Business Cycles

Business Cycles
An important feature of a capitalist
economy is the existence of alternate
periods of prosperity and depression.
Sweeping fluctuations in economic
activity, viz. Production, prices,
employment, etc.

A trade cycle is composed of good

trade characterized by rising prices and
low unemployment percentages,
alternating with periods of bad trade
characterized by falling prices and high
unemployment percentages.
Keynes

The business cycle represents wavelike

fluctuations in the level of business
activity from the equilibrium or trend
line.
Schumpeter

Generalising
The business cycle is an alternate
expansion and contraction in overall
business activity, as evidenced by
fluctuations in measures of aggregate
economic activity, such as the gross
product, the index of industrial
production, and employment and
income.

Phases of Business
Cycle

Level of Business Activity

A Typical Business Cycle

Y
prosperity

recession
M

boom
P

recovery
O

depression

Number of Years

Depression
Business activity is far below normal.
Sharp reduction in production, mass
unemployment, falling prices, falling profits,
low wages, contraction of credit, high rate of
business failure => all-round pessimism.
Construction activity comes more or less to a
standstill.
Food, clothing industry not much affected.

Recovery
Slight improvement in economic activity.
Industrial production picks up.
Employment increases.
Slow but sure rise in prices & profits.
Wages also rise.
New investments in K-goods industry.
Banks expand credit
Business inventories start rising slowly.
Atmosphere of cautious hope.

Prosperity
Increased production.
High capital investment in basic
industries
Expansion of bank credit.
High prices and profits
Optimism is very high.

Boom
Stage of rapid expansion in business
activity to new highs.
High stock and commodity prices.
High profits.
Overfull employment.
Boom carries within in the seeds of selfdestruction.
Boom is followed by bust.

Recession
Collapse of firms creates panic.
Banks withdraw loans.
Prices fall and confidence is shaken.
Construction activity slows down.
Unemployment appears in basic capital
goods industry => spreads to other
industries.
Fall in income, prices, profits

Classification of
Business Cycles
Prof. James Estey

Major & Minor Cycles

Major cycles may be defined as the fluctuations
of business activity occurring between
successive crises.
Also called Juglar cycles.
Approx. Length 8.33 yrs.
Each major cycle is made up of 2 or 3 minor
cycles. The upswing of business in major cycles
is often interrupted by minor downswings.
Likewise, the downswings.
Also called Kitchin cycles.
Approx Length - 40 months

Building Cycles
This refers to the cycle of building
construction.
The duration of the building cycle is longer
than that of the business cycle.
The duration of the building cycle varies
between 15 20 years. The average of the
building cycle is 18 yrs, just twice the length
of the business cycles.
There were 6 complex building cycles in the
USA in the period 1830 to 1934.

Kondratieff Cycles or
Long Waves
They are a 50 60 years cycle.
The long waves in economic activity were
discovered by the Russian economist,
Kondratieff, hence the name.
On the basis of statistical data for the period
17801920, Kondratieff was able to establish
2 long cycles in England and France, each
full cycle being of the duration of 60 years.

Theories of Business
Cycle

Sunspot theory
W. Stanley Jevons (British) 1875
Variations in atmosphere of the sun
frequency and magnitude of sunspots
cause rhythmical fluctuations in business
activity
Dark spots on the surface of the sun => affect
agricultural crops => affect other sectors =>
influence the level of business activity
Prof Henry L. Moore 8 yr cycle of rainfall in
America

Psychological theory
Prof A. C. Pigou => in his work
Industrial Fluctuations
Changes in psychology of industrialists
=> waves of optimism and pessimism
He could not explain the cause of the
changes in psychology.

Overproduction theory
Socialist minded economists
Several rival firms producing the same
commodity
want to capture market => produce
more stocks than can sell =>
overproduction => prices fall => rise in
cost of production => marginal firms
collapse => depression

Over-saving theory
Under-consumption theory
Capitalist society => inequality of incomes
Propertied class has too much wealth =>
save => invest the savings in business
Worker class => not enough purchasing
power to buy goods produced
Overproduction => fall in prices =>
depression
Too much saving and too little consumption is
the cause of business depression.

