Business cycles

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.

Time Unit (years)

GNP (%)

Phases of Business Cycle

Four phases:

Expansion, B to C and From F

Peak, (Boom) C to D

Contraction D to E (recession),

Trough (Slump/ depression) A to B and E to F

• 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.

Expansion

Contraction

Trough

A B

C D

E F

PeakExpansion

Contraction

SlumpG

G’

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/Recession: means the slowing down process of all economic activities.

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

process starts afresh.

Contd.

What is recession?

• Recession is a decline in a country's gross domestic product growth for two or more consecutive quarters of a year.

• A recession is also preceded by several quarters of slowing down.

• An economy which grows over a period of time tends to slow down the growth as a part of the normal economic cycle.

• A recession normally takes place when – consumers lose confidence in the growth of the

economy and spend less. – Investors spend less as they fear stocks values will

fall and thus stock markets fall on negative sentiment.

Causes of Business Cycles

Earlier Explanations of 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 factors causing business cycles.

Economic fluctuations are due to changes in rate of investment

Rate of investment depends upon:1. rate of interest, which remains stable in the

short run 2. marginal efficiency of capital ( MEC).

Keynes’ Theory

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

1. changes in prospective yield

2. supply price of capital

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

• Supply price of capital goods does not change in the short run.

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 Autonomous and Induced investment Multiplier and accelerator

Hicks’s Theory

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.

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

accelerator relationship Multiplier increases national income by a certain proportion (1/MPS)

due to increase in investment Increase in investment increases national income accelerator times The process continues

Period(1)

Autonomous Investment

(2)

Induced Consumption

(3)

Induced Investment

(4)

Increase in Income

(5) =(2+3+4)

Business Cycle Phase

1 100 0 0 100 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

Time (years)

GNP (%)

O

A’

A

L’

L

E’

E

F’

F

4 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.

S T

R M N

• 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.

• 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 to LL’ line, TM is the contraction/recession phase.

• 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.

Hicks’s Theory: Basic Assumptions

The economy is progressive, in which autonomous investment is increasing at a regular rate.

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.

Contd.

Real Business Cycle Theory

Explored by John Muth (1961) and others. Fluctuations and output and employment are the results of

a variety of real shocks that hit the economy Markets adjust to these shocks rapidly and always remain

in equilibrium 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. Minimizes the role of nominal fluctuations and money.

Real Business Cycle Theory

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 Cycles

During 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.

Effects of Business Cycles

During Recession Excess inventory: Those firms which had

produced in abundance during expansion phase face the problem of maintaining unsold items.

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

Below capacity operations and liquidation of firms.

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.

Costing: control wastages and reduce costs


At Government Level Monetary Measures:

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.


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.


Fiscal Measures Public expenditure

Expansion: Government reduces expenditure to curtail demand

Recession: Government increases expenditure on various activities like health, transport, communication, etc., to increase income of individuals; 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.

Economy & Finance

Business cycles