Business cycle

Introduction.

Many free enterprise capitalist countries such as USA and Great Britain
bave registered rapid economic growth during the last two centuries. But
economic growth in these countries has not followed steady and smooth
upward trend. There has been a long-run upward trend in Gross National
Product (GNP), but periodically there have been large short-run
fluctuations in economic activity, that is, changes in output, income,
employment and prices around this long term trend. The period of high
income, output and employment has been called the period of expansion,
upswing or prosperity, and the period of low income, output and
employment has been described as contraction, recession, downswing or
depression. The economic history of the free market capitalist countries
has shown that the period of economic prosperity or expansion alternates
with the period of contraction or recession. These alternating periods of
expansion and contraction in economic activity has been called business
cycles. They are also known as trade cycles. J.M. Keynes writes, "A trade
cycle is composed of periods of good trade charac erised by rising prices
and low unemployment percentages with periods of bad trade charac
terised by falling prices and high unemployment percentages. »1

A main feature about these fluctuations in economic activity is that they

are recurrent and have been occurring periodically in a more or less
regular fashion. Therefore, these fluctuations have been called business
cycles. It may be noted that calling these fluctuations as cycles' mean
they are periodic and occur regularly, though perfect regularity has not
been observed. The duration of a business cycle has not been of the same
length; it has varied from a minimum of two years to a maximum of ten to
twelve years, though in the past it was often assumed that fluctuations of
output and other economic indicators around the trend showed repetitive
and regular pattern of alternating periods of expansion and contraction.
Some business cycles have been very short lasting for only two to three
years, while others have lasted for several years.

During a period of recession or depression many workers lose their jobs

and as a result large-scale unemployment, which causes loss of output
that could nave been produced with full-employment of resources, come
to prevail in the economy. Besides, during depression many businessmen
go bankrupt and suffer huge losses. Depression causes a lot of human
sufferings and lowers the levels of living of the people. Inflation erode the
real incomes of the people and makes life miserable he poor people.
Inflation distorts allocation of resources by drawing away scarce resources
from productive uses to unproductive ones. Inflation redistributes income
in favour of the richer sections.

Features

Though different business cycles differ in duration and intensity they have
some common features which we explain below:

1. Business cycles occur periodically. Though they do not show same

regularity, they have some distinct phases such as expansion, peak,
contraction or depression and trough. Further the duration of cycles varies
a good deal from minimum of two years to a maximum of ten to twelve
years.

2. Secondly, business cycles are Synchronic. That is, they do not cause
changes in any single industry or sector but are of all embracing
character. For example, depression or contraction occur simultaneously in
all industries or sectors of the economy. Re cession passes from one
industry to another and chain reaction continues till the whole economy is
in the grip of recession. Similar process is at work in the expansion phase,
prosperity spreads through various linkages of input-output relations or
dermand relations between various industries. and sectors.

3. Thirdly, it has been observed that fluctuations occur not only in level of
producion but also simultaneously in other variables such as employment,
investment, consump tion, rate of interest and price level.

4.Another important feature of business cycles is that investment and

consumption of durable consumer goods such as cars, houses,
refrigerators are affected most by the cyclical fluctuations. As stressed by
JM. Keynes, investment is greatly volatile and unstable as it depends on
profit expectations of private entrepreneurs. These expec tations of
entrepreneurs change quite often making investment quite unstable.
Since consumption of durable consumer goods can be deferred, it also
fluctuates greaty during the course of business cycles.

5.. An important feature of business cycles is that consumption of non-

durable goods and services does not vary much during different phases of
business cycles. Past data of business cycles reveal that households
maintain a great stability in consumption of non-durable goods.

6. The immediate impact of depression and expansion is on the

inventories of goods. When depression sets in, the inventories start
accumulating beyond the desired level. This leads to cut in production of
goods. On the contrary, when recovery starts, the inventories Bo below
the desired level. This encourages businessmen to place more orders for
gooas whose production picks up and stimulates investment in capital
goods.

7. Another important feature of business cycles is profits fluctuate more

than any other type of income. The occurrence of business cycles causes
a lot of uncertainty to businessmen and makes it difficult to forecast the
economic conditions. During e depression period profits may even become
negative and many businesses go banku In a free market economy profits
are justified on the ground that they are necessa) payments if the
entrepreneurs are to be induced to bear uncertainty.

8. Lastly, business cycles are international in character. That is, once

started in one country they spread to other countries through trade
relations between them. For ex

ample, if there is a recession in the USA, which is a large importer of

goods from

other countries, will cause a fall in demand for imports from other
countries whose exports would be adversely affected.
In the Figure, the steady growth line represents the growth of economy
when there are no business cycles, On the other hand, the line of cycle

displays the business cycles that nove up and down the steady growth
line. The different phases of a business cycle are explained below.

