Business Cycle

Introduction
Business cycles or Trade cycles refer to the continuous fluctuations in economic activity in the
economy as a whole. Fluctuations in economic activity are a feature of every economy and pose a
persistent problem in the short run normally. These short term fluctuations in economic activity, which are
reflected in output and employment levels, are called trade cycles.
So we can say, business cycle is an alternate expansion and contraction in overall business activities.
Itis regular fluctuations in income, output and employment which tend to be self-reinforcing or
cumulative.
It refers to wave like fluctuations and is invariably start in the industrial sector and then spread itself over
the other sectors of the economy quickly because in modern economy, the different sectors are interrelated.
In short business cycle or trade cycles are the ups and downs in economic activities. So business cycles,
boom in one period and slump in the subsequent period, in economic activities are essentially continuous
features of the economic development of a country. Business cycles influence business decisions
tremendously and set the trends for future business.
There are five phases of business cycles namely, Depression, Recovery, Prosperity, Boom and
Recession. As the name suggests, the period of prosperity opens up new and lager opportunities for
investment, employment, and production and promotes business in the economy. On the other hand period
of depression reduces business opportunities and investment as well as employment in the economy.
Features of Trade Cycle
From the above definitions, we can draw the following features:
 Cyclical fluctuations are recurring in nature.
 A trade cycle contains self-generating forces which tend to terminate one phase and bring the other phase of the cycle.
 A trade cycle is cumulative self-reinforcing.
 Trade cycles are prevailing in their impacts. They affect virtually every part of the economy.
 Keynes pointed out that a trade cycle is characterized by the presence of crisis.
 Business cycles by and large follow a pattern of development.
 Business cycles occur periodically. It is synchronic in nature which means that changes not occur only in single
industry, but in the whole industry.
 Business cycles are international in character.
 One of the important features of business cycles is that consumption of non durable goods and services does not
change much during the phases of different trade cycles.
 The cycle will not have identical spacing, and thereby, asymmetric nature of the cycle exhibits a different time period of
occurrence.
 Most of the macroeconomic variables are affected by the cyclical movement. In the upswing phase, output, prices,
employment, income shows a upward trend, while an opposite trend is observed in downswing phase. Even though the
trend is similar, but the magnitude of impact may be different.
 Phases of Business Cycles
Business cycles have shown different phases the study
of which is useful for the proper understanding of
market. In general there are two phases of business
cycle and that is prosperity and depression. But there
are some stages in between two. These are:
 Expansion or boom or upswing or prosperity of
business activities
 Peak of boom or upper turning point
 Recession or contraction or downswing or
depression
 Trough, the bottom of depression or lower turning
point
Expansion and Boom:
 The various characteristics of economy in its expansion phase are increase in output, increase in
investment, increase in employment, increase in aggregate demand, and increase in sales, increase in
profits, increase in wholesale and retail prices, increase in per capita output and rise in standard of
living.
 There is absence of involuntary unemployment but structural and frictional unemployment prevails in
the economy.
 So when expansion gathered momentum we have prosperity in the economy and in this phase gap
between potential GNP and actual GNP is zero. It means in this phase level of production is at maximum.
 So in prosperity phase there is a high level of effective demand, employment and income. People enjoy
a high standard of living also.
 In the later stages of prosperity, it may happened sometimes that banks start reducing credit or profit
expectations change adversely and trader become doubtful about future state of the economy.
 However different economists have different views regarding the possible reasons for the end of boom
phase and start of downswing in economic activity. Some have argued that the contraction in bank
credit may cause downswing and in the eyes of others, sudden collapse of expected rate of profit is a
major cause of downswing.
Recession and Depression:

 In this phase, economic activities slide down their normal level.

 In this phase not only output decreases but the level of employment also reduce and the
result of this there is fall in GNP also.
 Depression is a just contrast of prosperity, as there is presence of involuntary unemployment
in the economy, output and trade declines, profit and wages fall as a result income also,
decline in investment and aggregate demand.
