UNIT 4 BUSINESS CYCLE

Structure
4.0 Objectives
4.1 Introduction
4.2 Features of Business Cycles
4.3 Phases of Business Cycles
4.3.1 Expansion
4.3.2 Contraction
4.4 Identification of Business Cycles
4.5 Business Cycle Indicators
4.5.1 Leading Indicators
4.5.2 Lagging Indicators
4.5.3 Coincident Indicators
4.6 Theories of Business Cycles
4.6.1 Keynesian Theory of Business Cycle
4.6.2 Schumpeter’s Innovation Theory of Business Cycle
4.6.3 Samuelson’s Model of Business Cycle: Interaction between Multiplier and
Accelerator
4.6.4 Real Business Cycle Theory
4.7 Let us Sum Up
4.8 Answers to Check Your Progress Exercises

4.0 OBJECTIVES
After going through the unit you will be able to
 explain the concept and features of Business cycle;
 identify the various phases of Business cycle;
 ascertain the theoretical framework which explains the occurrence of business
cycle;
 distinguish between the monetary and real factors behind business cycle; and
 distinguish between the leading, lagging and coincident indicators.

4.1 INTRODUCTION
Rapid economic growth witnessed by many developed economies during the past
two centuries has not been a smooth one. There have been periodical ups and
downs in the GDP levels of these countries. Along with output, there have been
fluctuations in various economic aggregates such as income, employment and
prices and their long term trends. These economies have experienced phases of


Dr. Archi Bhatia, Associate Professor, Department of Economics and Public Policy, Central
University of Himachal Pradesh, Dharamshala.
Economic Growth expansion and contraction in output and other economic aggregates alternatively.
These alternating phases of upswings and downswings are known as business
cycles.
Theoretical explanations of business cycles evolved in the early 20th century.
Periods of expansion and contraction in an economy exhibited a remarkable
degree of regularity. The characteristics of these phases are carefully documented
by economists like Wesley Mitchell, Simon Kuznets and Frederick Mills.
Mitchell documented the co-movement of variables over the cycles; Mills
documented the co-movement of prices and quantities over expansions and
contractions, while Kuznets studied the patterns of both growth and fluctuations.
The 1930s was a very active period of business cycle research as the National
Bureau of Economic Research (NBER) continued its program (begun by Mills
and Mitchell) of empirically documenting the features of business cycles.
However, interest in business cycles waned after the publication of Keynes’
General Theory which turned attention away from Business cycles to short run
management of the economy. Interest in business cycles revived in the 1970s
when the prevalent economic crisis in many countries could not be explained by
Keynesian model.
In this unit we first explain the features of business cycles and the various phases
of business cycles. We proceed further to examine how to identify business
cycles and measure the aggregate state of the economy using various economic
series. Subsequently we explain the important theoretical frameworks of business
cycles.

4.2 FEATURES OF BUSINESS CYCLES

Business cycles are economy-wide fluctuations in output, unemployment, prices,
revenue, profits, and interest rates, among other variables. These fluctuations
occur across the economy and over a number of years. Fluctuations always take
place in an economy. Business cycles, however, do not refer to fluctuations that
are specific to one geographic region or industry within an economy. To identify
business cycles, we must look at factors that can have an effect on the entire
economy.
Business cycles consist of recurrent alternating phases of expansions and
contractions in a number of economic variables including employment,
production, real income, and real sales. Business cycles involve multidimensional
processes, in which quantities and prices, stocks and flows, outputs and inputs,
real, monetary, and financial variables all tend to move together. These are
asymmetric in the sense that expansions typically exceed contractions in size and
duration. Business cycles can be distinguished from the other fluctuations in that
they are usually larger, longer, and widely diffused.

