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Business Cycle

Business Cycle: MeaningMost of the capitalist countries that have registered growth in their national income, standard of living etc, do not show a steady and smooth upward trend. For a certain time all the indicators like income, consumption, price level etc show a rising trend. After a certain period the same indicators show a falling trend.Business Cycle: MeaningThe period of rising income, employment, output etc. has been called expansion, boom, upswing or prosperity. The period of falling income, employment, output etc has been called, contraction, recession, downswing, depression.These alternating periods of expansion and contraction in economic activity has been called business cycle.Business CycleThe Business Cycle allows people to understand the direction the economy (GDP) is going (growing or shrinking) and plan accordingly.

The economy follows the Business Cycle regularly.

Phases of the Business CycleExpansion (Growing)Peak (Top)Contraction (Shrinking)Trough (Bottom)

Business CycleExpansionPeakContractionTroughExpansionPeakContractionExpansionDuring a period of expansion:Wages increaseLow unemploymentPeople are optimistic and spending moneyHigh demand for goodsBusinesses startEasy to get a bank loanBusinesses make profits and stock prices increase

PeakWhen the economic cycle peaks:The economy stops growing (reached the top)GDP reaches maximumBusinesses cant produce any more or hire more peopleCycle begins to contract

ContractionDuring a period of contraction:Businesses cut back production and layoff peopleUnemployment increasesNumber of jobs declinePeople are pessimistic (negative) and stop spending moneyBanks stop lending money

TroughWhen the economic cycle reaches a trough:Economy bottoms-out (reaches lowest point)High unemployment and low spendingStock prices drop

But, when we hit bottom, no where to go but up!UNLESS.

Recession/DepressionA prolonged contraction is called a recession (contraction for over 6 months)

A recession of more than one year is called a depression

What keeps the Business Cycle Going?4 variables cause changes in the Business Cycle:Business InvestmentWhen the economy is expanding, sales and profit keep rising, so companies invest in new plants and equipment, creating new jobs and more expansion. In contraction, the opposite is trueWhat Keeps the Business Cycle Going?Interest Rates and CreditLow interest rates, companies make new investments, adding jobs. When interest rates climb, investment dries up and less job growthConsumer ExpectationsForecasts of an expanding economy fuels more spending, while fear of a recession decreases consumer spendingWhat keeps the Business Cycle Going?External ShocksExternal Shocks, such as disruptions of the oil supply, wars, or natural disasters greatly influence the output of the economy

Ex. 1992-2000 was the longest period of expansion in U.S. history. Early in 2001, signs of contraction appeared, though the Bush administration denied it. The Sept. 11th 2001 terrorist attacks quickly caused the business cycle to shift into a contraction.Who Cares?????Why should you care about the business cycle and economy?

Lots of reasons! Dont quit that job!If the economy is going into a contraction, jobs will become more scarce. If you quit, you may not find another job!

But, if the economy is in a period of expansion, jobs are readily available. It may be a good time to switch careers.Should I make a big purchase?Only if you know that you wont lose your job in a contraction. So, buy your house during an expansion.HOWEVER,When the economy starts to slow down (contraction), interest rates will decrease. Wait to buy a house until the rates drop to a low point, if you are sure you wont lose your job.Theories of Business cycle

Different theories are given to explain what causes business cycle.Hawtreys TheoryThis is applicable in the case of country following gold standard and it is monetary theory. Increase in the quantity of money raises availability of bank credit for investment. This is found when rate of interest is low. The result is higher demand, higher prices and over all expansion. Demand for both domestic and imported goods will rise. In case of trade deficit, there will be gold outflow

Hawtreys theory

Expansion cannot continue for ever. Outflow of gold will reduce supply of money and bank credit. Result is rise in rate of interest and lesser investment expenditure that will set in contraction process. Contraction also will not last for ever. Imports will fall very much, resulting in trade surplus followed by inflow of gold. This will again raise the supply of money and expansion process in due course of time.It is concluded that rise and fall in the supply of money is the basic cause of trade cycle,Keynesian Theory of business cycle

Income, employment, output depend upon effective demand (ED). If ED is high then investor will employ greater amount of resources. On the other hand, if ED is low, smaller amount of output is required, so we can say that changes in ED will bring fluctuations in economic activity. During expansion phase, MEC is high. This raises investment, income and employment that includes the operation of multiplier. During this boom period MEC falls due to 2 reasons: decline in the rate of MEC and rising cost of capital. So after reaching its highest level, contraction begins.Keynesian Theory of business cycleDuring the downturn, investment falls due to falling MEC. This has cumulative effect on income and employment. Multiplier operation will be in reverse direction. This also cannot continue for ever. Revival depends on many factors like normal rate of growth and length of life of capital goods. More the rate of growth, shorter the depression and shorter the life of capital goods, shorter the duration of depression. The basic cause of trade cycle is the changes in MEC with respect to rate of interest. Hicks TheoryAccording to Hicks, interaction between multiplier and accelerator result in trade cycle. There are two types of investment: autonomous and induced.As per government policies autonomous investment goes on increasing that causes operation of multiplier and it results in rise in income, employment and output. This encourages induced investment particularly in the capital goods sector, setting in the operation of accelerator.Interaction of multiplier and accelerator results in upswing in trade cycle.

Hicks TheoryHicks has incorporated in his analysis the role of buffers. On the one hand, he introduces output ceiling when all the given resources are fully employed and prevent income and output to go beyond it, and, on the other hand, he visualizes a floor or the lower limit below which income and output cannot go because some autonomous investment is always taking place.

Hicks TheoryBusiness cycle occurs over a rising trend of income. There is an equilibrium rate of growth over and below which the fluctuation takes place. Due to operation of multiplier and accelerator the income increases but after reaching level of full employment it can not rise further. It remains at that level for a while after which it starts falling. Similarly, after reaching the lowest level, it remains there for some time and then starts rising again.