Business CycleBusiness Cycle

Dr. Gopalakrishna B.V.Dr. Gopalakrishna B.V.

Faculty in MBA,Faculty in MBA,

SDM CollegeSDM College,,

Business cycle or trade cycle is a part of the Business cycle or trade cycle is a part of the capitalistic economy. capitalistic economy.

The business cycle refers to fluctuation in The business cycle refers to fluctuation in economic activities such as levels of income, economic activities such as levels of income, employment, prices and output, occurs more or employment, prices and output, occurs more or less in regular time sequences.less in regular time sequences.

Business cycle is characterised by upward and Business cycle is characterised by upward and downward movement of economic activities.downward movement of economic activities.

In a business cycle, there are wave-like In a business cycle, there are wave-like fluctuations in aggregate employment, income fluctuations in aggregate employment, income output and price level.output and price level.

DefinitionsDefinitions Prof. Haberler’sProf. Haberler’s defines “an alternation of defines “an alternation of

periods of prosperity and depression of good periods of prosperity and depression of good and bad trade”.and bad trade”.

J.M. KeynesJ.M. Keynes “it composed of periods of “it composed of periods of good good tradetrade characterised by rising prices and low characterised by rising prices and low employment percentage, altering with period of employment percentage, altering with period of bad tradebad trade characterised by falling prices and characterised by falling prices and high unemployment percentage”. high unemployment percentage”.

Gordon’sGordon’s define “business cycles consist of define “business cycles consist of recurring alternation of expansion and recurring alternation of expansion and contraction in aggregate economic activities in contraction in aggregate economic activities in the economy”.the economy”.

Estey “Estey “cyclical fluctuations are characterised by cyclical fluctuations are characterised by alternating waves of expansion and contraction”.alternating waves of expansion and contraction”.

Characteristics of Business cycleCharacteristics of Business cycle

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

2.2. Cyclical fluctuations are wave – like movements.Cyclical fluctuations are wave – like movements.

3.3. Fluctuations are recurrent in natureFluctuations are recurrent in nature

4.4. They are non-periodic or irregular – the peak and They are non-periodic or irregular – the peak and troughs do not occur at regular intervals.troughs do not occur at regular intervals.

5.5. They occur in such aggregate variables as output, They occur in such aggregate variables as output, income, employment and prices.income, employment and prices.

6.6. Upswings and downswings are cumulative process Upswings and downswings are cumulative process in their effects.in their effects.

7.7. They are not secular trends such as long-run growth They are not secular trends such as long-run growth or decline in economic activity.or decline in economic activity.

Phases/stages of Business cyclePhases/stages of Business cycle

A typical cycle is generally divided into A typical cycle is generally divided into five phasesfive phases

1.1. DepressionDepression

2.2. RecoveryRecovery

3.3. Full employmentFull employment

4.4. ProsperityProsperity

5.5. RecessionRecession

1. Depression1. Depression Recession merges into depression when there is a Recession merges into depression when there is a

general decline in economic activity.general decline in economic activity. There is considerable reduction in the production of There is considerable reduction in the production of

goods and services, employment, income, demand and goods and services, employment, income, demand and prices.prices.

The general decline in economic activity leads to a fall in The general decline in economic activity leads to a fall in bank deposits.bank deposits.

When credit expansion stops, even business community When credit expansion stops, even business community is not willing to borrow.is not willing to borrow.

Thus, a depression is characterised by mass Thus, a depression is characterised by mass unemployment – general fall in prices, wages, profits, unemployment – general fall in prices, wages, profits, interest rate, consumption expenditure, investment – interest rate, consumption expenditure, investment – bank loans and advances falling – factories close down bank loans and advances falling – factories close down – capital goods industries are also closed down.– capital goods industries are also closed down.

During this phase, there will be pessimism leading to During this phase, there will be pessimism leading to closing down of business firms.closing down of business firms.

2. Recovery2. Recovery Recovery denotes the turning point of business Recovery denotes the turning point of business

cycle from depression to prosperity.cycle from depression to prosperity. There is a slow rise in output, employment, There is a slow rise in output, employment,

income and price – demand for commodities go income and price – demand for commodities go up steadily.up steadily.

There is increase in investment – bank and There is increase in investment – bank and financial institutions are also willing to granting financial institutions are also willing to granting loans and advances.loans and advances.

Pessimism gives way to optimism.Pessimism gives way to optimism. The process of recovery becomes combative The process of recovery becomes combative

and leads to prosperity.and leads to prosperity.

