Business Cycle

Introduction:
➢ Business cycle or trade cycle is a part of the capitalist system.
➢ Knowledge of business cycles is significant for companies, investors,
and policymakers to be aligned with the prevailing economic
conditions and undertake appropriate decisions.
➢ In a business cycle, there are wave-like fluctuations in aggregate
income, employment, output and price level.
➢ BCs are a type of fluctuation found in the aggregate economic activity
of a nation - a cycle that consists of expansions or contractions
occurring at about the same time in many economic activities.
➢ This sequence of changes is recurrent but not periodic.
Definitions:
➢ It is defined in various ways by different economist.
➢ A trade cycle is composed of periods of good trade characterized by
rising prices and low unemployment percentage, altering with periods
of bad trade characterized by falling prices and high unemployment
percentage.
➢ Business cycles consist of recurring alteration of expansion and
contraction in aggregate economic activity, the altering movements in
each direction being self-reinforcing and pervading virtually, all parts
of the economy.
➢ Cyclical fluctuations are characterized by alternating waves of
expansion and contractions. They do not have a fixed rhythm, but they
are cycles in that the phases of contraction and expansion recur
frequently and in fairly similar patterns.
Characteristics of Business cycles
➢ Cyclical fluctuations are wave-like movements
➢ Fluctuations are recurrent in nature
➢ They are non-periodic or irregular
➢ They occur in such aggregate variables as output, income,
employment and prices.
➢ These variables move at about the same time in the same direction
but at different rates.
➢ The durable goods industries experience relatively wide fluctuations
in output and employment but relatively small fluctuations in prices.
➢ Non-durable goods industries experience relatively wide fluctuations
in prices but relatively small fluctuations in output and employment.
Phases of a Business Cycle
➢ Business cycle is generally
divided into four phases:
recovery, prosperity,
recession and depression.
➢ Each stage reflects different
economic conditions and
behaviors, influencing how
businesses, consumer and
policy maker respond.
Recovery
➢ In the lower turning point there may be some exogeneous or endogenous
forces to put the economy on the revival path.
➢ Suppose the semi-durable goods wear out which necessitate their
replacement in the economy. It leads to increase in demand, investment and
employment which became cumulative.
➢ There is a lot of excess or idle capacity in the economy so, output increases
without a proportionate increase in total costs. But, output becomes less
elastic over time; bottlenecks appear with rising costs, deliveries are more
difficult and plants may have to be expanded.
➢ Under these conditions, prices rise, profits increase, business expectations
improve and optimism prevails. Investment is encouraged leading to
increase in demand for bank loans and credit expansion.
➢ The cumulative process of increase in investment, employment, output,
income price feeds upon itself and becomes self-reinforcing. Ultimately,
revival enters the prosperity phase.
Prosperity
➢ This phase is characterized by economic expansion, rising incomes,
low unemployment, and increased consumer spending, with
businesses responding by increasing production and offering new
products. They tend to raise prices leading to increase in profit
margin. The economy is engulfed in waves of optimism.
➢ The expansionary process becomes cumulative and self-reinforcing
until the economy reaches the peak.
➢ The prosperity may lead the economy to over full employment and
to inflationary rise in prices which is the symptom of the end of the
prosperity phase and the beginning of the recession.
Prosperity (contd.)
➢ The seeds of the recessions are contained in the boom in the form of
strains in the economic structure acting as brakes to the expansionary
path.
✓ Scarcities of labor, raw materials, etc. leading to rise in costs relative to
prices leading to decline in profit margin.
✓ Rise in the interest rate due to scarcity of capital making investment
costly.
✓ Failure of consumption to rise due to rising price and stable propensity
to consume when income increase leading to the piling up of
inventories indicating that sales lag behind production.
➢ These forces become cumulative and self-reinforcing.
➢ Entrepreneurs, businessmen and traders become over cautious and over
optimism gives way to pessimism.
Recession
➢ Its outward signs are liquidation in the stock market, strain in the
banking system and some liquidation of bank loans, and the
beginning of the decline of prices and profit margins. Some firms
close down and others reduce production and try to sell out
accumulated stocks. Investment, employment, income and demand
decline.
➢ Recession may be mild or severe. The latter might lead to a sudden
explosive situation emanating from the banking system or the stock
market and a panic or crisis occurs.
➢ A recession, once started, tends to build upon itself.
Depression
➢ Recession merges into depression when there is a general decline in
economic activity.
➢ There is considerable reduction in the production, employment,
income, demand and prices. The general decline in economic activity
leads to a fall in bank deposits. Credit expansions stops as business
community is not willing to borrow, Bank rate falls considerably.
➢ A depression is characterized by mass unemployment, general fall in
the prices, profits, wages, interest rate, consumption, expenditure,
investment, bank deposits and loans.
Causes of Business Cycle
➢ External factors:
Sunspots, wars, revolutions, political events, gold discoveries,
growth rate of population, migrations, discoveries and
innovations.
➢ Internal factors:
✓ Bank credits
Expansion/contraction of bank credit leading to changes in
demand for money.
✓ Over-saving or under-consumption
Income and wealth disparities
✓ Over investment
Easy bank loan without proportionate saving
Causes of Business Cycle (contd.)
