Unit 5
Unit 5
SCHOOL OF BUSINESS | BBA - IB - SEM II
UNIT V:
BUSINESS CYCLES AND
MACROECONOMIC
POLICIES
BY:
PROF. MAYURESH SHENDURNIKAR
WHAT ARE BUSINESS CYCLES?
Economic crises have affected every country in history, as
business cycles cause fluctuations in economic activity with
periods of expansion and contraction. These cycles impact
firms and have common characteristics.
The business cycle refers to the natural rise and fall of a
firm's production and output, and is a tool to understand
economic conditions. It is a natural phenomenon that every
firm goes through, with no constant growth or decline, and
fluctuations in economic activity.
HOW THESE CYCLES OCCUR?
Business cycles are caused by internal and
external factors. Internal factors include changes
in demand, fluctuations in investments,
macroeconomic policies, and supply of money.
External factors include wars, technology shocks,
natural disasters, and population expansion.
Demand and investment fluctuations affect the
phases of business cycles, with an increase in
investment leading to economic expansion while
a decrease in investment leading to a trough or
even depression. Wars and natural disasters lead
to a fall in income, employment, and economic
activity, while new technology boosts the
economy. Population growth can cause a
reduction in savings and investments, leading to
a slowdown or depression in the economy.
ARE THESE CYCLES NECESSARY?
Business cycles are inevitable and every
company must go through the four basic
phases of expansion, peak, trough or
depression, and recovery. It is crucial for
firms to identify their current phase to
frame appropriate policies and make
strategic business decisions. Businesses
that are more vulnerable to changes in the
economy, such as cyclic businesses, need to
keep a close look at the changes at all
times. The phase of the trade cycle also
greatly affects the entry and exit of a
product from the market. Therefore,
understanding business cycles is important
for firms to stay competitive and successful
in the long run.
FEATURES OF BUSINESS CYCLE
Occur Periodically: As we saw, these phases occur from time to time. However, they do
not occur in for specific times, their time periods will vary according to the industries and
the economic conditions. Their duration may vary from anywhere between two to ten or
even twelve years. Even the intensity of the phases will be different. For example, the firm
may see tremendous growth followed by a shallow short-lived depression phase.
They are Synchronic: Business cycles are not limited to one firm or one industry. They
originate in the free economy and are pervasive in nature. A disturbance in one industry
quickly spreads to all the other industries and finally affects the economy as a whole. For
example, a recession in the steel industry will set off a chain reaction until there is a
recession in the entire economy.
FEATURES OF BUSINESS CYCLE
All Sectors are Affected: All major sectors of the economy will face the adverse effects of
a business cycle. Some industries like the capital goods industry, consumer goods
industry may be disproportionately affected. So, the investment and the consumption of
capital goods and durable consumer goods face the maximum brunt of the cyclic
fluctuations. Non-durable goods do not face such problems generally.
Complex Phenomena: Business cycles are a very complex and dynamic phenomenon.
They do not have any uniformity. There are no set causes for business cycles as well. So it
is nearly impossible to predict or prepare for these business cycles.
FEATURES OF BUSINESS CYCLE
Affectes all Departments: Trade cycles are not only limited to the output of goods and
services. It has an effect on all other variables as well such as employment, the rate of
interest, price levels, investment activity etc.
International in Character: Trade cycles are contagious. They do not limit themselves to
one country or one economy. Once they start in one country they will spread to other
countries and economies via trade relations and international trade practices. We have an
actual example of this when the Great Depression of 1929 in the USA, later on, had an
adverse effect on the entire global economy. So, in an integrated global economy like
today’s the effects of a trade cycle spread far and wide.
PHASES OF BUSINESS CYCLE
The business cycle, as the
name suggests, fluctuates
from four different
phases:
1. Expansion or Boom
2. Peak
3. Contraction
4. Depression
EXPANSION OR BOOM
This phase is characterized by an increase in output and
employment. There is also an increase in the demand in the
market, capital expenditure, sales and subsequently an
increase in income and profits. This cycle will continue till
there is hundred percent utilization of available resources.
