BUSINESS ECONOMICS (MACRO) (1) TRADE CYCLE

6
Business cycle

Introduction :Business cycle

The capitalist and the socialist countries of the world have achieved remarkable economic
progress in the last 150 years. This progress has not been smooth. There had been upward and
downward swings in business. Every boom was followed by a slump and vice versa. This is a
business cycle. The fluctuations of a rhythmic nature which get manifested in the form of
expansions and contraction of business activity is commonly called as ‘business cycle’ or ‘trade
cycle.’
6.1 Meaning of a Business Cycle
The trade cycles are the ups and downs in the economic activities. The cyclical changes
have attracted the major attention of economists as they affect the economic development and
their causes cannot be easily found out.
“ A business cycle refers to wavelike fluctuations of business activity characterised by
recurring phases of expansion and contraction in periods varying from three to four years.”
Definitions of Business Cycle :
A trade cycle is defined in various ways by different economists.
(1) According to W. C. Mitchell “Business cycles are a type of fluctuations found in the
aggregate economic activity of nations that organise their work mainly in business enterprises. A
cycle consists of expansions occurring at about the same time in many economic activities
followed by similarly general recessions, contractions and revivals which merge with the
expansion phase of the next cycle. This sequence of change is recurrent but not periodc.”
(2) According to Haberler “The business cycle in the general sense is an alternation of
periods of prosperity and depression of good trade and bad trade.”
(3) According Lord Keynes “ A trade cycle is composed of periods of good trade
characterised by rising prices and low unemployment percentages altering with the periods
of bad trade characterised by falling prices and high unemployment percentages.”
(4) According to Prof. Schumpeter, a trade cycle represents wave-like derivations in
business
activity from the equilibrium or trend line.
From these definitions some common featrures or characteristics of a trade cycle can be
described as follows.
BUSINESS ECONOMICS (MACRO) (2) TRADE CYCLE

6.2 Features of Business Cycles

(1) A Business cycle consists of four phases, namely,
(1) Prosperity (2) Recession (3) Depression (4)
Recovery. (2) Trade cycles follow a regular order.
(3) Trade cycles are all-pervading.
(4) They differ in size but have all the four phases.
(5) They are a wave-like movement.
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(6) There is a general consensus of opinion that the trade cycle takes 7 to
10 years to complete itself.
(7) Some trade cycles are small, medium size or big.
(8) The interval is not a precise one but the degee of regularity is
sufficient to demonstrate the periodicity of a trade cycle.
6.3 Phases of a Business Cycle
X

Prosperity Recovery

Level of
economic Recession
Normal
activity
above normal level

below
normal

Depression
0 X
Time period (in years)

The 4 phases are :

(1) Prosperity/Boom/Upswing/Peak expansion.
(2) Recession
(3) Depression/Slump/Slack/Trough/downswing.
(4) Recovery/Revival.
In the above figure, the time period is shown on the x axis and the level of econonomic
activity on the y axis. Normal level of the economic activity is shown by the horizonatl line. Any
deviation from this level shows the business fluctuations. It is mentioned as ‘ above normal’ or
‘below normal’ in the figure.
Explanation of Phases :
(1) Prosperity : This phase is also known as the upswing or expansion. The latter part of
it is known as Boom.
This phase is in the upper half of the cycle as shown in the figure. Prosperity is the most
desirable stage of a business cycle. During it, all the economic activities like investment,
production etc. are in full swing. The atmosphere is full of optimism. The optimism grows and
spreads far and wide. The business community expects rise in the rate of return which Keynes
BUSINESS ECONOMICS
calls as the ‘marginal (MACRO)
efficiency (4) With the rise in the MEC investment
of capital’ (MEC). TRADE CYCLE
increases
giving rise to production,
BUSINESS ECONOMICS (MACRO) (5) TRADE CYCLE

