Business Cycle

Definition

A business cycle can be defined as a wave like fluctuations of business activity characterized by recurring phases of expansion and contraction in periods varying from three to four years. This relatively simple definition of a business cycle suggests that business activity never takes place in a steady manner. While

3456123456A business cycle refers to regular fluctuations in economic activities in the economy as a whole. It signifies wavelike fluctuations in aggregate economic activity particularly in national income, employment and output. A business cycle is a period of up and down movement in aggregate measures of current economic output and income.

According to W.C. Mitchell, "Business cycles are a species of fluctuations in the economic activities of organised communities.

According to Keynes, "A trade cycle is composed, of periods of good trade characterized by rising prices and low unemployment percentages, altering with periods of bad, trade characterized by falling prices and high unemployment percentages."

In the words of Gordon, "Business cycles consist of recurring alternation of expansion and contraction in aggregate economic activity, the alternating movements in each direction being self-reinforcing and prevailing virtually all parts of the economy." Frederic Benham has define business cycle as "a period of prosperity followed by a period of depression. It is not surprising that economic process should be irregular, trade being good at some time and bad at others."

12.2 CHARACTERISTICS OF BUSINESS CYCLES

(1)Recurring Fluctuations : Business cycles are characterized by fluctuations which occur periodically in a free rhythm. This implies that the recurrence of expansion and contraction has no fixed or invariable period.

(2)Period of Business Cycle is longer than a Year : A typical business cycle completes itself in a period of 3 to 4 years. In some cases, duration of business cycles is shorter or longer than those of a normal business cycle. In any case the period of a business cycle is not shorter than one year. A business cycle in its character is distinctly different from seasonal fluctuations in economic activity which take place within the period of a calendar year and are due to causes connected directly or indirectly with the physical season.

(3)Presence of the Alternating Forces of Expansion and Contraction : A business cycle is characterized by alternating an economy to prosperity and depression. These forces are in-built in the system. The force of expansion when born gathers momentum over time, taking the economy to a high level of activity. This force is, however, first weakened and then completely replaced by a counter force which leads to contraction and the process ends up with depression.

(4) Phenomenon of the Crisis : An important characteristic of the business cycle is the phenomenon of crisis. This implies that the peak and the trough are asymmetrical. Normally the prosperity phase of business cycle comes to an end abruptly, whereas recovery after the depression is gradual and slow.

(5)Business cycles are repetitive and rhythmic. The period of prosperity is followed by depression and which again is followed by a period of prosperity. Thus the economy moves from one extreme to another almost like a pendulum. As Hicks says, "Periodicity and synchronism are the virtues of a business cycle. Regularity is its feature".

(6)Synchronic: 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 occurs simultaneously in all industries or sectors of the economy. Recession passes from one industry to another and chain reaction continues till the whole economy is in the grip of recession.

(7)Consumption of Non-Durable Goods and Services: 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.

(8)Profits Fluctuate More than any other Type of Income: An important feature of business cycles is that profits fluctuate more than any other type of income. The occurrence of business cycles causes a lot of uncertainty for businessmen and makes it difficult to forecast the economic conditions.

(9)International in Character: 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 example, if there is a recession in the USA, which is a large importer of goods from other countries, it will cause a fall in demand for imports from other countries whose exports would be adversely affected causing recession in them too. Depression of 2008 in USA engulfed the entire capital world.

PHASES OF BUSINESS CYCLE

No business cycle is same as another. In fact, the details of cycles differ. However, all the cycles belong to the same family and thus have common characteristics and stages. Every business cycle passes through certain well defined phases. Broadly, there are two phases—(1) the upward or expansion phase, and (2) the downward or contraction phase. The expansion phase extends form trough to peak while the contraction phase covers the length from peak to trough.

