Trade cycle


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Trade cycle

  1. 1. Trade Cycle Definition:According to Keynes, "A trade cycle is composed of periods of Good Trade, characterized by rising prices and low unemployment percentages, shifting with periods of bad trade characterized by falling prices and high unemployment percentages." Features of Trade Cycle: The characteristics or features of trade cycle are: 1. Movement in Economic Activity - A trade cycle is a wave-like movement in economic activity showing an upward trend and a downward trend in the economy. 2. Periodical - Trade cycles occur periodically but they do not show the same regularity. 3. Different Phases -Trade cycles have different phases such as Prosperity, Recession, Depression and Recovery. 4. Different Types -There are minor and major trade cycles. Minor trade cycles operate for 3-4 years, while major trade cycles operate for 4-8 years or more. Though trade cycles differ in timing, they have a common pattern of sequential phases. 5. Duration -The duration of trade cycles may vary from a minimum of 2 years to a maximum of 12 years. 6. Dynamic -Business cycles cause changes in all sectors of the economy. Fluctuations occur not only in production and income but also in other variables like employment, investment, consumption, rate of interest, price level, etc. 7. Phases are Cumulative- Expansion and contraction in a trade cycle is cumulative, in effect, i.e. increasing or decreasing progressively. 8. Uncertainty to businessmen-There is uncertainty in the economy, especially for the businessmen as profits fluctuate more than any other type of income. 9. International Nature-Trade Cycles are international in character. For e.g. Great Depression of 1930s. Types of Trade Cycle:Dynamic forces operating in a capitalist economy create various kinds of economic fluctuations. These fluctuations can be classified as follows:- 1. Short-Time Cycle: This trade cycle occur for a short period of time. It is also known as minor cycles. It lasts for about 3-4 years. 2. Secular Trends: This trade cycle occurs for a long period of time and is known as Long term cycle. It lasts for about 4-8 years or more. It is also known as major cycle. 1
  2. 2. 3. Seasonal Fluctuations: This refers to trade cycles, which take place due to seasonal changes in the economy. For e.g. failure of monsoon can cause a downtrend in the economy which may be followed by a good monsoon and up to trend. 4. Irregular or Random Fluctuations: These trade cycles are unpredictable and occur during a period of strikes, war, etc., causing a shock to the economic system. 5. Cyclic Fluctuation: These fluctuations are wave-like changes in economic activity caused by recurring phases of expansion and contraction. There is an upswing from a trough (low point) to peak and downswing from the peak to trough caused due to economic changes in demand, or supply or various other factors. Four Phases of Business Cycle: Business Cycle (or Trade Cycle) is divided into the following four phases:1. Prosperity Phase: Expansion or Boom or Upswing of economy. 2. Recession Phase: from prosperity to recession (upper turning point). 3. Depression Phase: Contraction or Downswing of economy. 4. Recovery Phase: from depression to prosperity (lower turning Point). Explanation of Four Phases of Business Cycle The four phases of a business cycle are briefly explained as follows:- 1. Prosperity Phase When there is an expansion of output, income, employment, prices and profits, there is also a rise in the standard of living. This period is termed as Prosperity phase. The features of prosperity are:1. High level of output and trade. 6. Large expansion of bank credit. 2. High level of effective demand. 7. Overall business optimism. 3. High level of income and employment. 8. A high level of MEC (Marginal efficiency of capital) and investment. 4. Rising interest rates. 5. Inflation. Due to full employment of resources, the level of production is Maximum and there is a rise in GNP (Gross National Product). Due to a high level of economic activity, it causes a rise in prices and profits. There is an upswing in the economic activity and economy reaches its Peak. This is also called as a Boom Period. 2. Recession Phase The turning point from prosperity to depression is termed as Recession Phase. 2
  3. 3. During a recession period, the economic activities slow down. When demand starts falling, the overproduction and future investment plans are also given up. There is a steady decline in the output, income, employment, prices and profits. The businessmen lose confidence and become pessimistic (Negative). It reduces investment. The banks and the people try to get greater liquidity, so credit also contracts. Expansion of business stops, stock market falls. Orders are cancelled and people start losing their jobs. The increase in unemployment causes a sharp decline in income and aggregate demand. Generally, recession lasts for a short period. 3. Depression Phase When there is a continuous decrease of output, income, employment, prices and profits, there is a fall in the standard of living and depression sets in. The features of depression are:1. Fall in volume of output and trade. 6. Contraction of bank credit. 2. Fall in income and rise in unemployment. 7. Overall business pessimism. 3. Decline in consumption and demand. 8. Fall in MEC (Marginal efficiency of capital) and investment. 