Business cycle

Introduction.

Many free enterprise capitalist countries such as USA and Great Britain bave registered
rapid economic growth during the last two centuries. But economic growth in these
countries has not followed steady and smooth upward trend. There has been a long-run
upward trend in Gross National Product (GNP), but periodically there have been large
short-run fluctuations in economic activity, that is, changes in output, income,
employment and prices around this long term trend. The period of high income, output
and employment has been called the period of expansion, upswing or prosperity, and
the period of low income, output and employment has been described as contraction,
recession, downswing or depression. The economic history of the free market capitalist
countries has shown that the period of economic prosperity or expansion alternates
with the period of contraction or recession. These alternating periods of expansion and
contraction in economic activity has been called business cycles. They are also known
as trade cycles. J.M. Keynes writes, "A trade cycle is composed of periods of good trade
charac erised by rising prices and low unemployment percentages with periods of bad
trade charac terised by falling prices and high unemployment percentages. »1

A main feature about these fluctuations in economic activity is that they are recurrent
and have been occurring periodically in a more or less regular fashion. Therefore, these
fluctuations have been called business cycles. It may be noted that calling these
fluctuations as cycles' mean they are periodic and occur regularly, though perfect
regularity has not been observed. The duration of a business cycle has not been of the
same length; it has varied from a minimum of two years to a maximum of ten to twelve
years, though in the past it was often assumed that fluctuations of output and other
economic indicators around the trend showed repetitive and regular pattern of
alternating periods of expansion and contraction. Some business cycles have been very
short lasting for only two to three years, while others have lasted for several years.

During a period of recession or depression many workers lose their jobs and as a result
large-scale unemployment, which causes loss of output that could nave been produced
with full-employment of resources, come to prevail in the economy. Besides, during
depression many businessmen go bankrupt and suffer huge losses. Depression causes
a lot of human sufferings and lowers the levels of living of the people. Inflation erode the
real incomes of the people and makes life miserable he poor people. Inflation distorts
allocation of resources by drawing away scarce resources from productive uses to
unproductive ones. Inflation redistributes income in favour of the richer sections.

Features

Though different business cycles differ in duration and intensity they have some
common features which we explain below:
 1. Business cycles occur periodically. Though they do not show same regularity, they
have some distinct phases such as expansion, peak, contraction or depression and
trough. Further the duration of cycles varies a good deal from minimum of two years to a
maximum of ten to twelve years.

2. Secondly, business cycles are Synchronic. That is, they do not cause changes in any
single industry or sector but are of all embracing character. For example, depression or
contraction occur simultaneously in all industries or sectors of the economy. Re
cession passes from one industry to another and chain reaction continues till the whole
economy is in the grip of recession. Similar process is at work in the expansion phase,
prosperity spreads through various linkages of input-output relations or dermand
relations between various industries. and sectors.

3. Thirdly, it has been observed that fluctuations occur not only in level of producion but
also simultaneously in other variables such as employment, investment, consump tion,
rate of interest and price level.

4.Another important feature of business cycles is that investment and consumption of

durable consumer goods such as cars, houses, refrigerators are affected most by the
cyclical fluctuations. As stressed by JM. Keynes, investment is greatly volatile and
unstable as it depends on profit expectations of private entrepreneurs. These expec
tations of entrepreneurs change quite often making investment quite unstable. Since
consumption of durable consumer goods can be deferred, it also fluctuates greaty
during the course of business cycles.

5.. An important feature of business cycles is that consumption of non-durable goods

and services does not vary much during different phases of business cycles. Past data
of business cycles reveal that households maintain a great stability in consumption of
non-durable goods.

6. The immediate impact of depression and expansion is on the inventories of goods.

When depression sets in, the inventories start accumulating beyond the desired level.
This leads to cut in production of goods. On the contrary, when recovery starts, the
inventories Bo below the desired level. This encourages businessmen to place more
orders for gooas whose production picks up and stimulates investment in capital
goods.

7. Another important feature of business cycles is profits fluctuate more than any other
type of income. The occurrence of business cycles causes a lot of uncertainty to
businessmen and makes it difficult to forecast the economic conditions. During e
depression period profits may even become negative and many businesses go banku In
a free market economy profits are justified on the ground that they are necessa)
payments if the entrepreneurs are to be induced to bear uncertainty.
8. Lastly, business cycles are international in character. That is, once started in one
country they spread to other countries through trade relations between them. For ex

ample, if there is a recession in the USA, which is a large importer of goods from

other countries, will cause a fall in demand for imports from other countries whose
exports would be adversely affected.
In the Figure, the steady growth line represents the growth of economy when there are
no business cycles, On the other hand, the line of cycle displays the business cycles
that nove up and down the steady growth line. The different phases of a business cycle
are explained below.

