Business Cycles

So far………

Development & analysis of determination of income and output => how investment, savings & consumption interact to determine income –

static theory of income determination.

Dynamics of Income Movements

Why expansion comes to an end?

Why does the economy move downwards?

Why and how does a slump come to an end?

How a recovery begins and gives rise to prosperity?

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

A Typical Business Cycle

Number of Years

Lev

el o

f B

usin

ess

Act

ivity

P

M

depression

boom

recessionprosperity

recovery

X

Y

O

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 creditBusiness 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 self-destruction. 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 CyclesMajor 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 1780–1920, Kondratieff was able to establish 2 ½ long cycles in England and France, each full cycle being of the duration of 60 years.

Theories of Business Cycle

Sunspot theoryW. 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 economistsSeveral 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 theoryCapitalist society => inequality of incomes Propertied class has too much wealth => save => invest the savings in businessWorker class => not enough purchasing power to buy goods producedOverproduction => fall in prices => depressionToo 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

Hick’s 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 it’s 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.

Ia = --------------

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

1 Rs.10 0 0 Rs. 10

2 Rs.10 Rs. 5 Rs. 10 Rs. 25

3 Rs.10 Rs. 12.5 Rs. 15 Rs. 37.5

4 Rs.10 Rs. 18.75 Rs. 12.5 Rs. 41.25

5 Rs.10 Rs. 20.62 Rs. 3.74 Rs. 34.36

6 Rs.10 Rs. 17.18 Rs. – 6.88 Rs.20.3

7 Rs.10 Rs. 10.15 Rs. – 14.06 Rs. 6.09

8 Rs.10 Rs. 3.05 Rs. –14.20 Rs. –1.15

9 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

-10

0

10

20

30

40

50

1 2 3 4 5 6 7 8 9 10 11

Years

Nat

ion

al In

com

e (

Rs

. cr)

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.