And the production level will be at the maximum capacity.
The unemployment rates will be zero except for voluntary
unemployment and frictional or structural employment
(which is temporary).
In this phase both the prices and cost increase at a
somewhat faster rate. But generally, the public enjoy
prosperity and a higher standard of living. The growth rate
will eventually deaccelerate as the economy approaches its
peak.
PEAK
As the name suggests this is the highest point of all the
phases of business cycles. At this point the output is
maximum, and the involuntary unemployment is basically
zero. As the economy goes through expansion, inputs
become rarer. Their demands increase and so does their
prices.
This leads to an increase in the price of consumer goods as
well. Income does not see a proportional increase. So,
consumers have to review their expenses and cut back on
their consumption.
Aggregate demand in the market will stagnate. This will
mark the end of the expansion phase. The growth of the
economy stabilizes at the peak for a short period. Then it
goes in the reverse direction.
CONTRACTION
At the peak of an economy, demand is stagnant. Then very soon,
demand starts falling in certain sections of the economy. This is
the start of the contraction phase of the trade cycle, which is the
opposite of the expansion phase.
Even the investment levels and employment levels decrease along
with the demand. Now there is a mismatch between demand and
supply in the market. Once producers become aware of the shift in
the economy they start disinvesting, scaling back operations,
cancelling orders for goods and labour etc.
This will start a domino effect. Now producers of capital goods and
raw materials will also start cancelling orders and holding off
investment.
At this turning point in the economy, the prices of the goods also
fall. Income levels decreases which decrease consumer spending
as well. The outlook about the economy is pessimistic and we will
see a contraction in economic activities across all sectors. We call
this phase recession.
DEPRESSION
Depression is the lowest of the phases of business cycles. It is
a severe form of recession. In this phase, we will see a
negative growth rate in the economy. There is a continuous
decrease in demand.
The companies that cannot dispose of their stocks keep
reducing the prices. Some companies will be forced to shut
down due to mounting losses. This will adversely affect
employment rates.
The capital and money market also suffer greatly. The
interest rate is at its lowest. After this phase, the economy
will recover by additional investments, and the business
cycle will continue.
Inflation: Meaning,
Types, Causes and
Effects
Key Takeaways
Inflation is when a country’s
economy sees an increase in Inflation types include demand
the prices of products and pull, cost pull, creeping,
It is mainly caused by increased
services and eventually a galloping, and hyperinflation.
monetary supply, government
decline in purchasing power of In this situation, borrowers,
policies, interest rate
the people. businessmen, entrepreneurs,
fluctuations, and similar things.
farmers, and employees enjoy
David Hume first proposed the the profits.
concept in the 18th century.
Inflation in brief:
Inflation is a measure of how the value of money decreases over time, leading to higher prices for goods
and services. The concept has been around since ancient times when people used metal coins extensively.
In the 17th century, fiat money was introduced to address the shortage of coins.
Scottish philosopher and economist David Hume first used the term "inflation" in the 18th century, and
later, American economist Milton Friedman proposed that the money supply should increase as the
economy grows to stabilize prices.
Other economists, such as John Maynard Keynes and Ludwig von Mises, also contributed to the study of
inflation. Keynes proposed that inflation occurs when the demand for goods exceeds supply.
Inflation is driven by two main factors: prices and money supply. If the government increases the money
supply, people will have more money and demand more goods, leading to higher prices.
The government can control inflation by reducing the money supply or raising interest rates.
Types of Inflation:
1 – Demand Pull Inflation
It occurs when the demand exceeds supply. Thus, forcing the firms to increase the prices. For instance,
the Lawson boom of the late 1980s. At that moment, the United Kingdom saw a huge rise in the prices of
houses. Also, household consumption increased massively. Therefore, as a result of increasing prices,
the demand surpassed supply.