1. Expansion

The line of eycle that moves above the steady growth line represents the expansion
phase ofa business cycle. In the expansion phase, there is an increase in various
macro-cconomic factors, such as production, cmployment, output, wages, profits,
demand and supply of products, and sales.

In addition, in the expansion phasec, the prices of factor of production and output
inereases simultaneously. In this phase, debtors are generally in good financial
condition to repay their debts; therefore, creditors lend money at higher interest rates.
This leads to an increase in the flow of money.

In expansion phase, due to increase in investent opportunities, idle funds of

organizations or individuals are utilized for various investment purposes. Therefore, in
such a case, the cash inflow and outflow of businesses are equal. This expansion
continues till the economic conditions are favorable.

2. Peak

The growth in the expansion phase ultimately slows down and reaches to its peak. This
phase is known as peak phase. In other words, peak phase refers to the phase in which
the increase in growth rate of business cycle achieves its maximum limit. In peak phase,
the economic factors, such as production, profit, sales, and employment, are higher,
but do not increase further. In this phase, there is a gradual decrease in the demand of
various products due to increase in the prices of input. This is the stage beyond which
no further expansion is possible. This stage sees the downward turning point.

The increase in the prices of input leads to an increase in the prices of final products,
whereas the income of individuals remains constant. This also leads consumers to
reorganize their monthly budget. As a result, the demand for products, such as
jewellery, homes, automobiles, refrigerators and other durables, starts falling.

3. Recession

In peak phase, there is a gradual decrease in the demand of various products due to
increase in the prices of input. When the decline in the demand of products becomes
speedy and stable, the recession phase takes place.
In recession phase, all the macro economic factors, such as production prices, saving
and investment, starts decreasing. Generally, producers are uninformed of decrease in
the demand of products and they continue to produce goods and services. In such a
case, the supply of products exceeds the demand.

Over the time, producers understand the surplus of supply when the cost of
manufacturing of a product is more than profit generated. This disorder firstly
experienced by few industries and slowly blowout to all industries.

This situation is firstly considered as a small fluctuation in the market, but as the
problem exists for a longer duration, producers start noticing it. Therefore, producers
avoid any type of further investment in factor of production, such as labor, machinery,
and furniture. This leads to the reduction in the prices of factor, which results in the
decline of demand of inputs as well as output.

4. Trough

During the trough phase, the economic activities of a country decline below the normal
level. In this phase, the growth rate of an economy becomes negative. In addition, in
trough phase, there is a rapid decline in national income and expenditure

(In this phase, it becomes difficult for debtors to pay off their debts. As a result, the rate
of interest decreases; therefore, banks do not prefer to lend money. Acçordingly, banks
face the situation of increase in their cash balances)

Apart from this, the level of economic output ofa country becomes low and
unemployment becomes high. In addition, in trough phase, investors do not invest in
stock markets. In trough phase, many weak organizations leave industries or rather
dissolve. At this point, an economy reaches to the lowest level of shrinking. )

Thus there are two turning points in the cycle, one at peak when the economy starts
sliding down and the other at trough, when the economy picks up momentum for
another phase of growth.

5. Recovery

As already discussed, in trough phase, an economy reaches to tie lowest level of

shrinking. This lowest level is the limit to which an economy shrinks. Once the economy
touches the lowest level, it happens to be the end of negativism and beginning of
positivism. This leads to reversal of the process of business cycle. As a result,
individuals and organizations start developing a positive attitude toward the various
economic factors, such as investment, employment, and production. This process of
reversal starts from the labor market. Consequently, organizations discontinue laying
off individuals and start hiring but in limited number. At this stage, wages provided by
organizations to individuals is less as compared to their skills and abilities. This marks
the beginning of the recovery phase.

In recovery phase, consumers increase their rate of consumption, as they accept that
there would be no further reduction in the prices of products. As a result, the demand
for consumer products increases. In addition in recovery phase, bankers start utilizing
their accumulated cash balances by declining the lending rate and increasing
investment in various securities and bonds. Similarly, adopting a positive approach
other private investors also start investing in the stock market As a result, security
prices increase and rate of interest decreases.

Price mechanism plays a very important role in the recovery phase of economy. During
recession the rate at which the price of factor of production falls is greater than the rate
of reduction in the prices of final products.

Therefore producers are always able to earn a certain amount of profit, which increases
at trough stage. The increase in profit also continues in the recovery phase. Apart from
this, in recovery phase, some of the depreciated capital goods are replaced by
producers and some are maintained by them. As a result, investment and employment
by organizations increases. As this process gains momentum an economy again enters
into the phase of expansion. Thus, a business cycle gets completed.