employment and [Link] further increases the demand for goods and services as a result of
which prices increase. So again the MEC rises. Thus the economy experiences expansion or
the
‘multipliereffect’ in the forward direction. This is the virtuous circle of prosperity. There is
interaction
of multiplier and accelerator. They produce the ‘leverage effect’ or the ‘super-multiplier effect’.
the economy functions almost at the full employment level. There may be frictional or structural
unempoyment but it is short-live. The enterpreneurs are confident and introduce new schemes
of production. Crowd at the stock exchange increases. People experience a betterment of their
living standards. Demand for comforts and luxuries increases.
But this situation does not last long. Slowly the demand gets saturated and stocks start
piling
up. The second half of prosperity is associated with cost-push inflation. As the economy
functions almost at the full employment level, the entrepreneurs have to revise the wage rates
and other factor rewards to get them. This increases the cost of production. To cover the
increased costs, prices are raised. There is over-trading. The boom conditions generate their
own checks. Profit margins are first narrowed and then begin to disappear.
Haberler says that during prosperity, the level of output and trade is high and so is the level
of effective demand. Banks create more credit and the tendency of the economy is to operate at
the full capacity, along its possibility frontier. But profit -infloation and over-optimism which
increase the tempo, carry with them the seeds of self-destruction. The over-optimism paves the
way to over- pessimism. Thus prosperity digs its own grave.
(2) Recession : This is a short-lived and temperory phase. The economy goes at a rapid
rate from prosperity to depression. So it is also called as ‘the lower turning point’
During recession, the prices start falling due to the excess of supply over demand.
Orders get cancelled. The employers retrench the workers. They stop ordering further
equipment and materials. The bankers insist on [Link] bottlenecks appear and the
stocks accumulate. The businessmen lose confidence. Everybody feels pessimistic about the
future profitability of investment. So the investment falls drastically. Then there is the ‘multiplier
effect’ in the reverse direction.
Unemployment increases. Income declines. There is fall in the level of effective demand.
The stock market experiences a downfall. People do not turn to the stock market and hold cash.
The liquidity preference increases. Bank credit gets contracted. Normally, during recession
banks and other financial institutions do not reach the stage of bankruptcy. Whether the
depression will be reached by an orderly less trying transition or it will be accompanied by an
explosive financial panic depends on the nature of previous boom, existing state of mind of the
people and the policies of the bankers.
(3) Depression : It is also known as slump or trough. Depression is the most unwanted
phase of a trade cycle. Depression can be defined as forces of depression are self-
accumulating. There is general distress in the economy. depression is called as crisis- a point of
critical convulsions. Such crisis is the period of utmost suffering for businessmen. During this
phase, the most deplorable conditions prevail in the economy.
BUSINESS ECONOMICS
Haberler syas (MACRO)
that, the (6)
features of depression TRADE
are the reverse of prosperity. The CYCLE
output
contracts, unemployment increases, prices fall, investment contracts. So we can say that
depression
BUSINESS ECONOMICS (MACRO) (7) TRADE CYCLE

and prosperity differ in degree rather than in kind. The economy is full of pessimism. The
business community does not see any ray of hope.
The overall picture of the economy is gray. The production declines and is visible
throughout
the economy, but it is not uniform. Agricultural activity is not much affected in terms of output
and employment. Retail businees is little affected. There is substantial reduction in output in
manufacturing, mining and construction. The industries producting machines, tools etc. are
worst affected. There is unemployment amongst the industrial workers leading to fall in income,
and demand for the consumer’s goods. The house holds curtail their expenditure. They demand
only the essential commodities; so production and empoyment are little affeted in the sector
producting these goods. The declining prices continuously erode the profits. Some firms incur
losses and many are closed down. The volume of production as well as exchange transactions
suffer a substantial reduction. The velocity of circulation of money falls. Distortions appear in
cost-price relations. They worsen the income distrution and often prolong the period of
depression.
However, this phase is not a permanent feature of the economy. Due to the government
efforts and slow clearing of unsold stocks, the producers feel like undertaking investment. This
slowly increases the demand for the capital goods and then for the consumer’s goods. As a
result, investment. production, employment and income generated increases and the economy
comes out of depression. Pessimism vanishes and paves way for optimism. The recovery
starts.
(4) Recovery or Revival : The economy recovers when the forces that work to restore
the normal price relations and cost-price relations start operating effectively. Like recession, the
phase of revival is a passing phase. It is temporary and is always slow.
When the unsold stocks get cleared, the producers feel like undertaking investment and
production. They see no risk in it. This stage reaches faster in those fields where production can
be controlled easily.
The firms first start using the idle capacity to increase employment and the income level.
Demand for capital goods, to replace the depreciated equipment also increases. There is
correction of distoritions in cost-price relations. The general level of efficiency rises. Losses are
replaced by [Link] the course of depression. The cumulative process builds up and the phase
of prosperity is reached. The wave of recovery once initiated, begins to feed upon itself. The
cycle at this stage is ready to repeat itself.
Hawtrey says that the ordinary measures of the central bank like Bank rate, Open market
operations etc. help in bringing about a
revival.
Different economists have given different factors responsible for the occurrence of
trade cycles Hawtrey says that the instability of bank credit causes business fluctuatins. Hayek
syas that cyclical fluctuations are the result of shortening and lengthening of the process of
production that are brought about by an expansion in money supply causing the market rate of
interest to fall below the natural rate of interest.
According ot Malthus, Sismondi, Karl Marx and others, the root cause of a trade cycle is
BUSINESS ECONOMICS
over-saving (MACRO)
or under-consumption (8) to the existing unequal distribution
which is due TRADE CYCLEin
of wealth
the community. Pigou says that the psychological errors of optimism and pessimism give rise to
a trend of business fluctuations in a pervasive manner. Prof. J. B. Schumpeter says that trade
cycles are
BUSINESS ECONOMICS (MACRO) (9) TRADE CYCLE