But in these two main phases there are further sub-phases. There is however no uniformity of language in characterising these phases. As the cycle progresses, all parts of the economy display marked changes in activities as they move through distinctive periods. Production, prices, income and employment activities all show characteristic changes during the cycle. Generally, a business cycle is divided into five well-defined and interconnected recurring phases. These include :

1. Prosperity,2. Boom,3. Recession,4. Depression, and5. Recovery.

level of economic activity is above normal and is on the rise during the prosperity stage. But over optimism leads to peak or boom characterized by inflation. Inflation can't be sustained for too long; it is followed by recession or fall in economic activity. Ultimately there is depression in the economy and the level of economic activity reaches a very low level (i.e., trough). The government and monetary authorities take steps to put the economy to the stage of recovery. This marks the completion of a business cycle.

1. Prosperity or Full Employment

During this stage, there is full employment in the economy representing all-round stability of output, wages, prices, income, etc. All the factors of production are fully employed. There is no involuntary unemployment. According to Haberler, "Prosperity is a state of affairs in which the real income consumed, produced and the level of employment are high or rising and there are no idle resources or unemployed workers or very few of either".

The special features of prosperity phase are :a. There is a high level of output and trade.b. There is a high level of effective demand.c. There is a high level of employment and income.d. Wages, interest and profits are quite high.e. There is a large expansion of bank credit. f. Business failures are very few.

g. There is heavy investment in durable capital goods industries.Thus, there is a feeling of optimism in the whole economy and business confidence is at its highest. The

stage of full employment is very often the usual goal of the national economic policies of most of the countries.

2. Boom or Overfull Employment

The prosperity phase gives way to the emergence of boom or inflation. Business optimism stimulates further investment. Rise in investment increases pressure on available workforce and materials. Hence wages and prices rise. Number of jobs exceeds the number of workers available in the market. This situation is called overfull employment. Prices, wages, interest and profit move in the upward direction. Business people borrow more for investment. This adds fuel to the fire. The tempo of boom reaches new heights. There is an atmosphere of over optimism all round.

Boom carries with it the seeds of self-destruction. Bottlenecks begin to appear in the economy. Labour, materials etc. become scarce. This leads to higher wages and prices and in turn upsets the cost calculations of manufacturers. They stop further expansion of existing units.

From the point of view of consumers, inflation is very dangerous. During the period of inflation, the consumers go to the market with bags full of money and return home with pockets full of commodities. This is because of rocketing prices in the market. This atmosphere paves way for the succeeding stage, i.e., recession.

3. Recession

Recession is a turn from boom to depression. It is generally for a short period. The recession is first reflected in the stock market. During this period, businessmen lose their confidence. The failure of some business houses discourages fresh investments. Bank loans are contracted or withdrawn. Due to decline in production, unemployment appears first in basic industries and then it spreads out to other industries. The increase in unemployment further depresses the economy by bringing down the income, expenditure, prices and profits. Thus, in a recession there is feeling of panic all around. There is uncertainty about the prices and the business activity slows down. As Lee remarked, "A recession, once starts, tends to build upon itself much as forest fire, once under way tends to create its own draft and give internal impetus to its destructive ability."

The important characteristics of recession are :f. There is a downfall in the activities of stock exchanges.g. Failure of some business creates panic among businessmen.h. No new ventures are taken up.i. Banks curtail credit.j. Business expansion stops.f. Workers are laid off.g. There is unemployment in the economy.h. Income, expenditure, prices, profits, industrial and trade activities all fall.Thus, recession is a period of utter confusion and chaos. Once the recession starts in the economy, it

gathers momentum till it reaches its final stage of business cycle, i.e., depression. Thus, in brief, recession is the intervening phase between the boom and depression.

4. Depression

During depression or contraction the level of economic activity is very low. In the words of Haberler, "Depression means a state of affairs in which real income consumed or volume of production per head and the rate of employment are falling or are subnormal in the sense that there are idle resources and unused capacity, especially unused labour." Therefore, depression is characterised by a bad situation of low output and low unemployment. The prices fall. Savings decline rapidly because people have low income. So investments also fall. Wages and profits decline. Demand and expenditure fall. There is general contraction of credit. Stock markets crash and everywhere pessimism prevails.

