore cause of business cycle.

Over Investment Theory of Business Cycle:-

A.F.Hayek assumes economy in equilibrium, whenever this equilibrium is disturbed then there is expansion or contraction. This theory says that when the economy is in equilibrium, the rate of interest is such that Saving = Investment there is no unemployed resources. Now if suppose the bank credit expansion takes place then the equilibrium rate of interest is disturbed. This low market rate of interest will tempt the businessmen to borrow more and invest in new ventures. This leads to upswing in business cycle as a result employment, output, profit and demand increases. But then this phase does not continue indefinitely.. Due to scarcity of resources this expansion phase cannot go on and on. But due to increase in price the people are forced to decrease consumption and start saving more. This forced saving due to high price makes the bank ease credit and investment starts. The economy comes out of its downswing as income increases and people revert back to earlier consumption and expenditure levels. This helps economy to recover and the upswing starts again. This theory says that the over investment due to forced saving by people in inflation is the cause of fluctuations in economic activities. He says voluntary saving leads to change in structure of production permanently but forced saving brings changes which are not permanent. The limitation for this theory are-

Assumption of full employment is unrealistic. Undue importance is given to banks rate of interest. Even if the rates of interest

are constant there will be variation in production when the business starts getting profits.

Pure Monetary theory of Business Cycle:(Hawtrey’s Monetary Theory of Business Cycle):-

According to Prof. R.G. Hawtrey, a British economist, there is direct relationship between volume of money supply and the economic activity. Where ever there is change in the flow of money or money supply changes, there will be business fluctuations. Here he means the credit creation by the banking system that is expansion in bank credit leads to in demand and so the upswing of business cycle starts. On the other hand when there is decrease in money supply through contraction of bank credit, it leads to down swing and thus leads to depression.

Let us take it in detail-Expansion of bank credit happens when interest rates are reduced which means the loans are cheaper. Due to liberal loans the profit margins changes as they are very sensitive to the change in interest rate. Thus investment increases and so the employment which in turns increases the income and demand. This increase in demand leads to increase in

price and profit margins, therefore the upward trends start that is the upswing starts. But as each phase has the germs of other phase the turning point starts when bank changes its policy of credit expansion as the cash reverse with the bank reduces. The lending rates are increased to discourage the demand for fresh loans and they start calling to return loans. The producers start disposing for their stock to repay loans. The restricted policy on credit and high rate of interest discourages a new investment which leads to downswing. The income falls and cash starts coming back to the bank. But as the cash reserve with the bank improves, again the bank starts using liberal attitude towards credit creation and so the revival starts. This takes the economy to expansion or prosperity. According to R G Hawtrey flow of money supply is the sole cause for business fluctuations. This theory was not unchallenged. Some limitations are-

Business cycle is a very complex phenomenon and we cannot attribute it completely to credit creation by banking system.

Bank plays a important role in the financing of business but it cannot be the only reason for business crisis. It can just aggravate the situation.

Too much of importance is given to bank credit. Many times traders don’t borrow from bank but plough back their profit.

Investment not only depends on interest rates but on the rate of return also. Hawtrey has totally ignored MEC.

This theory has totally ignored the non monetary factors like innovation, climatic conditions, psychological factors etc.

Multiplier – Acceleration theory of Business Cycle

Samuelson’s model is regarded as the first step in the direction of integrating theory of Multiplier and the principle of Acceleration. His model shows how the multiplier and acceleration interaction with each other to generate income, to increase consumption and investment demand more than expected and how this causes economic fluctuations.To understand Samuelson’s model, let us first understand derived investment, derived demand is the investment in capital equipment, which is undertaken due to increase in consumption making new investment necessary. We will try to understand this interaction briefly. When autonomous investment takes place in a society, income of the people rises and the process of Multiplier start increasing the income which leads to the increase in demand for consumer goods depending on the marginal propensity to consume. If there is excess production capacity, the existing stock of capital would prove inadequate to produce consumer goods to meet the rising demand. Producers trying to meet the growing demand undertake new investments. Thus, increase in consumption creates demand for investment. This is derived investment. This derived marks the beginning of Acceleration process, when derived investment takes place income increases further, in the same manner as it happens when the autonomous investment takes place. With increase in income, demand for consumer goods rises. This is how the Multiplier and the Accelerator interact with each other and make the income grow at a rate much faster than expected. with the help of both the Multiplier and Acceleration principle he tried to relate the upswings and downswings of business cycle. there some criticism regarding the assumptions, they as follows-