3. Prosperity3. Prosperity In this period, demand, output, employment and In this period, demand, output, employment and

income are at a high level, they tend to raise prices.income are at a high level, they tend to raise prices. But wages, salaries, interest rates, rentals and But wages, salaries, interest rates, rentals and

taxes do not rise in proportion to the rise in prices.taxes do not rise in proportion to the rise in prices. The gap between prices and cost increases - the The gap between prices and cost increases - the

margin of profit increases.margin of profit increases. The increase of profit and the prospect of its The increase of profit and the prospect of its

continuance commonly cause a rapid rise in stock continuance commonly cause a rapid rise in stock market values.market values.

The economy is engulfed in waves of optimism.The economy is engulfed in waves of optimism. Larger profit expectation further increase – Larger profit expectation further increase –

investment which is helped by liberal bank credit.investment which is helped by liberal bank credit. This leads to peak or boom.This leads to peak or boom.

4. Recession4. Recession Recession starts downward movement of economic Recession starts downward movement of economic

activities from peak/boom.activities from peak/boom. It is a state in which there is general deceleration in the It is a state in which there is general deceleration in the

economic activity resulting in cuts in production and economic activity resulting in cuts in production and employment falling prices of stock market.employment falling prices of stock market.

Banking and financial institutional loans and advances Banking and financial institutional loans and advances beginning to decline.beginning to decline.

As a result profit margins decline further because costs As a result profit margins decline further because costs starts overtaking prices.starts overtaking prices.

Recession may be mild/severe – it lead to a sudden Recession may be mild/severe – it lead to a sudden explosive situation emanating from banking system and explosive situation emanating from banking system and stock markets.stock markets.

Such experience of the United States in 1873, 1893, Such experience of the United States in 1873, 1893, 1907, 1933 and 2007.1907, 1933 and 2007.

Expansions and Recessions in USExpansions and Recessions in US

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

Oct.1949-Jul.1953Oct.1949-Jul.1953 4444 Jul. 1953 – May 1954Jul. 1953 – May 1954 1010

May 1954-Aug. 1957May 1954-Aug. 1957 3939 Aug. 1957 – Apr. 1958Aug. 1957 – Apr. 1958 99

Apr. 1958-Apr. 1960Apr. 1958-Apr. 1960 2424 Apr. 1960 – Feb. 1961Apr. 1960 – Feb. 1961 1010

Feb. 1961- Dec. 1969Feb. 1961- Dec. 1969 105105 Dec. 1969 – Nov. 1970Dec. 1969 – Nov. 1970 1010

Nov. 1970- Nov. 1973Nov. 1970- Nov. 1973 3636 Nov. 1973 – Mar. 1975Nov. 1973 – Mar. 1975 1616

Mar. 1975- Jan. 1980Mar. 1975- Jan. 1980 5858 Jan. 1980 – Jul. 1980Jan. 1980 – Jul. 1980 66

Jul. 1980- Jul. 1981Jul. 1980- Jul. 1981 1212 Jul. 1981 – Nov. 1982Jul. 1981 – Nov. 1982 1616

Nov. 1982- Jul. 1990Nov. 1982- Jul. 1990 9292 Jul. 1990 – Mar. 1991Jul. 1990 – Mar. 1991 99

Mar. 1991- Mar. 2001Mar. 1991- Mar. 2001 120120 Mar. 2001 – Nov. 2001Mar. 2001 – Nov. 2001 88

Nov. 2007Nov. 2007

Theories of Business cyclesTheories of Business cycles

1.1. Hawtrey’s monetary theoryHawtrey’s monetary theory

2.2. Hayek’s monetary over investment theoryHayek’s monetary over investment theory

3.3. Schumpeter’s innovations theorySchumpeter’s innovations theory

4.4. The psychological theoryThe psychological theory

5.5. The Cobweb theoryThe Cobweb theory

6.6. J.M. Keynes business theoryJ.M. Keynes business theory

7.7. Samuelson’s model of business cycleSamuelson’s model of business cycle

8.8. Hick’s theory of business cycleHick’s theory of business cycle

1. Hawtrey’s monetary theory1. Hawtrey’s monetary theory

According to According to Prof. R.G. HawtreyProf. R.G. Hawtrey – business – business cycle is a purely monetary phenomenon.cycle is a purely monetary phenomenon.

It is changes in the flow of monetary demand on It is changes in the flow of monetary demand on the part of businessmen that lead to prosperity the part of businessmen that lead to prosperity and depression in the economy.and depression in the economy.

