Unit – 8Unit – 8

BUSINESSBUSINESS CYCLES CYCLES

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CONTENTSCONTENTSConceptCauses of Business CyclesThe Business CycleMeasure to control Business

Cycles

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The period of high income , output The period of high income , output and employment has been called and employment has been called the the period of expansion, upswing or period of expansion, upswing or prosperity. prosperity.

The period of low income, output and The period of low income, output and employment has been described as employment has been described as contraction, recession , downswing.contraction, recession , downswing.

These alternating period of expansion These alternating period of expansion and contraction in economic activity and contraction in economic activity have been called have been called BUSINESS CYCLEBUSINESS CYCLE

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PHASES OF BUSINESS PHASES OF BUSINESS CYCLECYCLEprosperity(Boom, upswing)RecessionDepressionRevival or Recovery

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Prosperity (Boom, upswing)

Income level tend to rise. Unemployment rate tend to decline.

Industrial growth rate accelerates.

Investment increases.Investor become optimistic.Consumption tend to rise.

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Consumption tend to rise.Consumer Demand for goods & services increase.

Price tend to rise & provide greater incentives for business expansion.

Interest rate increase Share price index tend to rise.

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Recessionary Phase Recessionary Phase When prosperity end recession

begins.Downfall in the stock market.Businessman lose confidence.Increase unemployment

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The Economy is like a Roller Coaster it has it’s ups and downs

These ups and downs are called

the Business cycle

The Business Cycle brings the goods times and the bad times.

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Causes of business cycleCauses of business cycle

Causes of the Business Cycle ◦High consumer demand causes expansion of the economy

◦Once people begin to spend less this causes a recession

◦Government policy can also cause the economy to expand or recess

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INFLATION◦Prices of various good’s are always going up or down

◦However when the prices of a large number of goods goes up this is called inflation

◦Inflation can be a serious concern because most people’s pay checks do not go up as fast as inflation .

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DEFLATION

◦During deflation most things cost less however, wages can fall too.

◦Falling wages can result in unemployment

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MONETORY POLICYMONETORY POLICY

Variations in the nation’s monetary policies, independent of changes induced by political pressures are an important influence in business cycle as well.

Such as increased government policy, change in fiscal policies etc.

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Fluctuations in exports and Fluctuations in exports and importsimportsThe difference between exports and

imports ins the net foreign demand for goods and services also called as net exports. Because net exports are a component of the aggregate demend in the economy, variations in exports and imports can lead to business fluctuations aswell. There are many reasons for variations in exports and imports over time. Growth in gross domestic product of an economy is the most important determinant of its demand for imported goods-as people’s

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Incomes grow, their appetite for additional goods and services, including goods produced abroad increases.

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Technological innovationsTechnological innovationsTechnological innovations can

have an acute impact on business cycles.

The personal computer industries,for instance have undergone immence technological innovations in recent years.

And this has lead to a pronounced impact on the business operations of countless organisaions.

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Real Business Cycle

New Classical Model

Keynesian Model

Rational E ions

Monet

odel

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• The interpretation of the labor market: Do fluctuations in employment reflect voluntary changes in the quantity of labor supplied?• The importance of technology shocks: Does the economy’s production function experience large, exogenous shifts in the short run?• The neutrality of money: Do changes in the money supply have only nominal effects?• The flexibility of wages and prices: Do wages and prices adjust quickly and completely to balance supply and demand?

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Real business cycle theory emphasizes the idea that the quantity of labor supplied at any given time depends on the incentives that workers face. The willingness to reallocate hours

of work over time is called the intertemporal substitution of labor. Consider this example:

Let W1 be the real wage in the first period. Let W2 be the real wage in the second period.Let r be the real interest rate.If you work in the first period, and save your earnings, you will have(1 + r)W1 a year later. If you work in period 2, you will have W2. 04/19/23 18

Criticisms of

Real BusinessCycle Theory

Critics of the real business cycle theory believe: Fluctuations in employment do not reflect changes in the amount people want to work. Desired employment is not sensitive to the real wage and the real interest rate– unemployment fluctuates over the business cycle. The high unemployment in recessions implies that markets don’t clear and that wages do not equilibrate labor demand and labor supply.