 In depression phase there is fall in interest rates also and with low rate of interest people
demand for money holding increases.
 All construction activities come to an end. Durable consumer goods and capital goods
industries are hit badly. In short all economic activities touch the bottom.
 A prolonged contraction is called recession (contraction for over six months).
 A recession of more than one year is called a depression.
Trough and Recovery:
 When economic activities touch the bottom level, the phase of trough is reached.
 It is a phase where capital stock is allowed to depreciation even without replacement.
 Technology advancement makes the capital goods obsolete.
 In this situation if a bank starts expanding credit facilities for the advancement of
technology, new types of machines and other capital goods then it brings a recovery in the
economy.
 In this phase, some firm’s plans investment, some going for renovation programmes and some
undertakes both. This step will generate construction activities in both capital and consumer
goods sector.
 As a result factor of production fully utilized
 wages and other input prices move upward, though it may not in a uniform rate but in
increasing trend. So when this process gathered momentum, economy again enters into the
phase of recovery and then expansion. Thus the business cycle going on.
Types of Business Cycle
Following the writings of Prof .James Arthur and Schumpeter, we can classify business cycle into
three types based on the underlying time period of existence of the cycle as follows:
 Short Kitchin Cycle (very short or minor period of the cycle, approximately 40 months
duration)
 Longer Juglar cycle (major cycles, composed of three minor cycles and of the duration of 10
years or so)
 Very long Kondratief Wave (very long waves of cycle, made up of six major cycles and takes
more than 60 years to run its course of duration)
What keeps the Business Cycle going?
Four variable cause changes in the business cycle:
 Business Investment
When the economy is expanding, sales and profit keep rising, so companies invest in
new plants and equipment, creating new jobs and more expansion. In contraction, the
opposite is true.
 Interest Rates
Low interest rates, companies make new investments, adding jobs. When interest rate
climbs, investment dries up and less job growth.
 Consumer Expectations
Forecasts of an expanding economy fuels more spending, while fear of a recession
decreases consumer spending.
 External Shocks
External shocks, such as disruptions of the oil supply, wars, or natural disasters
greatly influence the output of the economy.
 Measuring and Dating
Business Cycles
The severity of a recession is measured by the three D’s:
• depth,
• diffusion, and
• duration.
A recession's depth is determined by the magnitude of the peak-to-trough decline in the broad measures of
output, employment, income, and sales.
Its diffusion is measured by the extent of its spread across economic activities, industries, and
geographical regions.
Its duration is determined by the time interval between the peak and the trough.
 Stock Prices and the Business
 Cycle
The biggest stock price downturns tend to occur—but not always—around business cycle downturns (e.g.,
contractions and recessions). For example, the Dow Jones Industrial Average and the S&P 500 took steep
dives during the Great Recession. The Dow fell 51.1%, and the S&P 500 fell 56.8% between Oct. 9, 2007 to
March 9, 2009.
 There are many reasons for this, but primarily, it is because businesses assume defensive measures and
investor confidence falls during contractionary periods. Many events occur before those in an economy are
aware they are in a contraction, but the stock market trails what is going on in the economy.
 So, if there is speculation or rumors about a recession, mass layoffs, rising unemployment, decreasing
output, or other indications, businesses and investors begin to fear a recession and act accordingly.
Businesses assume defensive tactics, reducing their workforces and budgeting for an environment of falling
revenues.
 Investors flee to investments "known" to preserve capital, demand for expansionary investments falls, and
stock prices drop.
 It's important to remember that while stock prices tend to fall during economic contractions, the phase
does not cause stock prices to fall—fear of a recession causes them to fall.
Controlling Business Cycle
 Monetary Policy:
Whatever may be the cause of the short-business cycle it is always aggravated by
the monetary factors.
The monetary factors may not cause the business cycle, but once the cycle
occurs, the monetary factors do aggravate it.