Innovation theory
Joseph Schumpeter (USA)
Innovation
something new that changes the
existing method of production
Whenever innovation takes place, it
causes disequilibrium in the economy
=> continues till re-adjustment at some
new equilibrium level.

Monetary theory
Business cycle is a purely monetary
phenomenon
An elastic money supply => alternate
expansion and contraction of money

Theories of Business
Cycles
Hicks Theory

Multiplier
Ratio of change in income to change in
investment.
Y
1
K = ----------- = ------------I
1-c

Accelerator
Invented by A. Aftalion and T.N. Carver.
Shows the effect of a change in consumption
on investment.
Hayek explains the concept:
since the production of any given amount of
final output usually requires an amount of
capital several times larger. during any
short period of time, any increase in final
demand will give rise an additional demand
for capital goods several times larger than the
new final demand.

Acceleration principle
Investment depends on rate of interest
Investment an endogenous variable by
being dependent on changes in national
income
Lipsey possibility of systematic
fluctuations because level of investment
is related to changes in national income.

Two relationships
Between consumption demand and investment
spending:
An increase in demand for consumption goods can
cause a proportionately larger accelerated increase in
investment spending. E.g. a 10% increase in demand
may lead to 100% increase in investment spending as
business firms increase their production capacity to
meet increased demand.
When an increase in aggregate demand slows its
upward pace and begins to level off, a decline in
investment spending can occur, even if aggregate
demand continues to grow.

Level of investment is a function of the

rate of change in consumption (output)
and not the level of consumption (output).
Measures change in investment goods
industry as a result of changes in
consumption goods industry.
I
a = -------------C

Generation of Business
Cycle
J.R. Hicks =>.
Cyclical fluctuations occur due to the
combined action of the multiplier and
accelerator => called the leverage
effect.
Ia => k => Y => a => Ib => k => .

Example:
An investment of Rs. 10 cr is made by
the government on an infrastructure
project.
Given mpc = 0.5, a = 2.
Map the changes in income over the
next 10 years.

Multiplier
Period

Initial
Outlay

Induced
Consumption

Induced Net
Investment

Total increase
in NY

Rs.10

Rs. 10

Rs.10

Rs. 5

Rs. 10

Rs. 25

Rs.10

Rs. 12.5

Rs. 15

Rs. 37.5

Rs.10

Rs. 18.75

Rs. 12.5

Rs. 41.25

Rs.10

Rs. 20.62

Rs. 3.74

Rs. 34.36

Rs.10

Rs. 17.18

Rs. 6.88

Rs.20.3

Rs.10

Rs. 10.15

Rs. 14.06

Rs. 6.09

Rs.10

Rs. 3.05

Rs. 14.20

Rs. 1.15

Rs.10

Rs. - 0.58

Rs. 7.27

Rs. 2.15

10

Rs.10

Rs. 1.07

Rs. 3.32

Rs. 14.39

11

Rs.10

Rs. 7.20

Rs. 12.25

Rs. 29.44

Increase in National Income

National Income (Rs. cr)

50
40
30
20
10
0
-10

Years

10

11

Methods to Control
Business Cycles

Monetary Policy
Check undue expansion of money
supply through proper and adequate
cover against note-issue
Check expansion of bank credit
Bank rate, open market operations,
reserve ratios, moral suasion, etc.

Fiscal Policy
Taxation
Spending
Borrowing

Automatic Stabilizers
An automatic stabilizer is an economic
shock absorber that helps smooth the
cyclical business fluctuations of its own
accord, without requiring deliberate
action on the part of the government.

Progressive income tax

People in higher income bracket are
taxed at progressively higher rates
Unemployment insurance
Prosperity: employers pay taxes to
government but payment of doles to the
unemployed is considerably lower.
Recession: government lowers taxes
but pays out doles to unemployed.