Real business cycle theorists reply: • Unemployment statistics are difficult to interpret.• Simply becauseunemployment rate is high does not mean that intertemporal substitution of labor is unimportant.

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Real business cycle theory assumes that our economy experiences fluctuations in technology, which determine

our ability to turn inputs (capital and labor) into output (goods and services), and that these fluctuations in technology cause fluctuations in output and employment.

Real Business Cycle Theory

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Criticisms of

Real BusinessCycle Theory

Critics of the real business cycle theory:

• Are skeptical that the economy experiences large technology shocks, and propose that technological improvements happen more gradually.

• Believe that technological regress is especially implausible.

Real business cycle theorists reply: • Adopt a broader view of shocksto technology.• Events, although not technological, have a similar affect on the economy (i.e. weather, regulations, oil prices).

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Real business cycle theory assumes that money is neutral, even in the

short run. That is, it is assumed not to affect real variables such as output and employment.

Critics argue that the evidence does not support short-run monetary

neutrality. They point out that reductions in money growth and

inflation are almost always associated with periods of high unemployment.Advocates of real business cycle argue that their critics confuse thedirection of causation between money and output. They claim the money supply is endogenous: fluctuations in output might cause fluctuations in the money supply. For example, when Y rises, because of a tech shock, the quantity of money demanded rises. The Fed may then increase the money supply to accommodate greater demand.This gives the illusion of non-money neutrality.

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Real business cycle theorists believe that the assumption of

flexible prices is superior methodologically to the assumption

of sticky prices.Critics point out that wages and prices are not flexible. They

believe that this inflexibility explains both the existence of

unemployment and the non-neutrality of money.

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Some new Keynesian economists suggest that recessions result from a

failure of coordination. Coordination problems can arise in the setting

of wages and prices because those who set them must anticipate the

actions of other wage and price setters.

Not everyone in the economy sets new wages and prices at the same time. Instead, the adjustment of wages and prices throughout the economy is staggered. Staggering slows the process of coordination andprice adjustment. Staggering makes the overall level of wages and pricesadjust gradually, even when individual wages and prices change a lot.

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MEASURES TO CONTROL MEASURES TO CONTROL BUSINESS CYCLESBUSINESS CYCLESThere are 3 major techniques available

: monetary policy, fiscal policy and incomes policy.

Monetary policy involves controlling the money supply and interest rates. These determine the availability and costs of loans to businesses. Tightening the money supply theoretically helps to counteract inflation; loosening the supply helps recovery from a recession.

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Contd….Contd….

Fiscal measures include increased taxation of the wealthy.

Income policy seeks to hold wages and prices down to a level that reflects productivity growth.

Monetary and Fiscal policy acts as a measure to reduce the impact of business cycles. These are pursued by the state to combat the inflationary and deflationary tendencies in the economy.

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Monetary PolicyMonetary PolicyIt refers to the credit control

measures adopted by the central bank of an economy. These are of two kinds Quantitative or general controls and Qualitative or selective controls.

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Qualitative includes bank rate variations, open market operations and varying reserve ratios. They aim at regulating the overall level of credit in the economy through the commercial banks.

Reduction of money supply in the economy results in reduction of price level in the economy.

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Selective credit controls are used to encourage or discourage specific types of credit for particular purpose. In order to check the speculative activity in the economy the central bank changes the margin requirements to be charged by the commercial banks on these activities.

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Fiscal PolicyFiscal PolicyIt refers to the deliberate

changing of taxes and government spending for the purpose of keeping the actual GNP close to the potential full employment GNP. If the potential GNP exceeds it causes inflation and if actual GNP is lower it causes recessionary conditions.

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When inflation is due to excess purchasing power in relation to the amount of goods and services available, the basic remedy for controlling inflationary conditions is to drain any excess purchasing power. In such a case, fiscal policy should aim at taking rupees out of the income-expenditure steam.

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There are 2 ways of doing it :1)To restrain or reduce government spending and create surplus budget where tax revenue exceed government expenditure. The reduction in government expenditure would reduce aggregate demand in the public sector and its spillover effect would dampen aggregate demand.

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2)To increase taxes on business and consumers without increasing government expenditure.

These approaches can be used simultaneously.

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