The cyclical fluctuations are caused by The cyclical fluctuations are caused by expansion and contraction of bank credit which, expansion and contraction of bank credit which, in turn lead to variations in the flow of monetary in turn lead to variations in the flow of monetary demand on the part of producers and traders.demand on the part of producers and traders.

Credit is expanded or reduced by the banking Credit is expanded or reduced by the banking system by lowering or raising the rate of interest system by lowering or raising the rate of interest or purchasing or selling securities to merchants.or purchasing or selling securities to merchants.

This increases or decreases the flow of money This increases or decreases the flow of money in the economy and thus brings about prosperity in the economy and thus brings about prosperity or depression.or depression.

Expansion phaseExpansion phase – bank credit increases – – bank credit increases – lending rate of interest falling – encourages to lending rate of interest falling – encourages to borrower to borrow money in large scale – rate borrower to borrow money in large scale – rate of interest will decline – credit become cheap – of interest will decline – credit become cheap – stocks/inventories – peak/boomstocks/inventories – peak/boom

Contraction phaseContraction phase – bank credit decreases – – bank credit decreases – lending rate of interest increases – borrower lending rate of interest increases – borrower reduces loans – cost of loans become costlier – reduces loans – cost of loans become costlier – production falls etc. production falls etc.

2. Hayek’s monetary over – investment theory2. Hayek’s monetary over – investment theory

F.A. Hayek’s formulated monetary over-F.A. Hayek’s formulated monetary over-investment theory of trade cycle.investment theory of trade cycle.

He explained his theory on the basis of He explained his theory on the basis of distinction between the distinction between the natural interest rate and natural interest rate and market interest ratemarket interest rate..

The natural rate of interest is that rate at which The natural rate of interest is that rate at which the demand for learnable funds equal the supply the demand for learnable funds equal the supply of voluntary savings (loans = savings)of voluntary savings (loans = savings)

Market rate of interest is the money rate at which Market rate of interest is the money rate at which prevails in the market and is determined by the prevails in the market and is determined by the demand and supply of money.demand and supply of money.

According to Hayek as long as the natural rate of According to Hayek as long as the natural rate of interest are equals the market rate of interest – interest are equals the market rate of interest – the economy in the state of equilibrium and full the economy in the state of equilibrium and full employment existence – no places for trade employment existence – no places for trade cycle.cycle.

The trade cycles in the economy are caused by The trade cycles in the economy are caused by inequality between market rate of interest and inequality between market rate of interest and natural rate of interest.natural rate of interest.

When the market interest rate is less than the When the market interest rate is less than the natural rate, there is prosperity in the economy. natural rate, there is prosperity in the economy.

On the other hand, when the market interest is On the other hand, when the market interest is more than the natural rate, the economy is in more than the natural rate, the economy is in depression.depression.

3. Schumpeter’s innovations theory3. Schumpeter’s innovations theory The innovations theory of trade cycles is associated with The innovations theory of trade cycles is associated with

the name of the name of Joseph SchumpeterJoseph Schumpeter.. According to him, innovations in the structure of an According to him, innovations in the structure of an

economy are the source of economic fluctuations.economy are the source of economic fluctuations. Trade cycles are the outcome of economic development Trade cycles are the outcome of economic development

in a capitalist society.in a capitalist society. Schumpter approach involves two stages –Schumpter approach involves two stages –

• First stageFirst stage – deals with initial impact of innovation – deals with initial impact of innovation• Second stageSecond stage – follows through reactions to the original impact – follows through reactions to the original impact

of innovation.of innovation. When the economy is in equilibrium where every factor When the economy is in equilibrium where every factor

fully employed – cost = receipts – product price = fully employed – cost = receipts – product price = average and marginal cost – profit and interest are zero average and marginal cost – profit and interest are zero – no savings and investments – circular flow.– no savings and investments – circular flow.

Schumpeter theory starts with the breaking up of the Schumpeter theory starts with the breaking up of the circular flow by an innovation in the form of a new circular flow by an innovation in the form of a new product by entrepreneur for earning profits. product by entrepreneur for earning profits.

Schumpeter’s innovations theory…….Schumpeter’s innovations theory…….

An innovation may consists of –An innovation may consists of –1.1. The introduction of a new productThe introduction of a new product2.2. The introduction of a new method of productionThe introduction of a new method of production3.3. The opening up of a new marketThe opening up of a new market4.4. New sources of raw-materials or semi-New sources of raw-materials or semi-

manufactured goods andmanufactured goods and5.5. New organizations of an industry.New organizations of an industry. Changes in technology and expansion of bank Changes in technology and expansion of bank

credit.credit. Trade cycle starts with equilibrium.Trade cycle starts with equilibrium. Upward movement from equilibrium are prosperity Upward movement from equilibrium are prosperity

and recession.and recession. Downward movement equilibrium to depression and Downward movement equilibrium to depression and

revival.revival.