There is no government activity and no foreign trade No excess capacity One year lag in increase in consumption and investment demand

Conclusion:-

Though many economists had different approaches, some attribute business cycle to expansion and contraction of money supply some say it is due to the interaction of Multiplier & Acceleration which changes the aggregate demand and leads to fluctuations but some attribute it to the innovations in one sector which spreads to the rest of the economy that causes recession and boom. There are other economist who attributes fluctuation of business cycle to the politicians manipulating economic policies and some say supply shocks for eg 1970’s sharp increase in oil prices, increased inflation. All these theories have elements of truth but they are not valid in all the places and time. The key is to understand them and combine these theories and use the knowledge of macro economics to decide when and where to apply it.

Stabilisation policies to control business cycle:-

As you are introduced to the stabilization policies and know how it works from Unit -X we will now see how these policies are used in controlling the fluctuation of business cycle. To start with we will take monetary policy. Monetary policy includes all the instruments through which central bank controls the credit creation.

Monetary Policy in depression:-

We will just brush up the atmosphere in depression- low MEC, falling price, income, output and lots of uncertainty. In this atmosphere there is need to encourage investment and so the loans are made cheaper to stimulate investment and increase the demand by increasing income and employment because a cheap money policy will discourage saving and promote investment. Though it is said Monetary Policy has less scope in depression and fails to bring the economy out of depression as the MEC is low and so the businessmen are scared to invest, even though the rate of interest is low. Rate of interest is the factor but not the only factor for investment. Businessmen borrow when the business is expanding not when it is declining. Low rate of interest cannot make businessmen borrow as one can make a horse come to water but cannot make it drink. But however we cannot say it is totally useless because it can stimulate demand for durable goods and private investment. But open market operation can increase the liquidity overall in the economy, even if credit policy cannot turn the business cycle but it can create the necessary atmosphere for the other policies to be successful.

Monetary Policy during Inflation:-

Inflation is faced at the prosperity phase when MEC is high, rising prices, output and employment. The condition in the economy is very optimistic and business activities are rapidly increasing. Though this condition cannot go on continuously with increase in

consumer spending and investment spending the credit condition in the economy becomes tight. The banks start feeling difficult to cope with demand for credit in such a situation the rate of interest is raised by the banks to control the liquidity in the economy. The Cash Reserve Ratio, Statutory Liquidity Ratio are raised and a tight money policy is in effect to control the boom from turning into inflation. The effect of Monetary Policy in inflation is much greater than in depression.

Now we will try to understand how fiscal policy controls the business cycle.

Fiscal Policy during inflation:-

During inflation there is excessive aggregate spending and need to control the demand. We will discuss the measures of fiscal policy in controlling inflation.

1. Taxation: - There is need of new taxes to be introduced to wipe out the surplus purchasing power. The existing tax structure should not be increased too much otherwise it may lead to business recession by de-motivating the investments. The tax structure should be such that the demand for commodities should reduce or redistribution of tax so that it works as a measure for raising and stabilizing the consumption function. This means manipulating the tax structure in such a way that taxing low spending of high income group and taxing high spending of low and middle income group people. This work better than interest rates as it is a direct hit on the demand and thus works a aggregate demand management.

2. Public spending:- The government spending should be controlled in inflation.Though there is a minimum limit beyond which the government expenditure cannot be reduced but schemes such as construction of building, parks, schools etc can be postponed. Government can vary their expenditure pattern to control the inflationary pressures. But at the same time the revenue should be increased to create budget surplus.

3. Public Work:- This expenditure has two areas-

Expenditure on public works –such as hospitals, buildings, post offices, roads, schools etc.Transfer Payment:- This includes pensions, unemployment insurance, subsides, social security benefits etc. The government should take up some work when the economy shows the signs of recession and in such inflationary situations such programmes should be given up completely so the public investment will not compete with private investment.