1. Expansion

The line of eycle that moves above the steady growth line represents the
expansion phase ofa business cycle. In the expansion phase, there is an
increase in various macro-cconomic factors, such as production,
cmployment, output, wages, profits, demand and supply of products, and
sales.
 In addition, in the expansion phasec, the prices of factor of production
and output inereases simultaneously. In this phase, debtors are generally
in good financial condition to repay their debts; therefore, creditors lend
money at higher interest rates. This leads to an increase in the flow of
money.

In expansion phase, due to increase in investent opportunities, idle funds

of organizations or individuals are utilized for various investment
purposes. Therefore, in such a case, the cash inflow and outflow of
businesses are equal. This expansion continues till the economic
conditions are favorable.

2. Peak

The growth in the expansion phase ultimately slows down and reaches to
its peak. This phase is known as peak phase. In other words, peak phase
refers to the phase in which the increase in growth rate of business cycle
achieves its maximum limit. In peak phase, the economic factors, such as
production, profit, sales, and employment, are higher, but do not increase
further. In this phase, there is a gradual decrease in the demand of
various products due to increase in the prices of input. This is the stage
beyond which no further expansion is possible. This stage sees the
downward turning point.

The increase in the prices of input leads to an increase in the prices of

final products, whereas the income of individuals remains constant. This
also leads consumers to reorganize their monthly budget. As a result, the
demand for products, such as jewellery, homes, automobiles, refrigerators
and other durables, starts falling.

3. Recession

In peak phase, there is a gradual decrease in the demand of various

products due to increase in the prices of input. When the decline in the
demand of products becomes speedy and stable, the recession phase
takes place.

In recession phase, all the macro economic factors, such as production

prices, saving and investment, starts decreasing. Generally, producers are
uninformed of decrease in the demand of products and they continue to
produce goods and services. In such a case, the supply of products
exceeds the demand.
 Over the time, producers understand the surplus of supply when the cost
of manufacturing of a product is more than profit generated. This disorder
firstly experienced by few industries and slowly blowout to all industries.

This situation is firstly considered as a small fluctuation in the market, but

as the problem exists for a longer duration, producers start noticing it.
Therefore, producers avoid any type of further investment in factor of
production, such as labor, machinery, and furniture. This leads to the
reduction in the prices of factor, which results in the decline of demand of
inputs as well as output.

4. Trough

During the trough phase, the economic activities of a country decline

below the normal level. In this phase, the growth rate of an economy
becomes negative. In addition, in trough phase, there is a rapid decline in
national income and expenditure

(In this phase, it becomes difficult for debtors to pay off their debts. As a
result, the rate of interest decreases; therefore, banks do not prefer to
lend money. Acçordingly, banks face the situation of increase in their cash
balances)

Apart from this, the level of economic output ofa country becomes low
and unemployment becomes high. In addition, in trough phase, investors
do not invest in stock markets. In trough phase, many weak organizations
leave industries or rather dissolve. At this point, an economy reaches to
the lowest level of shrinking. )

Thus there are two turning points in the cycle, one at peak when the
economy starts sliding down and the other at trough, when the economy
picks up momentum for another phase of growth.

5. Recovery

As already discussed, in trough phase, an economy reaches to tie lowest

level of shrinking. This lowest level is the limit to which an economy
shrinks. Once the economy touches the lowest level, it happens to be the
end of negativism and beginning of positivism. This leads to reversal of
the process of business cycle. As a result, individuals and organizations
start developing a positive attitude toward the various economic factors,
such as investment, employment, and production. This process of reversal
starts from the labor market. Consequently, organizations discontinue
laying off individuals and start hiring but in limited number. At this stage,
wages provided by organizations to individuals is less as compared to
their skills and abilities. This marks the beginning of the recovery phase.
 In recovery phase, consumers increase their rate of consumption, as they
accept that there would be no further reduction in the prices of products.
As a result, the demand for consumer products increases. In addition in
recovery phase, bankers start utilizing their accumulated cash balances
by declining the lending rate and increasing investment in various
securities and bonds. Similarly, adopting a positive approach other private
investors also start investing in the stock market As a result, security
prices increase and rate of interest decreases.

Price mechanism plays a very important role in the recovery phase of

economy. During recession the rate at which the price of factor of
production falls is greater than the rate of reduction in the prices of final
products.