4. Fall in interest rate. 5. Deflation. In depression, there is under-utilization of resources and fall in GNP (Gross National Product). The aggregate economic activity is at the lowest, causing a decline in prices and profits until the economy reaches its Trough (low point). 4. Recovery Phase The turning point from depression to expansion is termed as Recovery or Revival Phase. During the period of revival or recovery, there are expansions and rise in economic activities. When demand starts rising, production increases and this causes an increase in investment. There is a steady rise in output, income, employment, prices and profits. The businessmen gain confidence and become optimistic (Positive). This increases investments. The stimulation of investment brings about the revival or recovery of the economy. The banks expand credit, business expansion takes place and stock markets are activated. There is an increase in employment, production, income and aggregate demand, prices and profits start rising, and business expands. Revival slowly emerges into prosperity, and the business cycle is repeated. Thus we see that, during the expansionary or prosperity phase, there is inflation and during the contraction or depression phase, there is a deflation. Different Theories of Trade Cycle:• Endogenous theories 3
  4. 4. – – Psychological theory – Inventory cycle theory – Monetary theory – Sunspot theory – i) Innovation theory Under-consumption theory – War theory • Exogenous theories Endogenous theories 1. The innovation theory or Kondratieff Cycles:This theory was formulated by J. A. Schumpeter. He regards innovations as the cause of trade cycles. Innovations mean the commercial application of inventions like new techniques of production, new methods of organizations etc. Schumpeter classifies innovations into 5 categories: Introduction of new type of goods.  Introduction of new type of method  Opening of new market  Discovering of new sources of material  Change in the organization of industry These all are innovation according to Schumpeter. Technical progress is certainly also an innovation, but the concept of innovation is broader than technical progress. The new combination usually have to extract means of production from some old combinations...we can say that this happens always. Implementation of new combinations means, therefore, only a different way of utilization of existing stock of means of production....Development means primarily the alternative ways of use of existing supplies, it means that the new products are produced whether these supplies grow or not. The primary role has innovations, i.e. the new combinations of existing stock of factors of production. Criticism  Its assumption of full employment situation is wrong.  It consider innovation to be the factor of cyclical fluctuations  It doesn’t include all the causes of trade cycle. 2. THE PSYCHOLOGICAL THEORY OF TRADE CYCLE: This theory is associated with professor Pigou. According to him trade cycles are caused by the optimistic and pessimistic attitude of the businessman. When the trade is brisk businessman earns high profit and expands the investment and production. They over-estimate the futures demand of the goods and increase the production. An optimistic wave covers all the quarter of the business and over all production increases. In this stage a period of prosperity is in full swing. The aggregate supply increases then the aggregate 4
  5. 5. demand. The market becomes over flooded with consumption goods when supply will exceed then the demand, and prices will fall. Rate of profit will decrease. Producer will reduce the investment. So rate of employment will also fall and economy will be caught by the rises. 3. THE MONETARY THEORY OF TRADE CYCLE: Sir Ralph Howtery offered this theory. He says that main cause of trade cycle is the contraction and expansion of bank credit. He says that most of the businesses are carried on with loans. When the trade is good, the bank expand credit by lowering the rate of interest. The merchants are attracted by the low rate of interest and they expand the business. The producer expands production keeping in view the demand. Employment output and money income increases. The expansion of credit brings up swing in the business cycle. A stage comes when the commercial banks realize that they have advance more than their limits. Some of the banks will feel that their cash reservation has reached to the danger point. They will increase the rate of interest and recall the advances. When the rate of interest will be high the rate of profit will fall and business will not borrow and he will reduce the production. Employment, profit and income decreases. According to Prof. Howtery the merchants are very sensitive to the change in the rate of interest. So changes in the rate of interest first affect merchants and then manufacturers when the rate of interest is low the merchants will increase their stock and they will place more orders with the manufacturers. When the rate of interest is higher, then there will be reserve situation. Criticism on Monetary Theory of Trade Cycle: 1. Critics says that trade cycle is not purely monetary phenomena. 2. Trade cycle is a worldwide phenomenon. It can not only occur in one or two countries. 