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The major features of business cycles are as follows: Business Cycle

1) Though business cycles do not show the same regularity, they have some
distinct phases such as expansion, peak, recession, trough and recovery.
The duration of cycle can vary between two years to twelve years.
2) Business cycles are synchronic. Depression or contraction occurs
simultaneously in most 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. Similarly, expansion spreads
through various linkages between industries or sectors.
3) Fluctuations occur simultaneously in the level of output as well as
employment, investment, consumption, etc.
4) Consumption of durable goods and investment are affected the most by
cyclical fluctuations. As stressed by Keynes, investment is very unstable
as it depends on profit expectations of private entrepreneurs. Any change
in these expectations makes investment unstable. Thus the amplitude of
fluctuation in the case of durable household effects is higher than that of
GDP.
5) Consumption of non-durable goods and services do not vary much during
the different phases of business cycles. Past data of business cycles reveal
that households maintain a great stability in the consumption of non-
durable goods. Thus the amplitude of fluctuations in the case of non-
durable consumption goods is lower than that of GDP.
6) The immediate impact of recession or expansion is on the inventories of
goods. When recession sets in, inventories start accumulating beyond the
desired level. It leads to cut in production of goods. In contrast, when
recovery starts, the inventories go below the desired level. It encourages
business houses to place more orders for goods which boost production
and stimulates investment.
7) Profits fluctuate more than any other type of income as the occurrence of
business cycles causes lot of uncertainty for the businessmen and makes it
difficult to forecast economic conditions. During depression, profits turn
negative and many businesses go bankrupt.
8) Business cycles are international in character. That is, once started in one
country, they spread to other countries through contagion effect. The
downslide in financial market, for example, in one country spreads
rapidly to other country as financial markets are linked globally through
capital flows. Further, recessions in one country, say the United States
can spread to other country as the imports of the U.S.A. will decline.
Countries which are major exporter to the U.S will witness a decline in
their exports and may witness recession.

4.3 PHASES OF BUSINESS CYCLES

Business cycles are characterized by expansion of economic variables in one
period and contraction in the subsequent period. In Fig. 4.1 you can observe the

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Economic Growth upward sloping curve (expansion phase) there is acceleration in growth rate. The
downward sloping segment of the curve indicates the ‘contraction phase’.
In Fig. 4.1 the upward sloping straight line indicates the steady state growth path
or the long run growth path of the GDP. The actual GDP fluctuates around the
steady state growth path due to business cycles.
According to some researchers there are four phases of a business cycle, viz.,
expansion, recession, depression and recovery. The four phases of a business
cycle are also depicted in Fig. 4.1. In fact, the expansion phase comprises both
recovery and expansion. Similarly, the contraction phase consists of both
recession and depression. You should note that the difference between recession
and depression is one degree. In the recession phase there is a deceleration in the
growth rate. In the depression phase, economic growth is below its long run trend
and the economy can witness negative growth rate also.
Similarly, the difference between recovery and expansion is one of degree and
extent. After negative growth, the economy passes through the recovery phase
and then through the expansion phase. The point at which the expansion ends and
a recession begin is called ‘peak’ of a business cycle. The point at which a
depression ends and recovery begins is called a ‘trough’. Thus peak and trough
are ‘turning points’ in a business cycle.

