Crack Grade B 1

BUSINESS CYCLE
Introduction
Consider the following:

1. During 1920s, UK saw rapid growth in Gross Domestic

Product (GDP), production levels and living standards. The
growth was fuelled by new technologies and production
processes such as the assembly line. The economic growth also
caused an unprecedented rise in stock market values.
2. China’s recent economic slowdown and financial mayhem are
fostering a cycle of decline and panic across much of the world,
as countries of nearly every continent see escalating risks of
prolonged slumps, political disruption and financial losses.

What are these? These are examples of business cycles. The first example
shows that the UK economy was going through boom during 1920s while
the second example of the recent slowdown in China indicates the
beginning of a recessionary phase.
The fluctuation in the level of economic activity between depressions and
booms has been called by the economists as business cycle or trade cycle.
Phases of Business Cycle
Economists have pointed out that the business cycle is characterised by
four phases or stages. These are:
1. Expansion (also called Boom or Upswing)
2. Peak or boom or Prosperity
3. Contraction (also called Downswing or Recession)
4. Trough or Depression
The four phases of business cycle are shown in the Figure. The broken line
(marked ‘trend’) represents the steady growth line or the growth of the
economy when there are no business cycles. The figure starts with ‘trough’
when the overall economic activities i.e. production and employment, are at
the lowest level. As production and employment expand, the economy
revives, and it moves into the expansion path. However, since expansion
cannot go on indefinitely, after reaching the ‘peak’, the economy starts
contracting. The contraction or downturn continues till it reaches the lowest

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turning point i.e. ‘trough’. However, after remaining at this point for some
time, the economy revives again and a new cycle starts.

Expansion: The expansion phase is characterised by increase in national

output, employment, aggregate demand, capital and consumer expenditure,
sales, profits, rising stock prices and bank credit. This state continues till
there is full employment of resources and production is at its maximum
possible level using the available productive resources.
Involuntary unemployment is almost zero and whatever unemployment is
there is either frictional (i.e. due to change of jobs, or suspended work due
to strikes or due to imperfect mobility of labour) or structural (i.e.
unemployment caused due to structural changes in the economy).
Prices and costs also tend to rise faster. Good amounts of net investment
occur, and demand for all types of goods and services rises. There is
altogether increasing prosperity and people enjoy high standard of living
due to high levels of consumer spending, business confidence, production,
factor incomes, profits and investment. The growth rate eventually slows
down and reaches its peak.
Peak: The term peak refers to the top or the highest point of the business
cycle. In the later stages of expansion, inputs are difficult to find as they are
short of their demand and therefore input prices increase. Output prices
also rise rapidly leading to increased cost of living and greater strain on
fixed income earners. Consumers begin to review their consumption
expenditure on housing, durable goods etc. Actual demand stagnates. This
is the end of expansion and it occurs when economic growth has reached a
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point where it will stabilize for a short time and then move in the reverse
direction.
Contraction: During contraction, there is fall in the levels of investment
and employment. Producers do not instantaneously recognise the pulse of
the economy and continue anticipating higher levels of demand, and
therefore, maintain their existing levels of investment and production. The
consequence is a discrepancy or mismatch between demand and supply.
Supply far exceeds demand. Producers being aware of the fact that they
have indulged in excessive investment and over production, respond by
holding back future investment plans, cancellation and stoppage of orders
for equipments and all types of inputs including labour. This in turn
generates a chain of reactions in the input markets and producers of capital
goods and raw materials in turn respond by cancelling and curtailing their
orders. This is the turning point and the beginning of recession.
Decrease in input demand pulls input prices down; incomes of wage and
interest earners gradually decline resulting in decreased demand for goods
and services. Producers lower their prices in order to dispose of their
inventories and for meeting their financial obligations. Consumers, in their
turn, expect further decreases in prices and postpone their purchases. With
reduced consumer spending, aggregate demand falls, generally causing fall
in prices. The discrepancy between demand and supply gets widened
further. This process gathers speed and recession becomes severe.
Investments start declining; production and employment decline resulting
in further decline in incomes, demand and consumption of both capital
goods and consumer goods. Bank credit shrinks as borrowings for
investment declines, investor confidence is at its lowest, stock prices fall
and unemployment increases despite fall in wage rates. The process of
recession is complete and the severe contraction in the economic activities
pushes the economy into the phase of depression.
Trough and Depression: During this phase of the business cycle, growth
rate becomes negative and the level of national income and expenditure
declines rapidly. Demand for products and services decreases, prices are at
their lowest and decline rapidly forcing firms to shut down several
production facilities. A typical feature of depression is the fall in the interest
rate. With lower rate of interest, people’s demand for holding liquid money
(i.e. in cash) increases. Despite lower interest rates, the demand for credit
declines because investors' confidence has fallen.
Recovery:

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The economy cannot continue to contract endlessly. It reaches the lowest
level of economic activity called trough and then starts recovering. A time
comes when business confidence takes off and gets better, consequently
they start to invest again and to build stocks; the banking system starts
expanding credit; technological advancements require fresh investments
into new types of machines and capital goods; employment increases,
aggregate demand picks up and prices gradually rise.
Besides, price mechanism acts as a self-correcting process in a free
enterprise economy. The rise of investment causes recovery of the economy.
This acts as a turning point from depression to expansion. As investment
rises, production increases, employment improves, income improves and
consumers begin to increase their expenditure. Increased spending causes
increased aggregate demand and in order to fulfil the demand more goods
and services are produced. Employment of labour increases, unemployment
falls and expansion takes place in the economic activity.
It is very difficult to predict the turning points of business cycles.
Economists use changes in a variety of activities to measure the business
cycle and to predict where the economy is headed towards. These are called
indicators. The types of indicators are shown in the chart –
Economic Indicators

LEADING LAGGING COINCIDENT or

INDICATORS INDICATORS CONCURRENT
INDICATORS

e.g. Changes in Stock e.g. Unemployment,

Price, New orders for corporate profit, labour e.g. GDP,
capital and consumer cost per unit of output inflation,
goods industrial
Production
A leading indicator is a measurable economic factor that changes before
the economy starts to follow a particular pattern or trend. In other words,

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those variables that change before the real output changes are called
‘Leading indicators’.
Lagging indicators reflect the economy’s historical performance and
changes in these indicators are observable only after an economic trend or
pattern has already occurred. In other words, variables that change after
the real output changes are called ‘Lagging indicators’.
A third type of indicator is coincident indicator. Coincident economic
indicators, also called concurrent indicators, coincide or occur
simultaneously with the business-cycle movements. These indicators give
information about the rate of change of the expansion or contraction of an
economy more or less at the same point of time it happens.
Features Of Business Cycle
Different business cycles differ in duration and intensity. But there are
certain features which they commonly exhibit:
(a) Business cycles occur periodically although they do not exhibit the same
regularity. The duration of these cycles vary. The intensity of fluctuations
also varies.
(b) Business cycles have distinct phases of expansion, peak, contraction
and trough. These phases seldom display smoothness and regularity. The
length of each phase is also not definite.
(c) Business cycles generally originate in free market economies. They are
pervasive as well. Disturbances in one or more sectors get easily
transmitted to all other sectors.
(d) Although all sectors are adversely affected by business cycles, some
sectors such as capital goods industries, durable consumer goods industry
etc, are disproportionately affected. Moreover, compared to agricultural
sector, the industrials sector is more prone to the adverse effects of trade
cycles.
(e) Business cycles are exceedingly complex phenomena; they do not have
uniform characteristics and causes. They are caused by varying factors.
Therefore, it is difficult to make an accurate prediction of trade cycles before
their occurrence.
(f) Repercussions of business cycles get simultaneously felt on nearly all
economic variables viz. output, employment, investment, consumption,
interest, trade and price levels.

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(g) Business cycles are contagious and are international in character. They
begin in one country and mostly spread to other countries through trade
relations. For example, the great depression of 1930s in the USA and Great
Britain affected almost all the countries, especially the capitalist countries
of the world.
(h) Business cycles have serious consequences on the well-being of the
society.
SUMMARY
 The rhythmic fluctuations in aggregate economic activity that an economy
experiences over a period of time are called business cycles or trade cycles
and are manifested in fluctuations in measures of aggregate economic
activity such as gross national product, employment and income.
 A typical business cycle has four distinct phases namely,
o Expansion (also called boom or upswing) characterized by increase in
national output and all other economic variables.
o Peak of boom or prosperity refers to the top or the highest point of the
business cycle.
o Contraction (also called downs-wing or recession) when there is fall in the
levels of investment, employment.
o Trough or depression occurs when the process of recession is complete
and there is severe contraction in the economic activities.
 Economists use changes in a variety of activities to measure the business
cycle and to predict where the economy is headed towards. These are called
indicators.
 A leading indicator is a measurable economic factor that changes before
the economy starts to follow a particular pattern or trend. i.e. they change
before the real output changes.
 Variables that change after real output changes are called ‘Lagging
indicators’.
 Coincident economic indicators, also called concurrent indicators,
coincide or occur simultaneously with the business-cycle movements.

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