Chapter 18

Business Cycles

Lecture Plan

Introduction Phases of Business Cycles Concepts of Multiplier and Accelerator

Interaction of Multiplier and Accelerator Causes of Business Cycles

Keynes’ Theory Multiplier-Accelerator Interaction

Hicks’ Theory Real Business Cycle Theory

Effects of Business Cycles Controlling Business Cycles

Monetary Measures Fiscal Measures

Chapter Objectives

To examine the intricacies of business cycles, causes of such cycles, and their effects.

To develop a critical understanding of the various theories on business cycles.

To understand the dimensions of concepts of and linkages between multiplier and accelerator.

To comprehend the measures of controlling business cycles.

Business Cycle

Shows the periodic up and down movements in economic activities.

Economic activities measured in terms of production, employment and income move in a cyclical manner over a period of time.

Cyclical movement is characterized by alternative waves of expansion and contraction.

Associated with alternate periods of prosperity and depression.

Characteristics of Business Cycles

Periodicity Wavelike movements in income and employment occur at

intervals of 6 to 12 years. Gap between two cycles is not regular or predictable with

certainty. Synchronism

Impact is all embracing, i.e. large sections of the economy experience the same phase.

Happens because of interdependence of various sectors of the economy.

Self Reinforcing Due to interdependence in the economy, cyclical movements

faced by one sector spread to other sectors in the economy; and from one economy to other economies.

Thus the upward swing of the cycle is reinforced for further upward movement and vice versa.

Expansion

Contraction

Trough

A B

C D

E F

Time Unit (years)

GNP (%)

Peak Expan

sion

Contraction

G

G

G’

Phases of Business Cycle

Four phases:

Expansion, B to C

Peak, (Boom) C to D

Contraction E to F (recession),

Trough A to B (depression)

• Time gap between two bouts of trough (from B to E) or peaks (from D to G) can vary between 6 to 12 years.

• For 3 to 5 years, the economy experiences growth, then for another 3 to 5 years, it faces contraction or recession.

• GG’ is the steady growth line, to show that the general trend is that of growth.

Phases of Business Cycle

Expansion: when all macro economic variables like output, employment, income and consumption increase. Prices move up, money supply increases, self reinforcing feature

of business cycle pushes the economy upward. Peak: the highest point of growth; referred to as boom.

Stage beyond which no further expansion is possible, Sees the downward turning point.

Contraction: means the slowing down process of all economic activities.

Trough: the lowest ebb of economic cycle. Followed by the next turning point in the cycle, when new growth

process starts afresh.

Contd.

Concepts of Multiplier and AcceleratorKeynesian Multiplier Referred to as autonomous expenditure multiplier or investment

multiplier. Depicts the relationship between changes in national income due to

change in autonomous investment. Income Function: Y=C+I=E Consumption is a linear function of national income: where (>0) is autonomous consumption. Marginal propensity to consume (MPC) is the measure of effect of

change in total income on the keenness of people to spend on consumption.

As Y increases C increases, but increase in C < increase in Y.

Marginal Propensity to Save (MPS) is a measure of the effect of change in total income on the keenness of people to save.

MPC + MPS =1. Since 0< MPC<1, 0<MPS= (1-c)<1

cYCC

C

dY

dCMPC

dY

dSMPS

A multiplier measures the effect of certain amount of capital investment on total employment or total income or total consumption.

Thus a change in income due to change in investment is given by the multiplier (k).

Multiplier is the reciprocal of marginal propensity to save.

Since 0<MPC<1, the multiplier is always greater than one.

mpsmpcId

dYk

1

1

1

Multiplier

Y=E

Consu

mpti

on &

In

vest

ment

E

E’

National Income

O

'ICE

IcYCE

cYCC

Idc

dY

1

1

II

Id

Multiplier Effect

Accelerator

Acceleration principle: Changes in the demand for consumer goods bring about wider changes in the production of appropriate capital goods. formulated by J. M. Clark.

Accelerator measures the relationship between changes in investment due to change in national income.

Assumptions Full utilization of the total stock of capital takes place keeping no

idle capacity. A fixed capital output ratio. Supply of capital stock is perfectly elastic. Increase in total output or income does not change in the structural

composition of aggregate output. If the optimum capital stock is more than the actual stock, more

investment needs to be pumped into the system.

Acceleration Principle

11 tt vYK

)( 1 ttt YYvI

)( 1 ttt YYvK

11 tttt vYvYKK

Let be the optimal stock of capital per unit flow of output at time period t.

Therefore, where is a positive constant and is the optimum capital stock required to produce an output at period t.

For the time period (t-1) If the output in period t is more than output in period (t-1), then the

total capital stock is fully utilized. This induces the need for new investment ( ), which is defined as

the change in capital stock. Hence:

v

tt vYK v tKtY

tI

tt YvI

The accelerator coefficient is the incremental capital output ratio. Yt

Kv

t

v

Interaction of Multiplier and Accelerator

Formulated by the post Keynesian economists like Paul Samuelson and others.