So far as money supply is concerned its under expansion could be checked by
insisting upon a proper and adequate cover against note-issue. As regards bank
credit, the Central Bank of the country could utilise the various weapons of
control, such as bank rate, open market operations, reserve ratios, moral suasion
etc., to control it.
Whatever, there is a tendency towards an over-expansion of business activity, the
Central Bank should utilise its weapons to check and control expansion of credit.
On the contrary whatever there is a tendency towards an undue slackening of
business activity, the Central Bank should utilise its weapons to ensure an
adequate expansion of credit.
 Controlling Business Cycle
 Fiscal Policy:
Monetary policy taken alone may not suffice to check cyclical business fluctuations. It is
therefore suggested that monetary policy should be properly integrated with a suitable fiscal
policy to achieve the desired results. Keynes and the Keynesians such as Alvin Hansen and
others have recommended compensatory finance or compensatory fiscal policy to bring about
stabilisation of business activity.
It is therefore suggested that the government should regulate its activities in such a manner as
to off-set the cyclical fluctuations in private business activity. The three main instruments of
fiscal policy-taxation, spending and borrowing can be used by the Government to achieve this
purpose.
If business activity shows signs of slackening down or there are symptoms of a down­swing, the
Government should at once enforce its three instruments of fiscal policy to check the down
trend and ensure stability in the economy. At such a time the Government should not levy any
new taxes on the people. Even the existing taxes should be substantially reduced.
This would leave more money in the hands of the people who should be encouraged to spend
in on buying additional goods and services to off-set the decline in demand and business
activity.
 Controlling Business Cycle
 At the same time, the government itself should embark on a vast spending programme to stimulate business
activity in the economy. The Government, at the time of depression should initiate Public Works Projects of
various kinds involving expenditure of money and additional employment of labour.
 The Government is expected to keep ready a number of Public Works Schemes, such as construction of roads,
canals, parks, schools, hospitals etc., and execute them at the first sign of the coming depression.
 These public works projects by giving employment to the unemployed workers, provide them with purchasing
power to buy consumer goods. This would help in off-setting the decline in effective demand and business
activity. The funds to finance the public works projects should be obtained either by printing more paper
money or by borrowing from the banks.
 In either case, more money would be created and put into circulation, thus off-setting the deflationary effect of
reduced business spending. The Government should at such a time follow the policy of Deficit budgeting,
which alone will increase the flow of income stream into the economy.
 When the economy recovers and a wave of prosperity sets in the Government should follow an exactly
opposite policy. Now, it should raise the existing taxes and even levy new taxes to check private spending. It
should reduce its expenditure on public works and similar projects.
 Controlling Business Cycle
 Automatic Stabilisers:
In this case the economists have suggested the introduction of a number of automatic
stabilisers or (built in stabilisers) to deal with the business cycle. An automatic stabiliser
or (built-in-stabiliser) is an economic stock-absorber that helps smooth the cyclical
business fluctuations of its own accord, without requiring deliberate action on the part of
the government.
For example:
Such device in U.S.A. is the federal progressive income-tax. This tax is so devised that
people in higher income brackets are taxed at a progressively higher rate than those in
the lower income brackets.
Such a progressive type of income-tax trends automatically to offset cyclical fluctuations
because in an up saving when incomes are rising people would pay more taxes to the
government and thus their expenditure would be checked and in a down swing when
incomes are declining and tax percentage is low people would pay less taxes to the
Government leaving more funds for them to spend.
Controlling Business Cycle
 Direct Controls:
This method is to ensure proper allocation of resources for the purpose of price
stability. They are in the form of rationing, price and wage controls, export
duties, exchange control, monopoly control etc. They are more effective in
overcoming shortages arising from inflationary pressures.
Their point of success mainly depends upon the existence of an efficient and
honest administration. They are mostly used in emergencies like war, crop
failures and in hyper inflation.