Business Cycles
Unit 11
Concept
Also called trade cycle, fluctuation in economy
characterized by periods of prosperity (upswing)
followed by periods of depression (downswing)
Characteristics of business cycle:
- like waves and are recurrent
- consists of expansion, recession, contraction and
revival/recovery
- movement from peak to trough and vice versa not
symmetrical; prosperity phase finishes faster
- it is self generating, each phase has germs of the
next phase
Phases of Business Cycle
Prosperity/ expansion/ upswing: there is increased
demand, consumption, production and employment,
high profit margins, inventories are piled up, general
optimism that increases investment/ production
which is faster than consumption; leads to rise in
factor prices due to full employment and scarcity of
factors, thus costs increase/profit margins decline
and this leads to recession
Recession: relatively shorter period; demand for
consumer goods begins to fall followed by decline in
investment activity, fall in demand of capital goods
which is faster, pessimist investment climate, lower
MEC perceived, employment declines
Phases of Business Cycle
contd.
Depression/Contraction/downswing: low economic activity, low
production and employment, fall in prices, profit margins;
demand for capital goods falls faster than demand for consumer
goods, liquidation of inventories piled up during prosperity
phase; costs tend to be more sticky, no fresh investment
activity taken up as MEC low
Recovery: is gradual, starts when piled up inventory stock is
finished, fresh investments planned, which generates
employment and incomes, thus increasing demand and boosts
prices and profit margins; optimism returns, MEC improves;
takes economy to phase of prosperity
Thus cycle repeats itself
Theories of Business Cycles
Schumpeter theory: says cause of business cycles is innovation i.e.
application of invention. For setting up this new industry (innovation/
new product), factors are to be attracted from old industry at higher
prices thus increasing their purchasing power and increasing demand
of old product (new is yet to hit the market), thus increasing its
production and causing prosperity. However this turns to recession
when new product comes in the market; demand for old product
declines, reducing its production and employment in that industry, thus
reducing incomes and causing deflation
Over-investment theory: by A.F.Hayek; in equilibrium
saving=investment; however when bank credit is expanded, interest
rate declines, thus increasing investment activity and causing upswing.
However such rising prices in upswing force people to save more and
reduce consumption thus causing downturn. However such forced
savings make banks ease credit and thus boosts investment bringing
the prosperity again. Thus voluntary savings bring permanent changes
in production structure, but forced savings cause economic fluctuations
Theories of Business Cycles
contd.
Pure Monetary theory: by R.G.Hawtrey; direct relationship between
volume of money supply and economic activity, change in money
supply brings business fluctuations. With credit expansion by banks,
upswing starts, however this leads to fall in cash reserves with banks,
who will then restrict credit to correct the situation, thus discouraging
fresh loans and calling off existing ones, thus beginning the
downswing; thus cash reserves begin to build up again, credit is again
eased and upswing begins
Multiplier acceleration interaction principle: by Samuelson. Autonomous
investment causes multiplier effect on income thus increasing demand
of consumer goods which lead to induced/derived demand for capital
goods to thus leading to acceleration process, increasing incomes
further. Thus both principles act to increase incomes at a faster rate.
Concept of ceiling and floor for capital investment. After it hits full
employment ceiling, further growth of capital is not possible, thus
reducing investment and output; fall continues till it hits the floor and
excess capacity is wiped out, hence no need for inv. to fall further, thus
it starts to rise leading to upswing
Stabilization Policies to control
Business Cycles
Monetary Policy in Depression: by reducing bank
rate, purchase of securities (OMO), reducing
SLR/CRR, cheap money policy followed to release
funds in the economy for investment and increase in
purchasing power to boost demand. However
pessimism difficult to tackle by this policy, but
creates conducive atmosphere
Monetary Policy in inflation: dear monetary policy
followed to capture excess liquidity from economy
and control inflation by controlling demand and
investment activity
Stabilization Policies to control
Business Cycles contd.