Following figure shows the interaction of Multiplier and Accelerator

Increase in autonomous Investment

Increase in income

through the multiplier

Increase in induced

investment through the accelerator

Magnified increase in aggregate output and

income Id

cdY

1

1tt YvI

Causes of Business Cycles

Explanations given to explain economic cycles: Climatic changes such as sunspots that may cause

different moods. Psychological aspects of entrepreneurs and consumers,

such as moods of optimism and pessimism. Monetary phenomenon like changes in money supply,

rate of interest, etc. Economic factors, such as over investment, under

consumption and over savings. Shocks in the conditions under which producers supply

goods such as technological breakthroughs.

Keynes’ Theory

Keynes is credited with presenting a systematic analysis of role of investment in causing business cycles

Economic fluctuations are due to changes in rate of investment Rate of investment depends upon:

rate of interest, which remains stable in the short run marginal efficiency of capital ( MEC).

Keynes introduced the concept of ‘marginal efficiency of capital’ (mec) to explain the expected rate of return on investment. marginal efficiency of capital depends upon

changes in prospective yield supply price of capital goods which does not change in the short

run.

Entrepreneurial expectations and the psychological aspect of business that determine prospective yields.

Keynes’ Theory

With increase in entrepreneurial expectations the marginal efficiency of capital increases Hence entrepreneurs make huge

investments (upward turning point)

The multiplier starts its action, bringing an increase in income, which is much higher than increase in investment, this is the multiplier effect. Expansion phase

Abundance of capital goods reduces marginal efficiency of capital, which discourages further investment. Downward turning point) Reverse action of multiplier.

Rate of Investment

Marginal efficiency of

capital

Rate of Interest

Prospective yield

Supply price of Capital

goods

Entrepreneurial expectations

Contd.

Hicks’s Theory Hicks demonstrated through mathematical models how the

interaction of multiplier and accelerator could bring several types of fluctuations in total output.

There is a full employment ceiling beyond which the economy may not grow.

In Hicksian model, three concepts play important role: Warranted rate of growth

Sustains itself in congruity with the equilibrium of saving and investment

Autonomous and Induced investment Autonomous investment includes public investment, investment

which occurs in direct response to inventions, and other long range investment.

Induced investment depends upon changes in the level of output or income; thus it is a function of an economy’s growth rate.

Multiplier and accelerator Fundamental causation of the trade cycle is in the multiplier

accelerator relationship

F’

Time (years)

GNP (%)

O

S T

R MA’

A

L’

L

E’

E

F

N

Hicks’s Theory4 levels of economic activity:

•AA’ is determined by autonomous investment.

•LL’ is the floor line which shows income level determined by autonomous investment and multiplier.

•EE’ is the equilibrium path of income and output.

•FF’ is the full employment ceiling, where all the productive resources are fully utilized in gainful activity.

At R on EE’, an outburst of investment via the multiplier accelerator interaction, pushes the economy to S on FF’, RS shows the expansion phase.

The economy crawls at FF’ from S to T. Rate of growth of output between RS and ST is very different this results in downward turning point at point T.

This slackening of growth rate causes a fall in induced investment, the economy slides further down to LL’ line, TM is the contraction phase.

Economy crawls at LL’ from M to N. Process of recovery starts between M and N; autonomous investment is greater than declining investment prior to M. Acceleration effect operates again. The cycle will be repeated.

Contd.

Period(1)

Autonomous Investment

(2)

Induced Consumption

(3)

Induced Investment

(4)

Increase in Income

(5) =(2+3+4)

Business Cycle Phase

1 100 0 0 10 Expansion2 100 67 134 3013 100 200 266 5664 100 378 356 8345 100 556 356 10126 100 675 238 1013 Full

employment7 100 518 20 778 Contraction8 100 346 -100 5189 100 230 -100 346

Assumptions Autonomous investment in the economy is Rs. 100 million MPC is 2/3 and accelerator is 2.

Hicks’s Theory:Multiplier Accelerator Interaction Contd.

Hicks’s Theory: Basic Assumptions The economy is progressive, in which autonomous investment is

increasing at a regular rate.

The saving and investment coefficients are distributed over time, so that any upward movement from the equilibrium path results in displacement from equilibrium, though it may be lagged.

Production cannot exceed the full employment ceiling.

Working of the accelerator in an economy on the downswing is different from its working while the economy is in the upswing.

There are fixed values for the multiplier and the accelerator throughout the different phases of a cycle.

Disinvestment cannot exceed depreciation because transformation of accelerator in the downsizing provides indirect constraints.

Contd.