2 – Creeping Inflation
In the initial stage, the inflation rate is around 2%, 3%, or 5%. At this point, the prices rise at a very
minimal rate gradually. However, ignoring them can cause prices to rise.
3 - Cost Push Inflation
This situation appears when the cost of production forces firms to increase their prices. For example,
the factors of production like labor, raw material, and technology are getting expensive.
4 - Walking Inflation
The hike is said to be walking when the rate rises by 3% to 10% yearly. In September 2022, Sweden’s
central bank announced an inflation report of 9%, probably the highest since 1990. Later, the western
countries had inflation news of 7-8%.
5 - Galloping Inflation
Galloping inflation occurs when the rate is between 20-1000%. In such situations, there is too much
instability within the economy. As a result, the governing bodies fail to bring situations within control.
For example, in the 1990s, Russia faced a galloping situation where the prices of food and goods
increased severely. In 1993, the rate in Russia was 839.21 %.
6 - Hyperinflation
It occurs when the rate is above 1000%. At this stage, the value of money depreciates faster.
Causes of Inflation
1 2
INCREASING MONEY SUPPLY
The money supply is one of the prime reasons for causing GOVERNMENT POLICIES
inflation. It occurs when the government prints more At times, government plans and policies can also cause
currency than the prevailing growth rate. For example, in inflation. For example, restrictions on imports cause the
2009, Zimbabwe printed excess currency to normalize the cost of production to rise. As a result, the firms try to adjust
economic situation. Similarly, other African nations also that extra cost by increasing the prices of their products.
print money to increase their supply.
Causes of Inflation
3 4
RISING WAGE RATES
CHANGES IN EXCHANGE RATE
The rising wage rate is one of the vital factors for inflation.
If the dollar’s value fluctuates, consumers have less
As the government increases the money supply, the
purchasing power. As a result, the prices of products rise,
salaries of individuals also increase. Thus, consumers tend
causing this situation.
to buy products causing prices to rise.
Effects of Inflation
1 – Depreciation Of Money E
The constant effect of the concept is the decline in money’s value. It
indicates depreciation in the value of money. An item that was affordable F
a day before becomes expensive the day after. For example, the average
price of a car back in 1974 was $97. However, now it ranges at around
$13,800.
F
2 – Increased Bank Rates
Rising prices force the government to increase bank rates. For example,
E
the Federal government has constantly increased bank rates by 0.5
points in the past few months. If they continue to do so, consumers will
borrow less and try holding money.
C
3 – High Standard Of Living
Since consumers have a good income, they tend to spend more on goods
T
and services. For example, a middle-class family avoids buying an oven
S
earlier. However, having extra money helps them to upgrade their living
standards.
Effects of Inflation
E 4 – Hiked Prices
One of the major impacts of inflation is on prices. If the firms learn about
F it, they will increase their prices. The firms believe customers are ready to
pay any amount, so services and goods become expensive.
F 5 – Income Distribution Inequality
E
Price rise impacts the poor and makes the rich richer. Simply put, firm
owners (businessmen and entrepreneurs) become rich by rising prices. In
contrast, the consumers keep paying them, leading to less income.
C 6 – Negative Impact On Exports
As the prices of raw materials increase, the exports also get affected. As
T
a result, the demand for products in the foreign market drops. Thus, there
is a drop in export revenues.
7 – Impact On Investors
S
As prices rise, investors try to save less and spend more. However, the
market will react negatively if a country has a high rate.
Advantages of Inflation:
Moderate inflation is good in the aggregate even if it doesn’t seem so for you at a specific moment.
Here’s why:
Economic growth: Moderate inflation is a sign of economic growth and sustained moderate,
stable inflation can prolong that growth. This is because prices and wages naturally increase in
tandem, allowing consumers to continue borrowing and purchasing while allowing businesses to
make more money.
