BUSINESS AND TRADE CYCLES

Prof. Prabha Panth,Osmania University,

Hyderabad

PRABHA PANTH

WHAT IS A TRADE CYCLE• Trade or Business cycles are regular and periodic

changes in the trend of economic activity in capitalist or market based economies. Features:– Occur periodically,– Regular fluctuations in NY and Employment of an economy,– Period of rising economic activity, followed by periods of

falling economic activity.– Wave like movement of expansion and contraction– Trend changes over sufficient period of time – not a

random change

PRABHA PANTH

Diagram of Trade Cycle

Second Phase: RecessionGDP

YEARS

First Phase: Peak or Boom – Full employment

Third Phase:Depression

Fifth

Phas

e:

Reco

very

Fourth Phase –Trough, Unemployment

0

Trade Cycle

GDP

PRABHA PANTH

Theories of Trade Cycles1. Schumpeter: Innovations Theory:

Business cycles caused by the “Innovations” activity of capitalists. Trade cycle caused due to technical change. This is a form of economic progress of industrial economies. Innovations consist of:a) Changes in combinations of factors of productionb) Changes in business organisationc) Transportd) New productse) New marketsf) New inputs

PRABHA PANTH

– Innovation means the application of inventions on a commercial scale in the economy.

– Inventions go on continuously in the laboratory,– But applied to the market only periodically – they

are discontinuous, because business not ready to take risks of new product or process.

– Innovations are lumpy – they can function only on a large scale.

– Leads to surge in industrial investment.– The economy moves into the period of ‘boom’

PRABHA PANTH

– An innovator is one who is the first to commercially use a new invention.

– Takes the risk of the new product or process, and its marketing.

– Profits are payments to innovators or entrepreneurs.

– others imitate his product or process.– Investment increases, and the economy surges

upwards.– This is the First Phase: Prosperity and Boom.– Investment , income and employment also.

PRABHA PANTH

– But with too much competition – price cutting takes place. Profits start falling.

– New opportunities in this area start decreasing.– Market is over supplied – not enough demand.– Investments start falling, also employment and income.– This is the Second Phase of the Trade Cycle –

Recession.– The economy goes into depression – Third Phase,– At the lowest point, when prices are very low,

businessmen may start the process of innovations again,

– This leads to the Fourth Phase: Recovery

PRABHA PANTH

• Criticism:– Innovations may not occur so periodically.– If there are no innovations, will not recovery take

place?– Monopoly and Patents may prevent use of

innovations by other competitors,– Innovations may not cause surge and full

employment, but lead to small changes.– Adjustment of the economy to innovations takes

time.– Recovery may not be automatic, but requires govt

policy

PRABHA PANTH

2. Samuelson’s Multiplier-Accelerator Theory:- Interaction between the Multiplier k = 1/mps, and Accelerator v = I/∆Y results in Trade cycles.Consumption function Ct = c0 + bYt-1

present consumption is a function of past income (with b as the marginal propensity to consume)

• Investment is composed of two parts:

It = I0 + v(Ct - Ct-1) I0 = autonomous investment, v (Ct - Ct-1) = investment induced by changes in

consumption demand (the "acceleration" principle)

PRABHA PANTH

Yt = Ct + It

• But Ct = bYt-1

• I = I0 + v (Ct - Ct-1) or Autonomous investment + Induced investment

So: Yt = bYt-1 + I0 + v (Ct - Ct-1) Changes in Y will depend on the values of b and v. The greater the value of v, the more the fluctuations in

income.Where: 0 < b < 1 i.e. MPC

And v > 0

PRABHA PANTH

Multiplier: When Autonomous Investment increases, Y will increase.

Accelerator: When Y increases, C increases, and encourages Induced investment.

Again the Multiplier will start working – and explosive situation will occur.

The Accelerator and Second order lag are necessary to generate a trade cycle.

Soon the negative effect [v(Ct − Ct-1)] will reduce Inv.Investment falls, then the recession will start.After the trough is reached, the low value of (− Ct-1 ) will increase

Induced Investment once again.

PRABHA PANTH

• Criticism:1) Shows the important role of Autonomous

Investment in the Trade cycle2) Induced or private investment is affected by the

state of the economy.But:3) Does not show the role of fiscal and monetary policy

to control inflation or deflation,4) The reason for the recovery is not well explained.

PRABHA PANTH

3. Hicks theory of Trade Cycles:Trade cycles are fluctuations along the growth path of an

economy.Multiplier and Accelerator interactions are important.Warranted rate of growth: real I is rising at the same rate as real

S. equilibrium growth path of economy.The fluctuations of NY take place around the steady warranted

growth rate of the economyLagged Consumption function: Ct = fYt-1

Autonomous I not affected by change in Y, exogenousInduced Investment: is affected by ∆C

PRABHA PANTH

HICKS TRADE CYCLE: F = Full capacity growth path

E = Equilibrium growth path

L = floor growth path

A = Autonomous Investment path

Output

Time

1

2

3

4

5

6

PRABHA PANTH

– Increase in Auto I leads to increase in Y and C.– Increase in C induces an increase in investment due

to the accelerator,– Autonomous investment continues steadily.– This goes on till the ceiling is reached at 2.– Now there is excess production capacity.– So Investment falls, multiplier works in reverse

direction, and Y and C falls.– Accelerator cannot work during the down swing.– Due to Auto Inv, again recovery takes place.

PRABHA PANTH

Criticism:• Hicks showed that trade cycles takes place around the

steady growth of the economy,But:• Cannot explain why the actual growth is different from the

steady growth path,• Cannot show how recovery of the economy takes place.• Does not show the role of fiscal policy – taxation, or public

expenditure on the economy,• Does not show the role of monetary policy – changes in rate

of interest, supply of money, credit, etc.