✓ Competition
Under competitive conditions, firms produce in anticipation of
demand
✓ Psychological causes
Over-optimism and over-pessimism
✓ Innovation
Innovation in the structure of the economy)
✓ Marginal efficiency of capital (MEC)
Fluctuations in the rate of investment caused by fluctuations in
the MEC which depends on supply price of capital assets and
their prospective yield which in turn depends on business
expectation.
Theories of Business Cycle
1. Hawtrey’s Monetary Theory (R. G. Hawtrey)
2. Hayek’s Monetary Over-investment Theory (F. A. Hayek)
3. Schumpeter’s Innovation Theory (Joseph Schumpeter)
4. The Psychological Theory (A. C. Pigou)
5. The Cobweb Theory (H. Schultz, J. Tinbergen, U. Ricci & N. Kaldor)
6. Keynes’s Theory (John Maynard Keynes)
7. Samuelson’s Model of Business Cycle (Paul Samuelson)
8. Hicks’s Theory of business Cycle (J. R. Hicks)
9. Goodwin’s Trade Cycle Model (R. M. Goodwin)
10. Friedman’s Theory of Business Cycle/Money and Business Theory (M.
Friedman and A. W. Schwartz)
11. Kaldor’s Model of the Trade Cycle (Nicholas Kaldor)
Schumpeter’s Innovation Theory
➢ Innovation in the structure of an economy. It is the outcome of
economics development in a capitalist society.
➢ Innovations are not inventions. It is the introduction of a new
product and the continual improvements in the existing ones that are
the causes of business cycles.
➢ Innovation means;
“such changes in the production of goods as cannot be affected
by infinitesimal steps or variations on the margin.”
➢ Innovation consist of;
Schumpeter’s Innovation Theory (contd.)
1. the introduction of a new product
2. the introduction of a new method of production
3. the opening up of a new market
4. the conquest of a new source of raw materials or semi-
manufactured goods
5. the carrying out of the new organizations of an industry

➢ Who is an innovator?
Schumpeter’s Innovation Theory (contd.)
➢ Entrepreneur – a man who introduces something entirely new.
He does not provide funds but directs their uses.
➢ To perform his economic function, the entrepreneur requires two
things;
1. the existence of technical knowledge in order to produce new
products
2. the power of disposal over the factors of production in the form of
bank credit.
➢ Capitalist society is full of untapped technical knowledge. To make
use of it credit is essential which help in braking the circular flow of
economy.
Schumpeter’s Innovation Theory (contd.)
➢ Model has two stages. The first stage deals with the initial impact of
innovation and the second stage follows through reactions to the
original impact of innovation.
➢ The theory starts with the breaking up of the circular flow by an
innovation.
➢ First approximation – Assuming equilibrium economic system with
every factor fully employed. Every firm is producing efficiently with
its costs equal to its receipts. Product prices are equal to both average
and marginal costs. Profits and interest rates are zero. No savings and
investments. This equilibrium is characterized as the Circular Flow
which continues to repeat itself in the same manner year after year.
Schumpeter’s Innovation Theory (contd.)
➢ Entry of an innovating entrepreneur backed by bank credit. With his
newly acquired funds, the innovator starts bidding away resources
from the other industries. Money income increase. Price begin to
rise, thereby stimulating further investment. The new innovation
starts producing goods and there is an increased flow of goods in the
economy. Consequently, supply exceeds demand. Price and cost
production of goods start declining until recession sets in. Because of
the low prices of goods, producers are not willing to expand
production. During this period of recession, credit, prices and
interest rate decline but total output is likely to be larger than in the
preceding prosperity.
Schumpeter’s Innovation Theory (contd.)
➢ The first approximation
consists of a two-phase cycle.
The economy starts at the
equilibrium state, rises to a
peak and then starts downward
into a recession and continues
till the new equilibrium
reached. This new equilibrium
will be at a higher level of
income than the initial
equilibrium because of the
innovation which started the
cycle (primary wave).
Schumpeter’s Innovation Theory (contd.)
➢ Second Approximation:
➢ Reaction of the impact of original innovation.
Once the original innovation become successful and profitable, other
entrepreneurs follow it in “swam-like cluster.” Innovation in one field
induces innovations in related fields. Consequently, money incomes and
prices rise and help to create a cumulative expansion throughout the
economy. With the increase in the purchasing power of customers, the
demand for the products of old industries increases in relation to supply.
Prices rise further. Profits increase and old industries expand by
borrowing from the banks. It induces a secondary wave of credit inflation
which is superimposed on the primary wave of innovation. Over optimism
and speculation add further to the boom. After a period of gestation, the
new product start appearing in the market displacing the old products and
enforcing a process of liquidation, readjustment and absorption.
Schumpeter’s Innovation Theory (contd.)
➢ The demand for the old products is decreased. Their prices fall. The
old firm contract output and some are even forced to run into
liquidation. As the innovators start repaying bank loans out of
profits, the quantity of money is decreased and prices tend to fall.
Profits decline. Uncertainty and risks increase. The impulse for
innovation in reduced and eventually come to an end. Depression set
in and the painful process of readjustment to the “point of previous
neighbourhood of equilibrium” begins. Ultimately, the natural forces
of recovery bring about a revival.
Schumpeter’s Innovation Theory (contd.)
➢ The second approximation develops into a four phase cycle with the
recession which was the second phase in the first approximation
continuing downward to give the depression phase. This extension of
cycle is followed by a period of revival which continues till the
equilibrium level is reached (Secondary Wave).