4. The Psychological theory4. The Psychological theory The psychological theory of business cycle has The psychological theory of business cycle has

been developed by been developed by Prof. A.C. Pigou.Prof. A.C. Pigou. He explain the phenomenon of business cycle He explain the phenomenon of business cycle

on the basis of changes in the psychology of on the basis of changes in the psychology of industrialists and businessmen.industrialists and businessmen.

According to Pigou, expectations (optimistic and According to Pigou, expectations (optimistic and pessimism) originated from some real factors pessimism) originated from some real factors such as good harvests, wars, natural calamities, such as good harvests, wars, natural calamities, industrial disputes, innovation etc.industrial disputes, innovation etc.

The cause of business cycle into two categories The cause of business cycle into two categories 1. inpulses 2. conditions.1. inpulses 2. conditions.1.1. Inpulses – refers to those causes which set a process Inpulses – refers to those causes which set a process

in motionin motion2.2. Conditions – the vehicles through which the process Conditions – the vehicles through which the process

passes and upon which the impulses act.passes and upon which the impulses act.

5. The Cobweb theory5. The Cobweb theory The cobweb theory of business cycles was The cobweb theory of business cycles was

advocated by Prof. Schultz in 1930, latter advocated by Prof. Schultz in 1930, latter it was fully developed by Prof. Kaldar, it was fully developed by Prof. Kaldar, Tinbergen and Ricci.Tinbergen and Ricci.

The cobweb model is used to explain the The cobweb model is used to explain the dynamics of demand, supply and price dynamics of demand, supply and price over long period of time.over long period of time.

The movement of up and down of prices The movement of up and down of prices and output of the commodities causes for and output of the commodities causes for business cycle.business cycle.

6. Keynes theory of trade cycle6. Keynes theory of trade cycle Keynes does not develop a complete and pure Keynes does not develop a complete and pure

trade cycle.trade cycle. According to Keynes effective demand will According to Keynes effective demand will

influence on fluctuations in economic activities.influence on fluctuations in economic activities. These effective demand consist of aggregate These effective demand consist of aggregate

demand function and aggregate supply function.demand function and aggregate supply function. Aggregate demand function consists – Aggregate demand function consists –

consumption and investment expenditure.consumption and investment expenditure. Aggregate effective demand determines the Aggregate effective demand determines the

level of income and employment.level of income and employment.

Keynes believes that consumption Keynes believes that consumption expenditure (short period) is stable and it expenditure (short period) is stable and it is fluctuation in investment expenditure is fluctuation in investment expenditure which is responsible for changes in output, which is responsible for changes in output, income and employment.income and employment.

Investment depends on rate of interest Investment depends on rate of interest and marginal efficiency of capital.and marginal efficiency of capital.

Since rate of interest is more or less stable Since rate of interest is more or less stable marginal efficiency of capital determines marginal efficiency of capital determines the level of investment.the level of investment.

These MEC depends on two factors such These MEC depends on two factors such as perspective yield and supply price of as perspective yield and supply price of the capital asset.the capital asset.

Keynes theory of trade cycle……Keynes theory of trade cycle……

An increase in MEC will create more An increase in MEC will create more employment, output and income leads to employment, output and income leads to prosperity.prosperity.

On the other hand, a decline in MEC leads to On the other hand, a decline in MEC leads to unemployment and fall in income and output, unemployment and fall in income and output, this result – depression.this result – depression.

During the period of expansion businessmen are During the period of expansion businessmen are optimistic – where MEC is rapidly increases – so optimistic – where MEC is rapidly increases – so entrepreneurs undertake new investment – the entrepreneurs undertake new investment – the process of expansion goes on till boom is process of expansion goes on till boom is reached.reached.

While, on the other hand, if MEC is falling While, on the other hand, if MEC is falling – profits level are also falling – price of – profits level are also falling – price of raw-material equipment cost falls – wages raw-material equipment cost falls – wages also go down – this leads to depression.also go down – this leads to depression.

Keynes explain business cycle with Keynes explain business cycle with reference to two kinds of turning points reference to two kinds of turning points

Upper turning pointUpper turning point – consists of – consists of recovery and boom/peak.recovery and boom/peak.