Real Business Cycle Theory Explored by John Muth (1961) and others. The ups and downs are caused by technology or other similar shocks

to the supply side of the economy. Highlights the importance of supply side of business. Reflects the outcome of rational decisions made by many individuals. Postulates that:

A boom will occur with an invention of a productivity increasing device, entrepreneurs increase investment, expand output and employ more people.

A recession will occur with new advances lacking, or productivity low, and at that point employers rationally choose not to produce as much.

Although booms are nicer than recessions, but there is no need to react to either, as they represent the best use of the opportunities available.

The theory has not attracted much empirical support.

Effects of Business CyclesDuring Expansion High growth: large investments, increase in employment, income and

expenditure Inflation: Increase in investment forces more money supply in the

system, demand for factor inputs increases, hence their prices increase which increases cost of production. So wages and prices of goods also increase.

Severe Competition: Firms resort to large amount of non productive expenditure on advertisements and publicity.

During Recession Unemployment, excessive inventory, below capacity operations and

liquidation of firms. Excess inventory: Those firms which had produced in abundance

during expansion phase face the problem of maintaining unsold items.

Retrenchment: in order to reduce investment, recession phase is marked by large scale retrenchment.

Controlling Business Cycles

At Firm Level Precautionary Measures: to be taken at the time of

expansion Investments: deter from investing huge amount of funds in

fixed assets. Inventory: should not create large inventory of raw material or

finished goods. Products: diversify in different markets and different products,

so that risk is diversified.

Curative Measures: to be taken at the time of recession

Pricing: Flexibility should be the right strategy, so that during recession prices may be adjusted to increase demand without eating away the margins.

Controlling Business CyclesAt Government Level Monetary Measures: Central bank uses methods of credit control.

Rediscount rate: Expansion: increase the rediscount rate to curb money supply Recession: reduce the rate to increase money supply.

Reserve ratios: Expansion: the ratios are increased so that banks are left with less

cash to be extended as credit Recession: the ratios are decreased so that banks can extend easy

credit. Two major reserve ratios are SLR and CRR

Open market operations: Expansion: sells securities and takes away disposable income from

people. Recession: buys securities to give more in the hands of people

Selective credit control: Banks are advised to extend credit to certain areas, while restrict to

certain other areas.

Controlling Business Cycles Fiscal Measures

Public expenditure Expansion: Government reduces expenditure to curtail

demand Recession: Government increases expenditure on various

activities like health, transport, communication, etc., thus income of individuals increases; this in turn increases aggregate demand.

Public revenue Expansion: An increase in taxes takes away portion of

people’s money income and thus brings down aggregate demand.

Recession: It is desirable that governments reduce taxes. An appropriate combination of these measures is adopted

after thorough examination of the causes of business cycles.

Contd.

Summary• Business cycle is the periodic up and down movement in economic activities,

measured in terms of production, employment and income move in a cyclical manner over a period of time.

• It is characterized by alternative waves of expansion and contraction, and is associated with alternate periods of prosperity and depression.

• It has three basic characteristics: periodicity, synchronism and self reinforcing.• It can be studied in four phases: expansion, peak, contraction (recession),

trough (depression) and two turning points, upward and downward.• Expansion is a phase when all macro economic variables like output,

employment, income and consumption increase. Peak or boom is the stage beyond which no further expansion is possible, and it sees the downward turning point.

• Contraction implies slowing down of all economic activities; it marks the onset of recession. Slump or depression is the lowest ebb of economic cycle, followed by the next turning point in the cycle, when new growth process starts afresh.

• Keynes proposed that economic fluctuations are basically due to changes in rate of investment, which depends upon two factors: rate of interest and marginal efficiency of capital.

• Hicks combined the approaches of Keynes, Samuelson, Harrod and Domar, and demonstrated through mathematical models how the interaction of multiplier and accelerator could bring several types of fluctuations in total output.

Summary• According to Hicks, the interaction between multiplier and accelerator fabricates economic

fluctuation around the warranted rate of growth.

• The real business cycle theory associates business cycles with rational expectations, and proposes that the ups and downs are caused by technology or other similar shocks to the supply side of the economy.

• Inflation is a necessary evil that comes with expansion; it is a by product of growth and expansion. Therefore governments are busy controlling inflation during expansion phase.

• Recession is unwarranted and creates negative implications for the economy; during this phase, the basic problems that occur are that of unemployment, excessive inventory, below capacity operations and liquidation of firms.

• Business cycles create problem for the economy. Hence governments constantly keep a watch on macro variables so as to contain either over heating or over dampening of economic activities. Measures to control business cycles can be categorized as preventive and curative measures.

• Not only governments but also the corporate sector plays a vital role in taking such measures which help reducing the ill effect of cycles. At government level these can be categorized into monetary and fiscal measures.

• In the expansion phase firms, which take preventive measures remain in competition. Similarly firms should plan in such a way that their losses during recession are minimized.

• Just as preventive measures are taken during expansion phase, similarly corrective measures are taken during recession phase.