Therefore producers are always able to earn a certain amount of profit,

which increases at trough stage. The increase in profit also continues in
the recovery phase. Apart from this, in recovery phase, some of the
depreciated capital goods are replaced by producers and some are
maintained by them. As a result, investment and employment by
organizations increases. As this process gains momentum an economy
again enters into the phase of expansion. Thus, a business cycle gets
completed.
Inflation
Inflation is a situation of persistently rising prices, it is also a situation of
persistently rising money supply. According to coulborn, inflation is a state
of "too much money chasing too few goods".in simple words inflation
implies an upward movement in the average level of prices. Inflation is a
quantitative measure of the rate at which the average price level of a
basket of selected goods and services in an economy increases over a
period of time. Often conveyed as a percentage, inflation indicates a
decrease in the purchasing power of a nation's currency. As prices rise,
they start to influence the general cost of living for the common public
and the appropriate monetary authority of the country, like the central
bank, then takes the essential measures to keep inflation within permitted
limits and keep the economy running smoothly. Inflation is measured in a
variety of ways depending upon the types of goods and services
considered.

Inflation is a rise in the general level of prices, it is intrinsically linked to

money. Thus, inflation can be defined as a persistent increase in general
pricelevel,or a persistent decline in real income of people, that means
decline in value of money. A onetime rise in prices due to some external
factor like nahral calamity.new tax,new wage and salary structure may not
be termed as inflation ae it can be automatically corrected. Inflation is
when the price rise is persistent.

Causes of Inflation
There are different questions that would naturally creep into our mind to
get into the details of inflation as a phenomenon. Price rise is the root of
inflation. though it can be attributed to different factors. In the context of
causes, inflation is classified into three types: Demand-Pull inflation, Cost-
Push inflation and Built-in inflation. Let us see the different causes of
inflation one by one.

1. Excess Money Supply

Inflation is primarily caused by an increase in the money supply that

outperfoms economic growth. For a very long period of time, money
supply was accepted as the most important cause of price rise, because it
can be directly linked with increase in aggregate demand.

2.

Demand-Pull Inflation

The demand-pull effect states that as wages increase within an economic

system, people will have more money to spend on consumer goods. This
increase in liquidity and demand for consumer goods results in an
increase in demand for products. As a result of the increased demand,
companies will raise prices to the level the consumer will bear in order to
balance supply and demand.

Demand pull inflation occur due to the combination of the followings

Increase in money supply-monetarists believe that money inflation

always precedes price inflation.

Increase in Disposable income-disposable income may increase due

to increase in per capita income, reduction in taxes etc.

Increase in aggregate spending-spending is largely a function ot

disposable income, but there are other factors as well like incentive save
for future, which is governed by interest rate on deposits and consumers
preferences for present consumption over future. A society which is more
present oriented has a low tendency to Save and spend more.

Increase in population of the country- population is an important

macroeconomic factor which significantly affect the aggregate demand
level. Increasing population will naturally increase demand and create
demand supply gap.

3.Cost-Push Effect

The other side of price determination is supply. There can be a situation

when demand is unchanged and yet prices rise.

Another factor in bumping up prices of consumer goods and services is

explained by an economic theory known as the cost-push effect. Basically,
this theory states that when companies are faced with increased input
costs like raw goods and materials, fuel electricity technical knowhow or
wages, they will reserve their profitability by passing this increased cost of
production onto the consumer in the form of higher prices. An increase in
price of any of the inputs, whether fixed or variable, will imply an increase
in the cost of production. In the nutshell, any inflationary pressure created
due to increase in cost is termed as cost push inflation. A simple example
would be an increase in milk prices, which would undoubtedly increase up
the price of ice-cream.

4. Exchange Rates

Inflation can be made worse by our increasing exposure to foreign

marketplaces. On a day-to-day basis, we as consumers may not care what
the exchange rates between our foreign trade partners are, but in an
increasingly global economy, exchange rates are one of the most
significant factors in determining our rate of inflation.

5. Low increase in supply of goods

If supply falls short of demand, prices will increase. Supply depends upon
various factors such as technology, government policies, availability of
material etc. Different determinants which restrain supply includes:

Obsolete Technology -old technology will hamper supply. Majority of less

developed countries suffer from this problem and face inflation. Deficient
Machinery-this is another roadblock in the growth of output. Scarcity of
resources-many countries have remained behind in the race of
development simply because they did not have enough resources. It may
be natural resources, capital or even human resources.

Natural calamities-sometime natural calamities like floods, drought cause

serious hindrance to the supply of output.

Inflation and Decision Making

Inflation is a double edged sword. It is necessary in mild doses for
maintaining profit motive of entrepreneurs, at the same time it is not
allowed to cross the certain limit as it taxes the common consumer by
reducing the real value of money. Individuals with tangible assets, like
property or stocked commodities, like to see round about inflation as that
advances the value of their assets which they can sell at a higher rate.
However, the buyers of such assets may not be contented with inflation,
as they will be required to spend more money.