Lower turning pointLower turning point – depression and – depression and recovery etc. recovery etc.

Control of Business CycleControl of Business Cycle

Economic statilisation is one of the main Economic statilisation is one of the main remedies to effective control of business cycle.remedies to effective control of business cycle.

Economic stabilizations is not merely confined Economic stabilizations is not merely confined to single sector of an economy but embraces to single sector of an economy but embraces all the sectors.all the sectors.

There are three ways by which a business There are three ways by which a business cycle can be controlled.cycle can be controlled.

1.1. Monetary PolicyMonetary Policy2.2. Fiscal PolicyFiscal Policy3.3. Automatic StabilisersAutomatic Stabilisers

1. Monetary policy1. Monetary policy Monetary policy as a method to control business Monetary policy as a method to control business

fluctuations is operated by the central bank of country.fluctuations is operated by the central bank of country. Monetary policy mainly concerned with Monetary policy mainly concerned with money supply, money supply,

bank credit and interest ratesbank credit and interest rates.. The central bank can adopts a number of methods to The central bank can adopts a number of methods to

control the business cycle with the help of quantitative control the business cycle with the help of quantitative and qualitative credit control.and qualitative credit control.

Dear money policyDear money policy – during boom/peak it raises its – during boom/peak it raises its bank rate policy, sells securities in the open market bank rate policy, sells securities in the open market operation and raises the cash reserve ratio and adopts operation and raises the cash reserve ratio and adopts number of selective credit control.number of selective credit control.

Cheap money policyCheap money policy – during recession/depression – – during recession/depression – reduces the bank rate policy and interest rates of banks reduces the bank rate policy and interest rates of banks – and also buys securities in the open market, reduces – and also buys securities in the open market, reduces cash reserve ratio etc. cash reserve ratio etc.

2. Fiscal policy2. Fiscal policy Monetary policy alone cannot check business cycle. Monetary policy alone cannot check business cycle.

Therefore, economists like JM Keynes and Hansen & Therefore, economists like JM Keynes and Hansen & many others have recommended that fiscal policy can be many others have recommended that fiscal policy can be bring about stabilisation of business cycle.bring about stabilisation of business cycle.

Fiscal policy is a policy of government which is Fiscal policy is a policy of government which is concerned with public expenditure, taxation and public concerned with public expenditure, taxation and public borrowing.borrowing.

These three instruments have to be effectively utilised to These three instruments have to be effectively utilised to control the severity of boom and depression.control the severity of boom and depression.

During the period of recession and depression, During the period of recession and depression, government should reduces taxation substantially, government should reduces taxation substantially, increases of public expenditure – public works – social increases of public expenditure – public works – social and economic infrastructure. Repayment of loans to and economic infrastructure. Repayment of loans to public - deficit budgetingpublic - deficit budgeting

In times of boom, government should raises tax rates, In times of boom, government should raises tax rates, levy new taxes, reduces public spending and public levy new taxes, reduces public spending and public borrowing – following surplus budgetingborrowing – following surplus budgeting

3. Automatic Stabilisers3. Automatic Stabilisers When economics fluctuation takes place in When economics fluctuation takes place in

the economy, the available monetary the economy, the available monetary policy and fiscal tools cannot be geared policy and fiscal tools cannot be geared quickly to set right the imbalance. Then quickly to set right the imbalance. Then automatic stabilizers become the automatic stabilizers become the prominence.prominence.

Automatic stabilizers should be used as Automatic stabilizers should be used as supplemented with fiscal and monetary supplemented with fiscal and monetary policies.policies.

Automatic stabilizers are also called as Automatic stabilizers are also called as built-in-stabilizers – it is proportion to the built-in-stabilizers – it is proportion to the rise and fall of economic activity.rise and fall of economic activity.

The The progressive taxationprogressive taxation and and unemployment unemployment insurance schemesinsurance schemes are the two important tools are the two important tools measures the automatic stabilizers in the measures the automatic stabilizers in the economy.economy.

During periods of prosperity or boom the During periods of prosperity or boom the employers pay taxes more and withdrawing employers pay taxes more and withdrawing unemployment benefits.unemployment benefits.

While, during period of depression – government While, during period of depression – government allowed to provision of unemployment benefits, allowed to provision of unemployment benefits, and lowers the taxes and increasing public and lowers the taxes and increasing public expenditure.expenditure.

Thus, the flow of money is regulated Thus, the flow of money is regulated automatically from the people to the government automatically from the people to the government in times of both boom and depression. in times of both boom and depression.