Y Fig. 4.1: Phases of a Business Cycle

Level Peak
of
GDP Steady State
Expansio Line
n
Recessio
n Prosperit
y
Prosperity

Depression

Line of Trough
Cycle

Time X

4.3.1 Expansion Phase

In the expansion phase, there is an increase in various economic factors, such as
production, employment, output, wages, profits, demand and supply of products,
and sales. An expansion stage can begin as the result of many forces, including
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willingness of financial institutions to lend more and willingness of business Business Cycle
houses to borrow more. There is overall optimism in the economy. The
expansion phase continues till the economic environment is favourable.
During the expansion phase, the economy often gets overheated in the sense that
various constrains and frictions develop in the economy. Wage rate and prices
increase much faster than output leading to hike in production cost and decline in
profits. The central bank pursues a restrictive monetary policy so that inflation is
in under control.
Economic growth in the expansion phase eventually slows down and reaches its
peak. During the peak of a business cycle, economic variables such as
production, profits, sales and employment are high; but do not accelerate further.
There is gradual decrease in the demand for various inputs due to the increase in
input prices. The increase in input prices leads to increase in production prices
while real income of people does not increase proportionately. It leads consumers
to restructure their monthly budget and the demand for products, particularly
luxuries and consumer durables, starts falling. The peak also occurs before
various economic indicators such as retail sales and the number of employed
people falls. When the decline in the demand for products become rapid and
steady, recession takes place
4.3.2 Contraction Phase
In recession phase, all the economic variables such as production, prices, saving
and investment, starts decreasing. Generally, in the beginning of the downturn,
producers are not aware of the decrease in the demand for their products and they
continue to produce goods and services. In such a case, the supply exceeds
demand and there is accumulation of inventories. Over the time, producers
realize that there is an unwanted accumulation of inventories, escalation in
production cost, and decline in profits. Such a condition is first experienced by
few industries and slowly spreads to the whole economy. During the recession
phase, producers usually avoid new investments which lead to the reduction in
the demand for factors of production, and consequent decline in input prices and
unemployment. Firms reduce levels of production and the number of people on
their payrolls. A chain reaction starts, lower income, lower demand, lower
output, lower employment, and so on. The adverse effects of recession extent
beyond the purely economic realm and influence the social fabric of society as
well. Social unrest and crimes tend to rise during recession.
When recession continues further, economic growth rate may be negative also.
This phase is sometimes termed as ‘depression’. During depression, there is not
just a decline in the growth rate; there is a decline in the absolute level of GDP.
As sales declines, business houses find it difficult to repay their debts. As
business sentiments are low enough to carry out new investments, demand for
credit declines. Banks also become cautious in their lending as the chances of
default on repayment increases. The economy however revives its growth rate
over a period of time and optimism build up in certain sectors of the economy.
This leads to reversal of the recession phase and the recovery phase starts.
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Economic Growth Individuals and organizations start developing a positive attitude towards the
various economic factors, such as investment, employment and production. In the
recovery phase, there is an increase in consumer spending and demand for
consumer goods. This provides incentive to firms to increase production, carry
out new investments, hire more labour, etc. Further, there could be some
investment during the recession phase due to replacement of obsolete machines
and maintenance of existing capital stock.
Price level plays a very important role in the ‘recovery phase’ of an economy. As
pointed out earlier, during the recession phase decline in input prices is greater
than the decline in product prices. This leads to a reduction in the cost of
production and increase in profits. Apart from this, in the ‘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, the business cycle gets completed.
Check Your Progress 1
1) What is meant by business cycle?
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2) Point out the important features of business cycle.

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3) What are the different phases of business cycle?

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4.4 IDENTIFICATION OF BUSINESS CYCLES

