Business Cycle

Meaning of a Business Cycle

• A wave like fluctuation of economic activity characterized by recurring phases of expansion & contraction in periods varying from 3 to 4 years

• Fluctuations found in aggregate economic activity of nations

• A cycle consists of general expansions, followed by general recessions, contractions & revivals which merge with the expansion phase of the next cycle

• This sequence of change is recurrent but not periodic

THE BUSINESS CYCLEPhases of the Business Cycle

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RECESSIONTROUGH RECOVERY

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The business cycle

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The business cycle

Characteristics of Business Cycles

• Recurring fluctuations: occur in a free rhythm, recurrence of expansion & contraction has no fixed period

• Period of business cycle is longer than a year- typically 3-4 yrs

• Presence of the alternating forces of expansion & contraction- these forces are in built into the system

• Phenomenon of the crisis: peak & trough are asymmetrical

Phases of Business Cycles

• Every business cycle has the critical mark-off points of peak & trough

• From trough to peak there is the expansion phase & from peak to trough the contraction phase

• Apart from these two longer phases there are two other turning points

• Upper turning point located at the peak marks the beginning of recession

• Lower turning point located at trough is venue of revival

• Both recession & revival phases are relatively shorter in duration

Phases of Business Cycles

• Acc. To Burns & Mitchell four distinct phases are:

• Revival

• Expansion

• Recession

• Contraction

Prosperity or Expansion

• The expansion phase begins from an equilibrium position under the stimulus of forces which create expectations of rising profits which in turn induce entrepreneurs to increase the scope of their activities

• Leads to more employment, more demand for raw materials, leads to larger employment in other industries, more wages, increase in demand for consumption goods

Prosperity or Expansion

• Rapid increase in supply & modest increase in prices

• Supply in later stages increases with a lag & this leads to rise in prices which gathers momentum later on

• Delay in price rise due to unutilized plant capacity available in the early stages, later stages bottlenecks appear

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Prosperity or Expansion

• Rise in prices more marked when large proportion of productive capacity is set up

• New factories, steel plants, increased production of heavy engineering goods, commercial & housing complexes, power projects

• Increases income , consumption• Supply of consumption goods does not

keep pace so increase in prices

Prosperity or Expansion

• Distortions of price relations: price do not rise uniformly during this phase

• Prices of raw materials & semi-finished goods rises faster than prices of consumption goods

• Wages, salaries, long pd interest rates, rentals, taxes lag behind

Prosperity or Expansion

• Expansion reaching its heights: rising profits & optimism about its continuance boost the stock prices

• Increase in investment by entrepreneurs- higher output, prices & profits

• Expansion in money supply especially bank credit• Confidence in business induce banks to expand

credit, speed up velocity of circulation of money• Leads to growth of fixed capital- plant, machinery &

equipment, wages increase, consumption increases• Manufacturers, wholesalers & retailers stock up

inventories

Prosperity or Expansion

• The end of expansion: expansion itself brings into play forces which lead to recession

• Gradual rise of costs relative to prices, narrows down profit margin & expansion gets weakened

• During later phase increase in costs due to growing pressure of demand for materials, labor & finance

Recession

• This phase is a turning point & is relatively shorter• Forces of expansion weakened & those of

contraction strengthened• Recession is characterized by liquidation in stock

market, strains in banking system, some fall in prices, sharp reduction in demand for capital & abandoning of projects

• Production of consumer goods does not decline immediately- people persist with their living standards for some time despite fall in income

• It falls with a lag

Recession

• In contrast fall in production of capital goods is dramatic• Abandoning of investment programs, demand for equipment,

machinery & plant falls• Most dramatic & noticeable signs of recession’s advent is the

weakening of the stock market• Borrowers on stock market find that their collateral is shrinking

& find it necessary to repay some of their loans

Recession

• New issues are postponed meaning corporate shelve their investment programs

• Orders for plants, machinery, equipment or buildings are reduced

• Banks are reluctant to expand the volume of credit

• Keynes has explained the turning point from expansion to recession by a collapse in the Marginal Efficiency of Capital

Depression or Contraction

• Recession ultimately merges into depression which is the phase of relatively low economic activity

• When economy moves from recession to depression there is a notable fall in production & employment

• Agriculture & Retail is affected less, manufacturing,, mining & construction affected more

• Industrial sector: worst affected are those which produce machines, tools, plants, equipment & steel

Depression or Contraction

• There is a substantial reduction in incomes of people & thus the demand for consumer goods & services declines

• Still decline is far less than the demand for machines & equipment

• Substantial reduction in demand for durable goods• Production & employment less affected in sectors producing

non durable goods• General price level falls, producers & wholesalers seeing

falling demand liquidate inventories piled up during prosperity phase

• Leads to increase in supply & fall in prices, also reduced purchasing power due to contraction also leads to fall in prices

Depression or Contraction

• Steadily declining prices erode the profits of producers & traders alike

• Pessimism , some firms close own, MEC collapses so no new investments, reduction in bank credit, distortions in price structure

• Distortions also appear in cost-price relations because costs do not fall proportionately to prices

• Some costs are rigid while others fall sharply• Wages & salaries are sticky, rents, interest rates,

insurance premium & taxes are slow to move downwards• Prices keep falling & profit margins are wiped out

Recovery

• Recovery starts when forces that work to restore the normal price relations & cost price relations start operating effectively

• Recovery is gradual, starts when prices stop falling• When inventories are exhausted, supplies reach

scarcity levels & downward movement of prices is arrested then producers see no risk in undertaking production

• Demand for durable goods & MEC , investment starts increasing

Recovery• Along with restoration of normal price relations, there is

correction of distortions in cost-price relations

• Lagging costs which had eroded profits during depression start falling

• Interest rates fall in the later phase of depression & so does rents, insurance & taxes

• Efficiency increases as efficient plants are used & inefficient managers have been dropped- lowers the AC

• Losses are replaced by profits- recovery gains momentum

• There is revival of stock exchange

• Profit expectations lead to new investment ventures & expansion, innovating activities get a boost