People holding cash may also not like inflation, as it erodes the value o
their cash holdings. Inflation promotes investments, both by businesses in
projects and by individuals in stocks of companies, as they presume better
returns than inflation.

However, an optimum level of inflation is required to promote spending to

a certain extent instead of saving. If the purchasing power of money
remains the same over the years, there may be no difference in saving
and spending. It may limit spending, which may negatively impact the
overall economy as decreased money circulation will slow overall
economic activities in a country. A balanced approach is mandatory to
keep the inflation value in an optimum and desirable range.
 High, negative or uncertain value of inflation negatively influences an
economy. It leads to uncertainties in the market, prevents businesses from
making big investment decisions, may lead to unemployment, endorses
hoarding as people flight to stock needed goods at the earliest among
fears of price rise and the practice leads to more price increase. This
further results in imbalance in international trade as prices remain
uncertain. and also impacts foreign exchange rates.

Control of Inflation
We have seen inflation wear down the value of money and discourages
savings. Large section of economists believe that zero inflation is
undesirable Therefore government do not try to reach zero inflation, but
still try to controlit Various methods are advocated for controlling inflation.
They may be broad]y divided into two measures: Monetary and Fiscal
Measures

1. Monetary Measures

As discussed that excessive money supply may bring about inflation,

therefore to control inflation it is necessary to curb money supply. Under
monetary measures, the central bank of the country uses various methods
of credit control to keep a check on inflation. It makes money costly and
less available in the hands of consumers by encouraging savings.

Some important measures adopted by the central bank includes:

Increasing the discount rate Higher reserve ratios Open market

operations Selective credit control

2. Fiscal Measures

Fiscal measures includes government revenue and government

expenditure. Using fiscal measures, the government may reduce public
expenditure or increase public revenue to keep a check on inflation.

Deflation
Deflation is reverse of inflation. It may be defined as persistent and
substantial fall in the general level of prices below full employment level.
When prices continue to fall from the level of full employment, income as
well as employment are adversely affected. This situation of fall in prices
accompanied by decrease in the level of output and economic activity is
called deflation. However, every fall in prices is not deflation just as every
rise in prices is not inflation. Deflation is the state of economy, where the
money value is rising or the price level is falling. The fall in the price level
is not only the result of the fall in the money supply, but it can also be the
cause of contraction m money supply.

Causes of Deflation

Deflation occurs, when production of goods and services rises ata faste
rate than money income, the two causes of deflation are deficient demand
and excess supply. On the demand side, money shortage, fall in
disposable income and fall in business outlays may lead to contraction of
credit, consumpti0n expenditure and investment expenditure on account
of tight money policy, higher rates of taxes and falling profit margins
respectively. This will have an adverse effect on the level of income and
employment in the country, resulting in deflationary situation in the
economy. Over investment may cause a rapid inerease in production
surpassing the demand. Such situation may also cause deflationary
situation in the economy.

Deflationary gap is opposite of inflationary gap. It arises when the volume

of goods and services is larger than the aggregate demand. Deflationary
gap may be defined as the amount by which aggregate expenditure falls
short of the aggregate income at full employment level. In other words the
excess of aggregate supply over the aggregate demand if full employment
is achieved is known as Deflationary gap. To wipe out the deflationary
gap, the government can raise the expenditure by investing in public
works.

Control of Deflation

Measures to check deflation are similar to those used to control inflation.

But these measures operate in the opposite direction.

1. Monetary measures

Deflation can be controlled through a fall in the bank rate, purchase of

govenmental securities and lowering of cash reserve requirements. This
policy, known as cheap money policy and pumps in money supply in the
economy through increase in the volume of credit. Various selective
control measures can also be used to increase the flow of credit in desired
channel.

2. Fiscal Measures

Fiscal; measures are most effective in controlling deflation. The

government on one hand, reduces the tax burden so as to leave a larger
amount of purchasing power with the public. On the one hand, the
government raises its spending on public works programmes such as
roads, railways, parks, irigation works, etc. under its fiscal policy. These
programmes will provide employment to those who are jobless and
therefore increases the demand for goods and services. The increase in
aggregate demand will invite investment in the private sector and lead to
further rise in employment. The basic idea of the fiscal policy is to
counteract the deficiency of demand for goods and

services.

Price support programmes can be used to prevent factor costs and prices
from falling below certain levels to control deflation. For this purpose, the
government has to secure necessary funds to buy the unsold surplus
stock programmes. In India, price support programmes are frequently
used in the agriculture sector.