Business CycleDr. Gopalakrishna B.V.Faculty in MBA,SDM College,

Business cycle or trade cycle is a part of the capitalistic economy. The business cycle refers to fluctuation in economic activities such as levels of income, employment, prices and output, occurs more or less in regular time sequences.Business cycle is characterised by upward and downward movement of economic activities.In a business cycle, there are wave-like fluctuations in aggregate employment, income output and price level.

DefinitionsProf. Haberlers defines an alternation of periods of prosperity and depression of good and bad trade.J.M. Keynes it composed of periods of good trade characterised by rising prices and low employment percentage, altering with period of bad trade characterised by falling prices and high unemployment percentage. Gordons define business cycles consist of recurring alternation of expansion and contraction in aggregate economic activities in the economy.Estey cyclical fluctuations are characterised by alternating waves of expansion and contraction.

Characteristics of Business cycle

Business cycle is a part of the capitalist economy.Cyclical fluctuations are wave like movements.Fluctuations are recurrent in natureThey are non-periodic or irregular the peak and troughs do not occur at regular intervals.They occur in such aggregate variables as output, income, employment and prices.Upswings and downswings are cumulative process in their effects.They are not secular trends such as long-run growth or decline in economic activity.

Phases/stages of Business cycleA typical cycle is generally divided into five phasesDepressionRecoveryFull employmentProsperityRecession

1. DepressionRecession merges into depression when there is a general decline in economic activity.There is considerable reduction in the production of goods and services, employment, income, demand and prices.The general decline in economic activity leads to a fall in bank deposits.When credit expansion stops, even business community is not willing to borrow.Thus, a depression is characterised by mass unemployment general fall in prices, wages, profits, interest rate, consumption expenditure, investment bank loans and advances falling factories close down capital goods industries are also closed down.During this phase, there will be pessimism leading to closing down of business firms.

2. RecoveryRecovery denotes the turning point of business cycle from depression to prosperity.There is a slow rise in output, employment, income and price demand for commodities go up steadily.There is increase in investment bank and financial institutions are also willing to granting loans and advances.Pessimism gives way to optimism.The process of recovery becomes combative and leads to prosperity.

3. ProsperityIn this period, demand, output, employment and income are at a high level, they tend to raise prices.But wages, salaries, interest rates, rentals and taxes do not rise in proportion to the rise in prices.The gap between prices and cost increases - the margin of profit increases.The increase of profit and the prospect of its continuance commonly cause a rapid rise in stock market values.The economy is engulfed in waves of optimism.Larger profit expectation further increase investment which is helped by liberal bank credit.This leads to peak or boom.

4. RecessionRecession starts downward movement of economic activities from peak/boom.It is a state in which there is general deceleration in the economic activity resulting in cuts in production and employment falling prices of stock market.Banking and financial institutional loans and advances beginning to decline.As a result profit margins decline further because costs starts overtaking prices.Recession may be mild/severe it lead to a sudden explosive situation emanating from banking system and stock markets.Such experience of the United States in 1873, 1893, 1907, 1933 and 2007.

Expansions and Recessions in US

Theories of Business cyclesHawtreys monetary theoryHayeks monetary over investment theorySchumpeters innovations theoryThe psychological theoryThe Cobweb theoryJ.M. Keynes business theorySamuelsons model of business cycleHicks theory of business cycle

1. Hawtreys monetary theory

According to Prof. R.G. Hawtrey business cycle is a purely monetary phenomenon.It is changes in the flow of monetary demand on the part of businessmen that lead to prosperity and depression in the economy.The cyclical fluctuations are caused by expansion and contraction of bank credit which, in turn lead to variations in the flow of monetary demand on the part of producers and traders.Credit is expanded or reduced by the banking system by lowering or raising the rate of interest or purchasing or selling securities to merchants.

This increases or decreases the flow of money in the economy and thus brings about prosperity or depression.Expansion phase bank credit increases lending rate of interest falling encourages to borrower to borrow money in large scale rate of interest will decline credit become cheap stocks/inventories peak/boomContraction phase bank credit decreases lending rate of interest increases borrower reduces loans cost of loans become costlier production falls etc.

2. Hayeks monetary over investment theory

F.A. Hayeks formulated monetary over-investment theory of trade cycle.He explained his theory on the basis of distinction between the natural interest rate and market interest rate.The natural rate of interest is that rate at which the demand for learnable funds equal the supply of voluntary savings (loans = savings)Market rate of interest is the money rate at which prevails in the market and is determined by the demand and supply of money.

According to Hayek as long as the natural rate of interest are equals the market rate of interest the economy in the state of equilibrium and full employment existence no places for trade cycle.The trade cycles in the economy are caused by inequality between market rate of interest and natural rate of interest.When the market interest rate is less than the natural rate, there is prosperity in the economy. On the other hand, when the market interest is more than the natural rate, the economy is in depression.