The remarkable features of depression are :a. The general price level in the economy is very low. b. The volume of production and trade is falling.c. Level of unemployment is very high.d. Most of the firms are incurring losses.e. Interest, wages and rent are all falling.f. Aggregate expenditure and effective demand go on declining.g. Bank credit contracts.h. There is little or no opportunity to invest.i. Stock market is dull and prices of securities fall to a low level.j. Construction activity comes to a complete stand still.k. The consumer goods industries are least affected, while capital goods industries come to a complete

stand-still.

5. Revival or Recovery

After the lowest point of depression is reached, the economic situation begins to improve as a result of monetary and fiscal measures. There is revival of business and economic activity Revival of business activity first appears in the capital goods industries. An increase in demand for capital goods leads to an increase in investment and employment in these industries. Increase in employment leads to rise in income. Increased income with the people pushes up the demand for goods and services. A rise in their demand leads to a rise in their prices and profits, further investment, further production and higher income and savings. Thus once investment expansion starts, it gathers momentum.

The striking features of revival phase are :

a. The levels of prices, production, employment and income slowly and steadily rise.b. The stock market becomes active.c. The profit margin slowly rises.d. Bank loans and demand for credit start increasing.

e. With the recovery in the industrial sector, the agricultural sector of the economy also recovers.f. Through multiplier and acceleration effects, the economy proceeds upward steadily and rapidly,g. Increased business and factor income result in increased expenditure which causes further increase in

income and business activity which, in turn, result in further increased expenditure and so on. Thus during recovery, the expectations of the businessmen will improve and optimism develops among them.

CAUSES OF BUSINESS CYCLES(1) Expansion and contraction of loans by banks : A change in the credit policy of banks is an important

cause of trade-cycles. When banks adopt the policy of credit expansion, it leads to the phase of prosperity. On the other hand, when banks adopt the policy of credit contraction, it leads to the phase of depression.

(2) Mal-adjustment between demand and investment: If there is mal-adjustment between savings and investment, it causes trade-cycles. When there is over-investment, it leads to the phase of prosperity and when there is under-investment, it leads to the phase of depression.

(3) Lack of adjustment between demand and supply: Demand and supply of goods and services play an important role in giving birth to trade-cycles. If the demand of goods and services is more than their supply, it causes prosperity. If, on the other hand, supply of goods and services is more than their demand, it causes depression.

(4) Lack of adjustment between income and expenses of consumer : If the purchasing power does not correspond to the expansion or contraction of production, the market suffers from maladjustments and, therefore, cyclical fluctuations. If the income of consumers is more than their regular expenses, the phase of prosperity is caused. If, on the other hand, income of consumers is less than their regular expenses, it leads to the phase of repression.

(5) Feeling of entrepreneurs : The profit mania of producer is also a contributory cause of the business cycles. This makes the producer too optimistic. He is under a constant illusion regarding the exact nature and volume of demand. The result is that if the retail trade is a little brisk, the producer magnifies the tendency by expanding production considerably and himself causing a mild boom in the raw material and the labour markets. If the retail trade slackens, the over-cautious producer immediately tends to reduce his output and cancels some of the orders placed by him for raw materials, plant, etc. This behaviour tends to intensify the processes of rise or fall in prices.

(6)Development of new technologies of production: Development of new technology of production affects the level of production, employment and income. If new technologies of production develop, it leads to the phase of prosperity and if there is a lack of development of new technologies, it may lead to the phase of depression.

(7)Lack of favourable ratio: Development of new technologies of production disturbs the exiting ratio of factor of production. Sometimes the ratio becomes more favourable and sometimes it becomes unfavourable. When this ratio is favourable, it leads to the phase of prosperity and when this ratio is not favourable, it leads to the phase of depression.

(8)Psychology of consumers: Psychology of consumers also causes business-cycles. If the consumers are hopeful and optimistic, it will lead to the phase of prosperity and if the consumers are pessimistic and not hopeful, it may lead to the phase of depression.

(9)Seasonal fluctuations: The cyclical changes in weather also contribute to the emergence of trade cycles. These changes affect agricultural production and the prices of those basic goods which the working class in a society consumes. This, in turn, affects the wage rate, cost of raw material, etc thereby contributing to the fluctuations in the economic activity.