Fiscal Policy in Depression:-

Taxation: - This phase needs more encouragement for private consumption and investment. Reduction in corporate and income tax is favorable as this increase the disposable income with people and so the purchasing power increases. Low corporate tax will encourage businessmen to enter new ventures. Though it cannot be a perfect

solution for unemployment but private investment can be encouraged by change in corporate tax and consumption can be increased by lowering sales tax and excise duties.

Public Spending:- Public expenditure is the right type of fiscal policy in depression as it encourages investment, production, employment and income. Government expenditure plays a very important role to bring about the variation in total income. In this phase, the private investment is below normal and therefore there is a need to increase the public investment. These investments done by the government will have Multiplier & Acceleration effects and in turn will increase the income consumption and employment. When the private spending is less due to business recession, public spending should improve to stimulate the investment and bring back the economy to a upward swing.

Public Work:- In depression, when there is need to increase the purchasing power the public work should be taken up to stimulate investment and generate employment but the problem is many projects which have been started in depression cannot be given up later and they cannot fill the gap of unemployment in private sectors. The social security measures like pensions; unemployment benefits etc not only raise employment but also leads to stabilization in long run. There is a need of correct co-ordination of public work and security measures, these things has to be financed by progressive taxation.

Conclusion:- The fiscal system with built - in -flexibility and built -in -stabilizers are one where in a change in employment and output changes the employment and taxes already in operation e.g. when the economy faces boom, the revenue collected through tax increases automatically and decreases when there is recession.

INFLATION

Money is used as measuring rod to measure the value of goods and services. A measuring rod is expected to be stable in its value like meters, liters, kilogram etc. value of money refer to its purchasing power which depends on price level. Value of money and price level is inversely related. A continues increase in general price level is called inflation. Inflation is a price rising. A sporadic rise in price cannot be termed inflation. Similarly it refers to a general price level and not sect oral or price of individual commodity

INFLATIONARY GAP

The concept of inflationary gap was introduced by Keynes. Inflation according to Keynes it is post employment phenomenon. It is a situation where there is excess demand for goods and services over the available at constant supply. It the difference between the aggregate money demands for the consumer goods and services and their supply. When the economy reaches full employment the supply tends to remain constant but due to increase in money supply increases the demand

INFLATION IN DEVELOPING COUNTRIES

Developing countries are in situation less than full employment or we can say that the resources are fully utilized. So strictly speaking they should not suffer with inflation but the factors responsible for inflation in these countries-

1. Developing countries need a lot of expenditure in developing projects, but these projects are financed by deficit financing which results to increase in the money supply in the system and this in turns leads to increase in the demand.

2. many a times the large portion of public expenditure goes to unproductive purposes and this injects additional purchasing power without increase in the supply of goods and services resulting in increase general price

3. capital intensive techniques of production has a long gestation period but during this period the demand increases without increase in the supply

4. Poor people spend major portion of their income on food grain, shortage in agricultural items can be due to low productivity of agriculture. Increase in the prices of agricultural commodities leads to cost-push inflation. Higher the prices of food grain higher will the demand for the worker to increase the wages and this leads to cost push inflation.

5. in developing countries the MPC and the income elasticity of demand is high where as the elasticity of supply is low then naturally the price will increase.

6. Increasing population leads to demand pull inflation because as the population increases the demand for goods and services will also increase but supply can not be increase at the rate and this leads to inflation.

7. the anti inflation measures are less effective due to tax base, dishonest and non committed administration and even the economic and political factors

8. Inflation in developing countries is the result of demand pull and cost push factors. The need to spend for the development increase the supply of money and result in increases in demand

DEMAND PULL Vs COST PUSH INFLATION

Some insist on demand pull inflation and others blaming on cost push inflation. The government was held responsible for the demand pull inflation as the excess demand was the result of budget deficit, trade union and monopoly power of the supplier of raw materials or other inputs were blamed for cost push inflation. Inflation can not sustain without the interaction of both factors, though it might have been initiated by any one of them. Excess demand generated in economy by itself would not cause inflation, if supply of goods and services could be increased at constant cost. Inflation started with demand pull but supported and aggravated by cost push forces. Similarly inflation caused by an increase in coat due to higher wages or higher input prices would not last long unless