4. OVER SAVING or UNDER CONSUMPTION THEORY OF TRADE CYCLE: Prof. J.A Hobson had developed the theory. He says that due to over savings depression takes place. He says that modern capitalistic world has divided the people into two classes rich and poor. Rich class is in small number, but possesses a large portion of the total wealthy. The wealthy community is so well-off that they can not consume all their income. So they use their savings in investment. They total production or supply of goods increases. But on the other side the poor class is in large number. They are so poor that they even cannot get basic needs of life. So the demand remain low the supply. Demand and supply balance is disturbed. The market becomes over flooded with unsold goods. The businessman will stop the production and it will lead to depression. Hobson says that if there is an equality of income there would be no crises or depression in the economy. Criticism on Under Consumption Theory of Trade Cycle: 1. The first objection on this theory is that it only explains the depression not the trade cycle. 2. This theory also fails to explain the period of trade cycle. ii) Exogenous theories 5
  6. 6. 1. THE SUN-SPOT WEATHER THEORY OF TRADE CYCLE: Mr. Jevan has offered this theory. He says that trade cycle are caused by sun spots which appears on the face of the sun at almost regular intervals of 10.4 years. He says that when these spots appear the sun emits less heat and leads to the failure of crops when the crops yield will be low, the income of the farmer will fall. So the demand or purchasing power of the farmers will decrease. In this way demand of consumption goods will fall. The industrialist income will be also affected. The industrialist will reduce the demand of raw material. He may also reduce the employees in his factory. So the down war swing starts. On the other hand when the sun is clear it emits normal heat and there is a bomber crops. The purchasing power of the farmers will increase. They buy more commodities and it will be a period of expansion. Criticism on Sun Spot Weather Theory of Trade Cycle: 1. They trade cycle do not occur at regular intervals of 10.4 year while length of the trade cycle is 7 to 8 years. 2. Good or bad crop can be only one factor of depression or expansion but they cannot account for all the features. THE KEYNES THEORY OF TRADE CYCLE: Keynes has not offered a pure theory of trade cycle. But he explains those factors which brings changes in income, output and employment. Yet it is an incomplete explanation of the trade cycle. According to Keynes, the cyclical fluctuations are caused by changes in the marginal efficiency of capital. If the rate of return of capital is greater than the rate of interest then businessman expands the business and increases the investment. On the other hand if ratio of interest is higher than rate of return the business will be contracted. While, the marginal efficiency of capital depends upon two factors. 1) Expected return from capital assets. 2) Replacement cost of the assets. Marginal efficiency of capital is raised by new investment and by expectation of rising prices. It is lowered by falling prices and fall in investment. When the rate of capital return is higher then the rate of interest, it leads to investment. The volume of employment and income increases. The demand for consumer goods and capital goods increases. It is called the expansion phase of the trade cycle. When marginal efficiency of capital is relatively lower than the current rate of interest. It is the phase of Contraction. Because further scope of investment declines. People save more money due to higher rate of interest. More savings reduce the demand of consumer goods. Due to the excess of savings the income and employment declines. We are in the phase of recession which finally results depression. 6
  7. 7. Keynes has also introduced very important terms which bring change in the economic activities. There are: 1) Propensity to Consumer. 2) Propensity to Save. 3) Marginal efficiency of Capital. He says that down swing of the trade is caused by the fall in the propensity to consume. Because when the income increases or decreases, consumption also changes but not according to that ratio as the income changes. There is always less change then the change in income. Whenever saving begins to exceed then the investment a depression is developed. Criticism on Keynes Theory of Trade Cycle: 1. This theory fails to explain the repetition of booms and depression at almost regular intervals. 2. Multiplier concept of Keynes does not offer the satisfactory explanation of the business cycle. 3. Hicks say that cyclical fluctuations are caused by the interaction of multiplier and acceleration. Methods to Control Business Cycles:Monetary Policy Check undue expansion of money supply through proper and adequate cover against note-issue Check expansion of bank credit Bank rate, open market operations, reserve ratios, moral suasion, etc. Fiscal Policy Taxation Spending Borrowing Automatic Stabilizers An automatic stabilizer is an economic shock absorber that helps smooth the cyclical business fluctuations of its own accord, without requiring deliberate action on the part of the government. Progressive income tax People in higher income bracket are taxed at progressively higher rates Unemployment insurance Prosperity: employers pay taxes to government but payment of doles to the unemployed is considerably lower. Recession: government lower 7