Understanding the various phases of business cycles is essential, because it will
help the government in taking counter-cyclical measures. This requires
identifying the turning points of a business cycle. In the United States, the
National Bureau of Economic Research (NBER) has a dedicated research
programme for identifying the dates of business cycle turning points.
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Similarly the Euro Area Business Cycle Dating Committee of the Centre for Business Cycle
Economic Policy Research (CEPR) identifies the chronology of recessions and
expansions of the Euro Area member countries. In India also there have been
some attempts by scholars to identify the chronology of business cycles (See, for
example, Dua and Banerjee (2000) and Chitre (2001)).
The NBER's Business Cycle Dating Committee maintains a chronology of the
United States business cycle. The chronology comprises alternating dates of
peaks and troughs in economic activity. A recession is a period between a peak
and a trough, and an expansion is a period between a trough and a peak.
According to NBER a recession is a significant decline in economic activity
spread across the economy, lasting more than a few months, normally visible in
real GDP, real income, employment, industrial production, and wholesale-retail
sales. Similarly, during an expansion, economic activity rises substantially,
spreads across the economy, and usually lasts for several years. Thus, the NBER
approach identifies cycles as recurrent sequences of alternating phases of
expansion and contraction in the levels of a large number of economic time
series. This working definition of business cycle has been in use at the NBER for
over fifty years, and it is currently employed by the NBER to identify and date
the United States business cycle. These dates are widely accepted by government,
researchers and business analysts.
In both recessions and expansions, brief reversals in economic activity may occur
– a recession may include a short period of expansion followed by further
decline; an expansion may include a short period of contraction followed by
further growth. The Business Cycle Dating Committee applies its judgment based
on the above definitions of recessions and expansions and has no fixed rule to
determine these upturns and downturns.
The Committee does not have a fixed definition of economic activity. It examines
and compares the behaviour of various measures of broad activity: real GDP
measured on the product and income sides, economy-wide employment, and real
income. The Committee also may consider indicators that do not cover the entire
economy, such as real sales and the Federal Reserve's index of industrial
production (IIP).
Table 4.1: NBER Chronology for United States Business Cycles
(duration in number of months)
Peak Trough Duration, Duration, Duration, Duration,
Peak Trough
month month peak to trough to peak to trough to
month month
number number trough peak peak trough
December --- 660 --- --- --- ---
1854
June 1857 December 690 708 18 30 --- 48
1858
October June 1861 730 738 8 22 40 30
1860
April December 784 816 32 46 54 78
1865 1867
June 1869 December 834 852 18 18 50 36
1870
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Economic Growth October March 886 951 65 34 52 99
1873 1879
March May 1885 987 1025 38 36 101 74
1882
March April 1888 1047 1060 13 22 60 35
1887
July 1890 May 1891 1087 1097 10 27 40 37
January June 1894 1117 1134 17 20 30 37
1893
December June 1897 1152 1170 18 18 35 36
1895
June 1899 December 1194 1212 18 24 42 42
1900
September August 1233 1256 23 21 39 44
1902 1904
May 1907 June 1908 1289 1302 13 33 56 46
January January 1321 1345 24 19 32 43
1910 1912
January December 1357 1380 23 12 36 35
1913 1914
August March 1424 1431 7 44 67 51
1918 1919
January July 1921 1441 1459 18 10 17 28
1920
May 1923 July 1924 1481 1495 14 22 40 36
October November 1522 1535 13 27 41 40
1926 1927
August March 1556 1599 43 21 34 64
1929 1933
May 1937 June 1938 1649 1662 13 50 93 63
February October 1742 1750 8 80 93 88
1945 1945
November October 1787 1798 11 37 45 48
1948 1949
July 1953 May 1954 1843 1853 10 45 56 55
August April 1958 1892 1900 8 39 49 47
1957
April February 1924 1934 10 24 32 34
1960 1961
December November 2040 2051 11 106 116 117
1969 1970
November March 2087 2103 16 36 47 52
1973 1975
January July 1980 2161 2167 6 58 74 64
1980
July 1981 November 2179 2195 16 12 18 28
1982
July 1990 March 2287 2295 8 92 108 100
1991
March November 2415 2423 8 120 128 128
2001 2001
December June 2009 2496 2514 18 73 81 91
2007
February --- --- --- --- 128 146 ---
2020

You can observe from Table 4.1 that the duration of a cycle is not uniform (see
from trough to trough or from peak to peak).

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Secondly, the duration of peak to trough (contraction phase) has been shorter Business Cycle
than the duration of trough to peak (expansion phase).

4.5 BUSINESS CYCLE INDICATORS

As you already know, a major objective of macroeconomic policy is to maintain
stability in economic growth and price level. An important part of the job of the
central bank is therefore to gather information of the current and if possible,
future economic conditions. The theoretical concept of measuring current
business activities using economic series such as GDP, sales, investment, stock
prices, etc. is rather simple though its practical application is difficult. Usually,
the time pattern of these fluctuating economic series is diverse. While some
economic series are expanding at a given point in time, others have already
reached their upper turning point (peak) and still others are on the downswing; a
few economic activities might even be at a lower turning point (trough). Thus the
question is how to measure the overall state of the economy using these
economic variables as they have diverse trends.
Economic indicators were conceived at the NBER originally by W.C. Mitchell
and A. F. Burns in the 1930s. This approach requires monitoring of economic
variables that tend to be sensitive to cyclical changes no matter what their cause.
There could be three scenarios: (i) certain economic variables move ahead of
business cycles (they ‘lead’ a business cycle), (ii) certain other economic
variables lag behind a business cycle (the turning points in these variables take
place later that with certain ‘lag’), and (iii) there are still other economic
variables which ‘coincide’ with business cycles. Burn and Mitchell studied a
group of about 487 variables to see if the turning points in the variables
persistently led, coincided with, or lagged behind the turning points in the U.S.
business cycle. Seventy one series were chosen and arranged according to the
average lead or lag with regard to the reference revivals. For example, six time
series had no average lead or lag. On the average, the leading series were from
one to ten months ahead of the reference revivals. The lagging series were on the
average from one to twelve months behind.

