Business/Trade cycles

Chapter 8

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Business cycle

For this chapter, you should also read the note of chapter 1.

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Meaning

A business cycle is a swing in total national output, income, and employment, usually lasting for a period of 2 to 10 years, marked by widespread expansion or contraction in most sectors of the economy.

The pattern of cycles is irregular. No two business cycles are the same.

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Meaning

A business cycle is a swing in total national output, income, and employment, usually lasting for a period of 2 to 10 years, marked by widespread expansion or contraction in most sectors of the economy.

The pattern of cycles is irregular. No two business cycles are the same. No exact formula applies to predict the duration and timing of business cycle.

But in their irregularities, business cycles more closely resemble the fluctuations of the weather.

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Meaning

Economists say cycles are like mountain ranges, with different levels of hills and valleys. Some valleys are very deep and broad as in the Great Depression of 1930s, others are shallow and narrow as in the American recession of 1991.

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Types of cycles

Business cycles are of the following types: The short run Kitchin cycle: It is also known as

the minor cycle which is of approximately 40 months duration. It is famous after the name of the British economist Joseph Kitchin, who made a distinction between a major and a minor cycle is 1923. He came to the conclusion, on the basis of his research, that a major cycle is composed of two or three more cycles of 40 months.

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Types of cycles

The Long Jugler Cycle: This cycle is also known as the major cycle. It is defined as the fluctuation of business activity between successive crises. In 1862 Clement Jugler, a French economist, showed that periods of prosperity, crisis and liquidation followed each other always in the same order. Later economists have come to the conclusion that a Jugler cycles duration is, on average of nine and a half years.

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Types of cycles

The Very Long Knodratieff Cycle: In 1925, N.D. Kondratieff, the Russian economist, came to conclusion that there are longer waves of cycles of more than 50 years duration made of six Juggler cycles. A very long cycle has come to be known as the Kondratieff wave.

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Types of cycles

Building Cycles: Another type of cycle relates to the construction of buildings which is of fairly regular duration. Its duration is twice that of the major cycles and is on an average of 8 year's duration. Such cycles are associated with the name of Warren and Pearson, two American economists, who came to this conclusion in World Prices and the Building Industry(1937).

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Types of cycles

Kuzents Cycle: Professor Simon Kuzents, the famous American economist, propounded a new type of cycle the secular swing of 16-22 years' which is so pronounced that it dwarfs that 7 to 11 years cycle into relative insignificance. This has come to be known as the Kuzents cycle.

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Phases of business cycles

The business cycle have four phases, which are explained in the following paragraphs.

Prosperity Recession Depression Recovery

(Remember these were discussed in chapter 1)

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Theories of business cycles The monetarist approach: Monetarists believe

that expansion and contraction in economy are attributed to money and credit. This is what Milton Friedman argued. The rough correlation between changes in the money supply and changes in the level of economic activity is accepted by many economists. Milton Friedman and Anna Schwartz argued that the severity of great depression was due to the contractionary monetary policy. Another example is of the severity of 1981-82 recession in the US and in many parts of the world when the Fed raised nominal interest rates to 18 percent to fight inflation.

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Theories of business cycles

The Keynesian approach: Keynes and his followers believe that both monetary and non-monetary forces are important in explaining business fluctuations. They argue that fluctuation in GDP are often caused by fluctuations in autonomous expenditures. And they believe that fluctuations in GDP cause fluctuations in money supply, contrary to the view of monetarists.

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Theories of business cycles The New classical approach: This approach

assumes that private agents have expectations of what policy makers are going to do and this influences private behavior. This is also called rational expectations. The idea is that any shift in aggregate demand that is expected at the time wages are set, such as an announced (anticipated) increase in the money supply will cause the SRAS to shift up immediately. Because of this, economy will experience price rise immediately without any increase in GDP. Only an unexpected increase in AD will lead to an increase in GDP in the short run.

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Theories of business cycles

The New classical approach: Robert Lucas assumed that this shock to AD would be an unexpected increase in the money supply. According to this approach, only unanticipated policy changes lead to changes in real national income. Systemic policy changes will be predictable and will have no real effects. Thus the claim of this theory is that misperceptions about price and wage movements lead people to supply too much or too little labor, which leads to cycles of output and employment.

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Theories of business cycles

External shock theories: External shocks are economic disturbances that originate outside the economy such as oil price hike, weather, and war. The example is of the oil prices of 1990s that severely weakened the oil importing economies. Internal strife and war at the global level both affect the output and infrastructure as well as capital investment. Similarly, in many economies that are agriculture dependent, weather plays a major role in output and income.

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Theories of business cycles

Long wave theory/real business cycle theories: In 1911, Joseph A. Schumpeter proposed a long wave theory of business cycles in which development is fueled when entrepreneurs initiate innovations such as: discoveries of raw materials, new goods or new quality in familiar products, technological advances, opening of new markets, and major reorganization of industries.

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Theories of business cycles

Long wave theory/real business cycle theories: Real business cycle proponents hold that innovations or productivity shocks in one sector can spread to the rest of the economy and cause fluctuations. In this classical approach, cycles are primarily caused by shocks to aggregate supply, and aggregate demand is unimportant for business cycles.

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Theories of business cycles The political business cycle theory: This theory

attributes fluctuations to politicians who manipulate fiscal or monetary policies in order to be reelected. In pre-election periods, politicians would rise spending and cut taxes. The resulting expansionary demand shock would create high employment and good business conditions. But the resulting inflationary gap would lead to a higher price level. And the government, after the election, will depress the demand to slack the inflationary gap.

The theory argues that vote maximizing government manipulates employment and output solely for the electoral purposes. Ronald Regan’s example is very often quoted in this regard.

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Business Cycle and Business Decision Making

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