Fiscal Policy in depression:
- reduction in income tax to increase purchasing power of people
- reduction in corporate tax to make fresh investments lucrative and
hence attractive
- lower indirect taxes to make goods cheaper and attract demand
- Public spending/investment: to stimulate investment, employment,
demand, production and income, has multiplier and acceleration effect
- public work/spending on schools, hospitals, roads etc. and on social
security measures (transfer payments) like unemployment allowance,
pensions, insurance benefits, subsidies to improve purchasing power of
people, boost private investment, and employment
- fiscal policy has in-built stabilizers to correct the economic fluctuations
Fiscal Policy in Inflation: reverse of above
Inflation
Money: value of money is inversely
related to price level
Inflation: general (not sectoral or
temporary) increase in price level
resulting in fall in value of money, too
much money chasing too few goods
Types of Inflation
On the basis of causes:
- demand pull: due to increased demand over supply of goods
- cost push: due to increase in cost of production
On the basis of time situation:
- Peace time: when govt. spends more on development activities
leading to excess liquidity in the system
- War and post war inflation: due to resources diverted to war
activities, uncertainties, hoardings etc.
On the basis of degree of price rise:
- creeping inflation: less than 3%, is considered healthy
- walking inflation: between 3% and 6%, alarms go off
- running inflation: when it reaches around 10%, is not desirable
- jumping/ galloping and hyper inflation: dangerously high, prices
increase substantially and very frequently
Causes of Inflation
Demand Pull inflation: supply takes time to catch up with excess
demand
Increase in money supply: due to cheap monetary policy
Deficit financing: thru printing of additional currency
Exports : reduce availability of goods in domestic markets, also
increases exporters’ incomes thus increasing demand
Population increase: increases demand
Black money: thru illegal activities, leads to accumulation of
unaccounted wealth creating demand pressures
Supply curve becomes inelastic after a point when economy
reaches full employment, thereafter increased demand (shift in
demand curve) is not matched by increased supply and this
causes serious inflation
Causes of Inflation contd.
Cost Push Inflation: increase in prices of factors of production,
wages, rent, interest cost, raw materials cost etc., increases
costs of goods and hence their prices, leading to inflation
Wages: called wage push inflation, role of trade unions
Material cost: other than specific raw materials, some like crude
oil, transportation etc. have spiraling effect on entire economy
Profit margins: artificially kept high like in monopoly, oligopoly
Natural/ artificial calamities like floods, wars etc. create scarcity
of raw materials
Given the demand curve as fixed, increase in cost of production
shifts supply curve leftwards, thus increasing the price of the
good
Demand pull vs. cost push inflation: both work in
tandem, increased demand calls for increased supply
which increases demand for factors and increases
their cost. Likewise, increased costs of factors
increases their incomes and thus increases demand;
so one leads to another
Inflationary gap: by Keynes. It is inflationary pressure
created by excess of demand due to increase in
money supply, over the supply which remains
constant at full employment and thus cannot be
increased; i.e. excess of disposable income over
national output
Effects of Inflation
On investment and production: before full employment, profit
margins increase and hence effect here is positive
Excess inflation however discourages savings and hence
adversely affects investment
On real income: purchasing power reduces even if money
income increases
On employment: mild inflation works as incentive for investment
activity and hence boosts employment; Philips curve: inflation
and unemployment are inversely related
On income distribution: fixed income group people suffer most
in inflation as their purchasing power goes down; farmers and
others whose demand is inelastic, benefit from increase in
prices provided costs are not increased too; debtors pay less
value and creditors receive less value
Policies to Control Inflation
Monetary Policy: control money supply to avoid inflation leading to recession
Fiscal Policy: increase taxes, reduce public spending, postpone public works as
possible
Inflation in developing countries: work at less than full employment, hence
should not have inflation, but in reality they do, due to foll. factors:
- need to spend on development work which is sometimes financed thru deficit
financing
- large portion of public expenditure goes to unproductive areas, thus increasing
purchasing power and demand without corresponding increase in supply
- capital intensive projects with long gestation period: time lag between demand
and supply
- agricultural productivity is low causing prices of food items to increase , thus
causing demand for higher wages by workers and leading to cost push inflation
- MPC and income elasticity is high, while supply elasticity is low
- increasing population
- corruption and inefficient administration, political factors defeat anti inflationary
measures