According to Business Cycle Indicators Handbook 2020, a business cycle

indicator should fulfil the following criteria:
(i) Conformity: the series must conform well to business cycles;
(ii) Consistent Timing: the series must exhibit a consistent timing pattern
over time as a leading, coincident or lagging indicator;
(iii) Economic Significance: the cyclical timing of the series must be
economically logical;
(iv) Statistical Adequacy: data on the variable must be collected and
processed in a statistically reliable way;
(v) Smoothness: month-to-month movements in the variable must not be too
erratic; and

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Economic Growth (vi) Currency: Data on the variable must be available on a reasonable
prompt schedule.

Those series are selected which are similar in timing at peaks and troughs with
business cycles. Business cycle indicators are classified into three groups, viz.,
leading, roughly-coincident and lagging.

4.5.1 Leading Indicators

Leading economic indicators help us assess where the economy is headed. They
foreshadow what is coming, such a turning point, before it actually happens.

One of the most significant leading indicators is the stock market itself, gauged
by an index such as the S&P 500. It will begin to rise before economic
environment seems favourable, and it will begin to decline before economic
conditions seem to warrant it. Another important leading indicator is interest
rates. Low interest rate stimulates borrowing and buying, which favours the
economy. An increase in interest rates shows the economy is doing well, but
eventually rising interest rates lead to a slowdown because less people borrow
money to start new projects.

4.5.2 Lagging Indicators

Unlike leading indicators, lagging indicators turn around after the economy
changes. Although they do not typically tell us where the economy is headed,
they indicate how the economy changes over time and can help identify long-
term trends. Lagging economic indicators reveal past information about the
economy.

Gross Domestic Product (GDP) is how much a country is producing. There is

significant lag time between when the data is compiled and when it is released,
yet it is still an important indicator. Many consider a recession to be underway if
two quarters see back-to-back declining GDP. Other indicators, such as the
Consumer Price Index (CPI), are also sometimes considered lagging indicators,
since they reveal information that is already known to most consumers.

4.5.3 Coincident Indicators

Coincident indicators change (more or less) simultaneously with general
economic conditions and therefore reflect the current status of the economy.
They give consumers, business leaders, and policy makers an idea about where
the economy is currently, right now. When the economy rises today, then
coincident indicators are also rising today. Similarly if the economy declines
today, then coincident indicators are also declining today. Typical examples of
coincident indicators are industrial production or turnover. In Table 4.1 we
present a list of business cycle indicators.
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 Table 4.2: Business Cycle Indicators Business Cycle
Leading Roughly- Lagging
Coincident
I. Investment in Fixed Capital and Inventories
New building Production of Backlog of capital
permits; housing business appropriations;
starts; residential Equipment; Business
fixed investment; Machinery and expenditures for
New business equipment sales new
formation; New plant and
capital equipment;
appropriations; Trade inventories
Contracts and
orders for plant and
equipment;
Change in business
inventories

II. Consumption, Trade, Orders, and Deliveries

New orders for Production of
consumer consumer
goods and Goods;
materials; Trade sales
Change in unfilled
orders, durable
Goods;
Vendor
performance (speed
of
deliveries);
Index of consumer
sentiment

III. Employment, Production, and Income

Average Non-agricultural Average duration of
workweek; employment; unemployment;
overtime unemployment Long term
Hours; Accession rate; GDP; unemployment
rate; layoff rate; personal income;
New industrial
unemployment production
insurance claims;
Productivity
(output per hour);
Rate of capacity
utilization

IV. Prices, Costs, and Profits

Bond prices; Stock Unit labour costs;
prices; Sensitive Labour share in
materials prices; national income
Profit margins;
Total corporate
profits; net cash
flows

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Economic Growth V. Money, Credit, and Interest
Monetary growth Velocity of money Short-term interest
rates; Change in rates; Bond yields;
liquid assets; Consumer credit
Change in outstanding;
consumer credit; Commercial and
Total private industrial loans
borrowing; Real outstanding
money supply
Note: The selection is based on the U.S. indicators published in Business Conditions
Digest, a monthly report by the Bureau of Economic Analysis, U.S. Department of
Commerce

Check Your Progress 2

1) What are the criteria that form the basis for selection of a business cycle
indicator?
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2) What is the importance of a lagging indicator?