Wage adjustment: When the cost of goods goes up, consumers need to have more money to
purchase them. When this happens they tend to push their employers for higher wages. In order
to remain competitive, employers have to continually offer higher wages. This has an added
benefit for businesses as well; they have a built-in incentive to only hire productive workers
since they’re paying a higher wage. This allows businesses to trim those who are
underperforming and replace them with better employees. For the average worker, jobs pay
more and are more plentiful.
Advantages of Inflation:
Product adjustment: Businesses are able to price their products more effectively when
demand is higher. Better sales mean better and more plentiful jobs for consumers. This
becomes a positive cycle which means that you tend to get a better deal for products you
want.
Deflation is hurtful: Perhaps the most powerful argument in favour of inflation is that
the alternative is disastrous. Deflation occurs when the value of a currency falls. The
price of products follows suit because consumers won’t be able to purchase at higher
prices. This can continue until it is no longer profitable to actually create products. In
addition, when consumers see prices headed down, they are less likely to purchase or
invest, hoping for cheaper prices down the road. Deflation was a major factor during the
Great Depression in the 1920s and 30s.
Disadvantages of Inflation:
It’s not all good news. There are some cons to inflation that can affect your bottom line. These mostly apply
to higher than normal inflation because a moderate amount is nearly always a positive (for the above
reasons).
It is not sustainable: Higher inflation, while it may create a booming market for a moment, is not
necessarily sustainable. This is because it leads to unpredictable boom and bust cycles. The economy
will be chugging along great for a bit, but then prices or wages will hit a wall and things will become
unaffordable quickly.
Uncompetitive: If inflation is high, that means the cost of products tends to be higher. This can make a
country very uncompetitive with others around the world. Products may sell around the world for X, but
due to inflation, a country can only sell that product for X*2.
Discouraged Investment: High inflation is unpredictable, which leads to less investment. Because
prices and values are rising so quickly, investors tend to think that they won’t be that way forever and
choose instead to hold onto cash in a savings account or keep it in safer investments. This also reduces
investment in machinery and other things that are used to create products.
Monetary
Policy &
Fiscal
Policy
Monetary Policy
Monetary policy refers to the use of instruments
under the control of the central bank (RBI) to
regulate the availability, cost and use of money
and credit.
According to Johnson, “Monetary policy is defined
as policy employing central bank’s control of the
supply of money as an instrument for achieving
the objectives of general economic policy.”
Objectives of
Monetary Policy
Full Employment
Price Stability
Economic Growth
Balance of Payments
Policy Instruments
BANK RATE
CASH RESERVE RATIO (CRR)
STATUTORY LIQUIDITY RATIO (SLR)
REPO RATE & REVERSE REPO RATE
OPEN MARKET OPERATIONS
BANK RATE
Bank Rate is also known as discount rate.
It is the rate at which RBI lends to the
commercial banks or rediscounts their bills.
If bank rate is increased, then commercial banks
also charge higher rate of interest on loans
given by banks to public because now
commercial banks get funds from RBI at higher
rate of interest.
Higher rate of interest will contract credit in the
economy i.e. public will take lesser loans
because of higher rate of interest.
The current bank rate is 6.75%.
CASH RESERVE RATIO (CRR)
Cash Reserve Ratio is a certain percentage of
bank deposits which banks are required to keep
with RBI in the form of reserves or balances.
Higher the CRR with the RBI lower will be the
liquidity in the system and vice-versa.
RBI is empowered to vary CRR between 3
percent and 15 percent.
But as per the suggestion by the Narshimam
committee Report the CRR was reduced from
15% in the 1990 to 5 percent in 2002.
The current CRR is 4.50 %.
STATUTORY LIQUIDITY RATIO (SLR)
It means a certain percentage of deposits is to be
kept by banks in form of liquid assets.
This is kept by bank itself the liquid assets here
include government securities, treasury bills and
other securities notified by RBI.
If SLR is more, then banks have to keep more part
of deposits in specified securities and banks will
have less surplus funds for granting loans. It will
contract credit.
