output, inflation, interest rates, andemployment form the Business Cyclesthat characterizes all market economies
Business Cycles are the irregular expansions and contractions in economic activity.
Business Cycles are economy-wide fluctuations in total National Output, Income, and Employment, usually last for a period of 2 to 10 years, marked by widespread expansion or contraction in most sectors of the economy.
Features of Business Cycles
The phases of business cycle recur with some sort of regularity and are uniform in case of different cycles.
In case of developed countries the cycle length is short (around 4.5 years) than the developing countries (around 7.5 years)
Amplitude of a business cycle is the maximum extent of departure from long run trend in either direction.
All economic variables are affected by the business cycles.
Phases of business cycle
Business Cycle is typically divided into four phases:
Recession merges into depression when there is a general decline in economic activity.
There is considerable reduction in the production of goods and services, employment, income, demand and prices.
The general decline in economic activity leads to a fall in bank deposits.
When credit expansion stops, even business community is not willing to borrow.
Thus, a depression is characterized by mass unemployment – general fall in prices, wages, profits, interest rate, consumption expenditure, investment – bank loans and advances falling – factories close down – capital goods industries are also closed down.
During this phase, there will be pessimism leading to closing down of business firms.
Recovery denotes the turning point of business cycle from depression to prosperity.
There is a slow rise in output, employment, income and price – demand for commodities go up steadily.
There is increase in investment – bank and financial institutions are also willing to granting loans and advances.
Pessimism gives way to optimism.
The process of recovery becomes combative and leads to prosperity
In this period, demand, output, employment and income are at a high level, they tend to raise prices.
But wages, salaries, interest rates, rentals and taxes do not rise in proportion to the rise in prices.
The gap between prices and cost increases - the margin of profit increases.
The increase of profit and the prospect of its continuance commonly cause a rapid rise in stock market values.
The economy is engulfed in waves of optimism.
Larger profit expectation further increase – investment which is helped by liberal bank credit.
This leads to peak or boom.
Recession starts downward movement of economic activities from peak/boom.
It is a state in which there is general deceleration in the economic activity resulting in cuts in production and employment falling prices of stock market.
Banking and financial institutional loans and advances beginning to decline.
As a result profit margins decline further because costs starts overtaking prices.
Recession may be mild/severe – it lead to a sudden explosive situation emanating from banking system and stock markets.
Such experience of the United States in 1873, 1893, 1907, 1933 and 2007.
Control of business cycle
Economic stabilization is one of the main remedies to effective control of business cycle.
Economic stabilizations is not merely confined to single sector of an economy but embraces all the sectors.
There are three ways by which a business cycle can be controlled.
Monetary policy as a method to control business fluctuations is operated by the central bank of country.
Monetary policy mainly concerned with money supply, bank credit and interest rates .
The central bank can adopts a number of methods to control the business cycle with the help of quantitative and qualitative credit control.
Dear money policy – during boom/peak it raises its bank rate policy, sells securities in the open market operation and raises the cash reserve ratio and adopts number of selective credit control.
Cheap money policy – during recession/depression – reduces the bank rate policy and interest rates of banks – and also buys securities in the open market, reduces cash reserve ratio etc.
Monetary policy alone cannot check business cycle. Therefore, economists like JM Keynes and Hansen & many others have recommended that fiscal policy can be bring about stabilisation of business cycle.
Fiscal policy is a policy of government which is concerned with public expenditure, taxation and public borrowing.
These three instruments have to be effectively utilised to control the severity of boom and depression.
During the period of recession and depression, government should reduces taxation substantially, increases of public expenditure – public works – social and economic infrastructure. Repayment of loans to public - deficit budgeting
In times of boom, government should raises tax rates, levy new taxes, reduces public spending and public borrowing – following surplus budgeting
When economics fluctuation takes place in the economy, the available monetary policy and fiscal tools cannot be geared quickly to set right the imbalance. Then automatic stabilizers become the prominence.
Automatic stabilizers should be used as supplemented with fiscal and monetary policies.
Automatic stabilizers are also called as built-in-stabilizers – it is proportion to the rise and fall of economic activity.
The progressive taxation and unemployment insurance schemes are the two important tools measures the automatic stabilizers in the economy.
During periods of prosperity or boom the employers pay taxes more and withdrawing unemployment benefits.
While, during period of depression – government allowed to provision of unemployment benefits, and lowers the taxes and increasing public expenditure.
Thus, the flow of money is regulated automatically from the people to the government in times of both boom and depression.
Theories of Business Cycle: Multiplier Accelerator
Income depends upon Investment.
For a given level of aggregate output to be maintained, investment activity must be maintained at certain level.
Current Investment depends upon the change in aggregate output from previous year to this year.
For a constant level of investment to be maintained output must grow at a certain rate.
Accidental increase in investment set up cumulative upward movement of output.
To generate business cycle two more ingredients are
a) Ceiling: beyond which real output cannot grow.
b) Floor: Below which the gross investment cannot fall.
Business Cycles Indicators
Monetary and Fiscal Policies which seek to combat these cyclical movements are called stabilization policies
Business Cycle Indicators
Leading Indicators: includes measures that generally indicate business cycle peaks and troughs three to twelve months before they actually occur.
Coincident Indicators: contains measures that indicate the actual incidence of business cycle peaks and troughs at the time they actually occur. The number of employees on payrolls, industrial production etc are examples.
Lagging Indicators: measures that generally indicate business cycle peaks and troughs three to twelve months after they actually occur. Labour cost per unit of output in manufacturing, the interest rate, outstanding commercial and industrial debt, the Consumer Price Index etc.
Used as a barometer to point out condition of economy
Unemployment is the result of deficiency of effective demand
Nature of unemployment in LDC’s are different than DCs
In LDCs unemployment is the result of inadequate capital equipment while in DCs it is the result of deficiency in effective demand
The Concept of Full Employment
Full employment is the level of employment that results when the rate of unemployment is normal.
At a given point of time there is some natural rate of unemployment in the dynamic exchange economy.
Natural rate of unemployment is the long run average of unemployment cause due to frictional and structural changes in labor market.
Policies the encourage workers to reject job offers and prohibit employer from offering appropriate wage rates increase natural rate of unemployment.
Actually rate of unemployment generally rise above the natural rate during recession and vice versa.