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4.6 THEORIES OF BUSINESS CYCLES

We have explained above the various phases and common features of business
cycles. Now, an important question is what causes business cycles. Several
theories of business cycles have been propounded from time to time. Each of
these theories spells out different factors which cause business cycles.
4.6.1 Keynes’ Theory of Business Cycle
J.M. Keynes in his seminal work ‘General Theory of Employment, Interest and
Money’ made an important contribution to the analysis of the causes of business
cycles. According to Keynes, the changes in the level of aggregate effective
demand will bring about fluctuations in the level of income. The aggregate
demand is composed of demand for consumption goods and demand for
investment goods. According to Keynes, propensity to consume is more or less
stable in the short run. Private investment however depends upon profit motive
and business expectations about the economy. Thus fluctuation in aggregate

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demand depends primarily upon fluctuations in investment demand. Multiplier Business Cycle
plays a significant role in causing magnified changes in income following a
reduction or increase in investment.
Keynesian theory however fails to explain the cumulative character of business
cycle. For example, suppose that investment rises by 100 rupees and that the
magnitude of multiplier is 4. From the theory of multiplier, we know that national
income will rise by 400 rupees and if multiplier is the only force at work that will
be the end of the matter, with the economy reaching a new stable equilibrium at a
higher level of national income. But in real life, this is not likely to be so, for a
rise in income produced by a given rise in investment will have further
repercussions in the economy. This reaction is described in the ‘principle of
accelerator’ (accelerator is the impact of income on investment). Samuelson
combined the accelerator principle with the multiplier and showed that the
interaction between the two can bring about cyclical fluctuations in economic
activity.
4.6.2 Schumpeter’s Innovation Theory of Business cycles
Joseph Schumpeter considered trade cycles to be the result of innovation activity
of the entrepreneurs in a competitive economy. Schumpeter calls the equilibrium
state of the economy as a “circular flow” of economic activity which just repeats
itself period after period. The circular flow of economic activity gets disturbed
when an entrepreneur successfully carries out an innovation. According to
Schumpeter, the primary function of an entrepreneur is innovation activity which
yields him/ her real ‘profit’.
According to Schumpeter, introduction of a major innovation leads to a business
cycle. As the innovator-entrepreneur begins bidding away resources from other
industries, money incomes increase and prices begin to rise thereby stimulating
further investment. As the innovation steps up production, the circular flow in the
economy swells up. Supply exceeds demand. The initial equilibrium is disturbed.
There is a wave of expansion of economic activity. This is what Schumpeter calls
the “primary wave”. This primary wave is followed by a “Secondary wave” of
expansion. This is due to the impact of the original innovation on the
competitors. You can imagine the impact of innovation if you relate it to some
real life examples such as the Internet, mobile phone, and on-line transactions.
As the original innovation proves profitable, other entrepreneurs follow it in
“swarm-like clusters”. Innovation in one sector induces innovations in related
sectors. Money incomes and prices rise. As potential profits in these industries
increase, a wave of expansion in the whole economy follows.
This period of prosperity ends as soon as ‘new’ products induced by the waves of
innovations replace old ones. Since the demand for the old products goes down,
their prices fall and consequently their producer-firms are forced to reduce their
output. When the innovators begin repaying their bank loans out of the newly-
earned profits, the quantity of money in circulation is reduced as a result of which
prices tend to fall and profits decline.
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Economic Growth In this atmosphere, uncertainty and risks increase. Recession sets in. The
economy cannot continue in recession for long. Entrepreneurs continue their
search for profitable innovations. The natural forces of recovery bring about a
revival.
4.6.3 Samuelson’s Model of Business Cycles: Interaction between Multiplier
and Accelerator
Samuelson in his seminal paper convincingly showed that an autonomous
increase in the level of investment raises income by a magnified amount
depending upon the value of the multiplier. This increase in income further
induces the increases in investment through acceleration effect. The increase in
income brings about incr
increase
ease in aggregate demand for goods and services. To
produce more goods we require more capital goods for which extra investment is
undertaken. Thus the relationship between investment and income is one of
mutual interaction; investment affects income which in turn affects investment
demand and in this process income and employment fluctuate in a cyclical
manner.

Fig. 4.2 shows how income and output will increase by even larger amount
when accelerator is combined with the Keynesian multiplier.