the offspring of ecnomic progress in a capitalist society. Lord Keynes gives fluctuations in the
rate of changes in the marginal efficiency of capital as the cause of a trade cycle. In his words,”
the trade cycle is best regarded as being occasioned by a cyclical change in the marginal
efficiency of capital as the cause of a trade cycle. In his words,’’ the trade cycle is best regarded
as being occasioned by a cyclical change in the marginal efficiency of capital though
complicated and often aggravated by associated changes in the other significant short period
variables of the economic system.”
Thus it can be said that opinions differ widely about the causes of cycles. Monetary, non-
monetary, psychological factors are responsible for the trade cycles. Thus trade cycles are a
complex phenomenon. Different cycles are caused by different factors at different times. It is an
unsolved riddle.
6.4 Anti-cyclical Monetary and Fiscal
Policies
The trade cycle disturb the normal functioning of the economy. So they need to be
controlled. A suitable monetary and fiscal policy can be used to the phase of prosperity and
reducing the span of depression.
1) Monetary Measures :
The apex monetary authority which is the central bank of the conunty adopts the credit
control measures to stabilise the economy. These are the credit control measures which are
quantitative and qualitative.
(a) Quantitative or general measures :
(1) Bank rate : It is the rate of discount of the central bank. An increase in the Bank rate
makes bank credit and borrowing from the central bank expensive. So, during prosperity the
bank rate should be raised to contract or discourage credit creation. During depression Bank
rate if lowered encourages borrowing and gives momentum to the economic activities.
(2) Open market operations : Buying and selling of government securities, gold etc. is
undertaken by the central bank with the purpose of controlling bank credit. During prosperity,
securities are sold and during depression securities are purchased. This affects the liquidity
position of the banks or their credit creating ability.
(3) Variable cash reserve ratio ( V.C.R.R) : By changing the C.R.R., the central bank
controls the credit creating activity of the banks. During prosperity the C.R.R. is raised by the
central bank so the banks are left with less cash. So the credit gets contracted. During
depression, if the C.R.R. is lowered then the banks have more funds for lending more cash in
hand. More credit can be created by more cash in hand.
(b) Qualitative or selective measures :
Margin requirement, Rationing of credit, Issue of directives, Moral suasion, direct action
are the measures that are used to discourage or encourage credit creation. These are used to
discourage credit creation during prosperity and encourage it during depression.
2) Fiscal Measures
:
The money raising and spending activities of the govt. are the fiscal activities. These can
be used as measures to stabilise the economy.
BUSINESS ECONOMICS
Govt. has to (MACRO)
spend on many items (10) like defence, administration, developmental
TRADE CYCLE

programmes etc. Govt.’ s expenditure is called the public expenditure. Govt’s expenditure, when
incurred, adds to
BUSINESS ECONOMICS (MACRO) (11) TRADE CYCLE

the money in circulation or to the income of the people. Govt. imposes taxes to raise the
revenue. This reduces the disposable income of the people. Reduction in taxes leaves more
purchasing power in the hands of the people.
If the govt.’ s revenue falls short of its expenditure, govt. may resort to borrowing. Govt. loan
is
known as public debt. Increase in the volume of public debt reduces the money supply and vice
versa.
So to stailise the economy these fiscal activities can be used as the measures. During
prosperity, Govt. should curtail its expenditure and impose more direct taxes. Public debt should
be raised sot that the money in circulation gets reduced & the effective demand declines.
During depression the same measures should be adopted in the opposite direction. That is
public expenditure should be increased, public debt should be repaid. The direct taxes decline
automatically as the base which is the income of the people declines. So the taxes like income
tax are called as the ‘built-in-stabilisers’
Thus with suitable combination of monetary and fiscal measures, economic stability can
be achieved to some extent. The cyclical fluctuation cannot be eliminated completely. this is
because the monetary and fiscal measures have their own limitations. For example, the
monetary measures can change the direction of the credit supply but fail to supervise the actual
use of the credit. The fiscal measures like taxes, have narrow coverage. Certain expenditure
cannot be reduced though required.
Delay in decision-making and their implementation, make the fiscal measures ineffective.
So the ups and downs continue.

MODEL QUESTIONS

1. What is trade cycle? Describe various phases of a trade cycle

?
2. What are the anticyclical measures to control trade
cycle

PPP