SLR is fixed by RBI and usually it has been ranging
between 25% to 40%. By an amendment of the
Banking regulation Act (1949) in January 2007, the
floor rate of 25% for SLR was removed.
The current SLR is 18%.
REPO RATE AND REVERSE REPO RATE
Repo rate is the rate at which RBI lends to commercial
banks generally against government securities.
Reverse Repo rate is the rate at which RBI borrows
money from the commercial banks.
Reduction in Repo rate helps the commercial banks to
get money at a cheaper rate and increase in Repo rate
discourages the commercial banks to get money as
the rate increases and becomes expensive.
As the rates are high the availability of credit and
demand decreases resulting to decrease in inflation.
This increase in Repo Rate and Reverse Repo Rate is
a symbol of tightening of the policy.
The current repo rate is 6.50% and reverse repo rate
is 3.35%.
OPEN MARKET OPERATIONS (OMO)
It means that the bank controls the flow of credit
through the sale and purchase of securities in the
open market.
When securities are purchased by central bank, then
RBI makes payment to commercial banks and public.
So, the public and commercial banks now have more
money with them.
It increases money supply with commercial banks and
public. This will expand credit in the economy.
In year 2012-13 RBI Purchases securities 8,000 crore.
Fiscal Policy
It refers to a policy concerning the use of state
treasury or the government finances to
achieve the macro-economic goals.
Government policy of changing its taxation
and public expenditure programs intended to
achieve its objective.
Government uses its expenditure and revenue
program to produce desirable effects on
National Income, production and employment.
OBJECTIVES OF FISCAL POLICY
To Achieve Equal Distribution of
Wealth
Increase in Savings
Degree of inflation
To Achieve Economic Stability
Price stability
DEFICIT POLICY
Deficit Financing refers to financing the
budgetary deficit.
Budgetary deficit here means excess of
government expenditure over government
income. It means “Taking loans from Reserve
bank of India by the government to meet the
budgetary deficit.”
Reserve bank gives loans by issuing new
currency notes. Increase in money supply
leads to fall in value of money. Fall in value of
money in turn leads to increase in price level.
So, deficit financing should be kept low as it
leads to price rise in economy.
Thus, due to deficit financing necessary funds
are made available for economic Growth and
on the other inflation of country increases.
PUBLIC EXPENDITURE
Public expenditure influences the
economic activities of country very much.
Public expenditure may be of two kinds
i.e., developmental, and non-
developmental.
Expenditure on developmental activities
requires huge amount of capital. So much
capital cannot be made available by
private sector alone. It requires
substantial increase in public expenditure.
Public expenditure may be made in many
ways :-
1. Development of state enterprises,
2. Support to private sector,
3. Development of infrastructure and
4. Social Welfare.
TAXATION POLICY
Taxes are the main source of revenue of government.
Government levies both direct and indirect taxes in
India.
Direct taxes are those which are directly paid by the
people to the government i.e. income tax, wealth tax
etc. Indirect taxes are paid indirectly by the public to
the government i.e. excise duty, custom duty, VAT,
GST etc.
Direct taxes are progressive in nature. Indirect taxes
are not progressive.
These change from all the segments of society at
same rate.
The main objectives of taxation policy are :-
1. Mobilization of resources,
2. To promote saving,
3. To promote saving and
4. To bring Equality of income and wealth.
PUBLIC DEBT
It is the total amount of money that is owed
to the public by the government to meet the
development funds.
Government needs lot of funds for economic
development of the country.
No government can mobilize so much funds
by way of tax alone.
It is therefore, becomes inevitable for the
government to mobilize resources for
economic development by resorting the
public debt.
Public debt is obtained from two kinds :-
1. Internal Debt,
2. External Debt
As we are done with the unit and syllabus also, now I hope
discussion about any economic issue or government's role
in economic policy making will not be the limited for you
only while sipping tea or coffee at shops or homes with
your friends / acquaintances; rather, it would be an
opportunity for you to be more analytical.
Wish you all the best for your future journey!
Keep studying, keep get inspiring!