3. Schumpeters innovations theoryThe innovations theory of trade cycles is associated with the name of Joseph Schumpeter.According to him, innovations in the structure of an economy are the source of economic fluctuations.Trade cycles are the outcome of economic development in a capitalist society.Schumpter approach involves two stages First stage deals with initial impact of innovationSecond stage follows through reactions to the original impact of innovation.When the economy is in equilibrium where every factor fully employed cost = receipts product price = average and marginal cost profit and interest are zero no savings and investments circular flow.Schumpeter theory starts with the breaking up of the circular flow by an innovation in the form of a new product by entrepreneur for earning profits.

Schumpeters innovations theory.An innovation may consists of The introduction of a new productThe introduction of a new method of productionThe opening up of a new marketNew sources of raw-materials or semi-manufactured goods andNew organizations of an industry.Changes in technology and expansion of bank credit.Trade cycle starts with equilibrium.Upward movement from equilibrium are prosperity and recession.Downward movement equilibrium to depression and revival.

4. The Psychological theoryThe psychological theory of business cycle has been developed by Prof. A.C. Pigou.He explain the phenomenon of business cycle on the basis of changes in the psychology of industrialists and businessmen.According to Pigou, expectations (optimistic and pessimism) originated from some real factors such as good harvests, wars, natural calamities, industrial disputes, innovation etc.The cause of business cycle into two categories 1. inpulses 2. conditions.Inpulses refers to those causes which set a process in motionConditions the vehicles through which the process passes and upon which the impulses act.

5. The Cobweb theoryThe cobweb theory of business cycles was advocated by Prof. Schultz in 1930, latter it was fully developed by Prof. Kaldar, Tinbergen and Ricci.The cobweb model is used to explain the dynamics of demand, supply and price over long period of time.The movement of up and down of prices and output of the commodities causes for business cycle.

6. Keynes theory of trade cycleKeynes does not develop a complete and pure trade cycle.According to Keynes effective demand will influence on fluctuations in economic activities.These effective demand consist of aggregate demand function and aggregate supply function.Aggregate demand function consists consumption and investment expenditure.Aggregate effective demand determines the level of income and employment.

Keynes believes that consumption expenditure (short period) is stable and it is fluctuation in investment expenditure which is responsible for changes in output, income and employment.Investment depends on rate of interest and marginal efficiency of capital.Since rate of interest is more or less stable marginal efficiency of capital determines the level of investment.These MEC depends on two factors such as perspective yield and supply price of the capital asset.

Keynes theory of trade cycle

An increase in MEC will create more employment, output and income leads to prosperity.On the other hand, a decline in MEC leads to unemployment and fall in income and output, this result depression.During the period of expansion businessmen are optimistic where MEC is rapidly increases so entrepreneurs undertake new investment the process of expansion goes on till boom is reached.

While, on the other hand, if MEC is falling profits level are also falling price of raw-material equipment cost falls wages also go down this leads to depression.Keynes explain business cycle with reference to two kinds of turning points Upper turning point consists of recovery and boom/peak.Lower turning point depression and recovery etc.

Control of Business CycleEconomic statilisation is one of the main remedies to effective control of business cycle.Economic stabilizations is not merely confined to single sector of an economy but embraces all the sectors.There are three ways by which a business cycle can be controlled.Monetary PolicyFiscal PolicyAutomatic Stabilisers

1. Monetary policyMonetary policy as a method to control business fluctuations is operated by the central bank of country.Monetary policy mainly concerned with money supply, bank credit and interest rates.The central bank can adopts a number of methods to control the business cycle with the help of quantitative and qualitative credit control.Dear money policy during boom/peak it raises its bank rate policy, sells securities in the open market operation and raises the cash reserve ratio and adopts number of selective credit control.Cheap money policy during recession/depression reduces the bank rate policy and interest rates of banks and also buys securities in the open market, reduces cash reserve ratio etc.

2. Fiscal policyMonetary policy alone cannot check business cycle. Therefore, economists like JM Keynes and Hansen & many others have recommended that fiscal policy can be bring about stabilisation of business cycle.Fiscal policy is a policy of government which is concerned with public expenditure, taxation and public borrowing.These three instruments have to be effectively utilised to control the severity of boom and depression.During the period of recession and depression, government should reduces taxation substantially, increases of public expenditure public works social and economic infrastructure. Repayment of loans to public - deficit budgetingIn times of boom, government should raises tax rates, levy new taxes, reduces public spending and public borrowing following surplus budgeting

3. Automatic StabilisersWhen economics fluctuation takes place in the economy, the available monetary policy and fiscal tools cannot be geared quickly to set right the imbalance. Then automatic stabilizers become the prominence.Automatic stabilizers should be used as supplemented with fiscal and monetary policies.Automatic stabilizers are also called as built-in-stabilizers it is proportion to the rise and fall of economic activity.

The progressive taxation and unemployment insurance schemes are the two important tools measures the automatic stabilizers in the economy.During periods of prosperity or boom the employers pay taxes more and withdrawing unemployment benefits.While, during period of depression government allowed to provision of unemployment benefits, and lowers the taxes and increasing public expenditure.Thus, the flow of money is regulated automatically from the people to the government in times of both boom and depression.