𝛥𝐼 = Increase in Autonomous Investment

𝛥y = Increase in Income
= Size of multiplier when MPC = Marginal Propensity to Consume

𝛥𝐼 = Increase in Induced Investment

v = Size of Accelerator
Let us assume that there is an increase in investment in the economy. This will
result in a magnified increase in output and income due to multiplier effect.
When output increases under the influence of multiplier effect, it induces further
increase in inv
investment.
estment. The extent to this induced investment in capital goods
industries depends on the capital-output ratio (v).
Increase in investment leads to further increase in income, which again leads to
increase in investment. The pattern of the interaction bet ween multiplier and
accelerator however differs depending upon the magnitudes of the marginal
propensity to consume and capital-output ratio. It implies that the interaction
between multiplier and accelerator can give rise to business cycles.

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The model of interaction between multiplier and accelerator can be Business Cycle
mathematically represented as under:
𝒀 𝒕 = 𝑪𝒕 + 𝑰 𝒕 ...(4.1)
𝑪𝒕 = 𝑪𝒂 + 𝒄 (𝒀𝒕 𝟏 ) ...(4.2)
𝑰𝒕 = 𝑰𝒂 + 𝒗 (𝒀𝒕 𝟏 − 𝒀𝒕 𝟐 ) ...(4.3)
where 𝑌 , 𝐶 , 𝐼 stand for income, consumption and investment respectively for
period t, 𝐶 stands for autonomous consumption, 𝐼 for autonomous investment,
c for MPC and v for capital-output ratio or accelerator.
From the above equation it is evident that consumption in a period t is a function
of income of the previous period, 𝑌 . That is, one period lag has been assumed
for income to determine the consumption of a period. As regards induced
investment in period t, it is taken to be a function of the change in income in the
previous period. It means that there are two period gaps for changes in income to
determine induced investment. In the equation (4.3) above, induced investment
equals 𝑣 (𝑌 − 𝑌 ). Substituting equations (4.2) and (4.3) in (4.1), we have
the following:
𝒀𝒕 = 𝑪𝒂 + 𝒄 (𝒀𝒕 𝟏 ) + 𝑰𝒂 + 𝒗 (𝒀𝒕 𝟏 − 𝒀𝒕 𝟐 ) ...(4.4)
Equation (4.4) indicates how changes in income are dependent on the values of
MPC ( c ) and capital-output ratio v, (i.e., accelerator).
By taking different combinations of the values of c and v, Samuelson could
describe different paths which the economy would follow. The various
combinations of the values of c and v are shown in Fig. 4.3.

Fig. 4.3: Combinations of c and v

Y

1
D
A
E

C
B

0 v X

Fig. 4.3 shows the four paths which the economic activity can have depending
upon combinations of the values of marginal propensity to consume (c) and
capital-output ratio (v).

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Economic Growth The five paths or patterns of movements in output or income can have depends
upon the combinations of the values of c and v. We depict these paths in Fig. 4,
Panels (a) to (e). When the combinations of c and v lie in the region marked A,
an increase in investment will increase output a decreasing rate. Finally it reaches
a new equilibrium as shown in panel (a) of Fig. 4.4.

Fig. 4.4 Panel (a): Income and Output

Y

Income
(Output New Equilibrium
)

Initial Equilibrium

0 X
Time

If the values of c and v lie in region B of Fig. 4.3, a change in investment will
generate fluctuations in income which follow the pattern of a series of damped
cycles as shown in panel (b) of Fig. 4.4. It means that the amplitude goes on
declining until the cycles disappear over a period of time.

Y Fig. 4.4, Panel (b): Income and Output

New Equilibrium
Income
(Output)

Initial Equilibrium

0
X
Time

You should note that region C of Fig. 4.3 represents the combinations of c and v
which are relatively high as compared to the region B. Such values of multiplier
and accelerator bring about explosive cycles as given in panel (c) of Fig. 4.4.

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It implies that the fluctuations of income will be successively greater and greater Business Cycle
in amplitude.

Fig. 4.4 Panel (c): Income and Output

Y

Ceiling Output

Income
(Output)

Initial Equilibrium

0 X
Time

The region D of Fig. 4.3 describes the combinations of c and v which cause
income to move upward or downward at an increasing rate. We have depicted it
in panel (d) of Fig. 4.4.

Fig. 4.4 Panel (d): Income and Output

Y
Ceiling Output

Income
(Output
)

Initial Equilibrium

0 X
Time

In a special case when values of c and v lie in the region E of Fig. 4.3, they
produce fluctuations in income of constant amplitude and are shown in panel (e)
of Fig. 4.4. You should note that all the above five cases do not give rise to
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Economic Growth cyclical fluctuations or business cycles. It is only combinations of c and v lying
in the regions B, C and E that produce business cycles.

Y Fig. 4.4 Panel (e): Income and Output

Income
(Output)

Initial Equilibrium

0 X
Time
Fig. 4.4 Panel (a) to (e) shows different patterns of income (output) movements
for various values of c and v which respectively determine the magnitudes of
multiplier and accelerator.

4.6.4 Real Business Cycle Theory

According real business cycle theory, monetary shocks or expectation changes
have no role to play in a business cycle. The real business cycle theory makes the
fundamental assumption that root cause of business cycle is real shocks to an
economy. These shocks could be from the supply side such as technology shocks
(changes in total factor productivity). Technological shocks include innovations,
bad weather, stricter safety regulations, etc.
Business cycles are primarily caused by real or supply side shocks that involve
exogenous large random changes in technology. An initial shock in the form of
technical progress shifts the production function upward. This leads to increase in
available resources, investment, consumption and real output. With the increase
in investment, the capital stock increases which further increases real output,
consumption and investment. This process of expansion of the economy
continues erratically due to changes in technology over time.
Real business cycle theory explains the causes of recession as follows: A
recession in the real business theory is just the reverse of expansion. Negative
real shocks decreases the available resources, and shifts the production function
downward as a result of which output declines.
There could be several examples of negative real shocks such as decline in
technology (i.e., technical regress), unexpected rise in input prices (crude oil
crisis), scanty rainfall (severe drought), etc. This starts a process of decline in
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investment, consumption, output and employment. But the models of real Business Cycle
business cycle do not explain a recession.
Check Your Progress 3

1) Explain in brief how multiplier and accelerator interact to generate

business cycles.
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2) Explain the real business cycle theory.
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4.7 LET US SUM UP

In this unit we focussed on three issues: characteristics of business cycle,
indicators of business cycle, and some important theories of business cycle.
Business cycle should be thought of as apparent deviations from a trend in which
many economic variables move together. The fluctuations are typically
irregularly spaced and of varying amplitude and duration. Nevertheless, the one
very regular feature of these fluctuations is the way variables move together.
Business cycle is characterised by four phases, viz., expansion, recession,
depression and recovery.
A major problem in empirical identification of business cycle is the lack of a
single and consistent measure of aggregate economic activity. In view of this,
movements in a number of indicators are considered for identification of turning
points of a business cycle. Timing and amplitude of these variables are used to
group them into leading, lagging and coincident indicators.
Some of the important theories which explain these feature of business cycles
are: (a) Keynesian theory which showed that changes in the level of aggregate
effective demand bring about fluctuations in the level of income, output and
employment; (b) Samuelson model of business cycle which shows that the
interaction between multiplier and accelerator gives rise to cyclical fluctuations
in economic activity; and c) real business cycle theory which says that business
cycles are due to real shocks to an economy.

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Economic Growth 4.8 ANSWERS/ HINTS TO CHECK YOUR
PROGRESS EXERCISES
Check Your Progress 1
1) Business cycle consists of recurrent alternating phases of expansion and
contraction in a large number of economic activities.
2) Business cycles are periodic, synchronic and once they start in one
country, they spread to other countries through trade relations between
them. See Section 4.2 for details.
3) There are four phases of a business cycle, viz., expansion, recession,
depression and recovery. See Section 4.3 for details.
Check Your Progress 2
1) A business cycle indicator should fulfil six criteria as described in Section
4.5.
2) The importance of a lagging indicator is its ability to confirm that a
pattern is occurring. Unemployment is one of the most popular lagging
indicators. If the unemployment rate is rising, it indicates that the
economy has been doing poorly.
Check Your Progress 3
1) You should describe equation (4.4) and draw inferences on the basis of
Fig. 4.3.
2) According to real business cycle theory, supply shocks generate business
cycles. Refer to Section 4.6.4.

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