Budget

1. CH-3. Economic performance and business cycle
Definition and Concepts of Business Cycle
Phases of Business Cycle
Causes and Effects of business cycle
Theories of business cycle
 Keynesian theory
 Monetarist Theory of Business Cycle
 Rational Expectation Theory
 Real Business Cycle Theory (RBC)
 Political Business Cycle
 Forecasting Business Cycle: Indicator Forecasting

2. Economic performance
Can be judged basically by:
 Inflation rate,
 growth rate of output (Output gap= potential output - actual output)
 Output gap <0 indicates overemployment, over time work etc.
and the reverse is true for large output gab.
 rate of unemployment
 What economics policy can produce
 Low inflation?
 Low unemployment? And
 High growth rate at the same time?

3. Definition and Concepts of Trade / Business Cycle
. Estey:-
 “Cyclical fluctuations are characterized by altering waves of
expansion and contractions. They do not have a fixed rhythm they
are cycles of contraction and expansion recur frequently and in
fairly similar patterns.”
 An important point:-” no cycle in perfect regular with uniform
frequency and amplitude that is the time taken to move from one
peak level of output to the next would always be the same and the
level of output and employment would always vary in the same
proportion between the upper and lower turning point but such
cycles never occurred.
 Thus, business cycles are recurrent fluctuations in aggregate
employment, income, and output and price level.

4. Definition and Concepts of Trade / Business Cycle
 The cyclical nature of economic activity is known as a trade
cycle or business cycle.
 Changes in aggregate demand bring about changes in the level of
 output,
 employment,
 income and price.
 These changes are generally cyclical in nature and follow a cycle of
four different stages:

5. Cont…
Prosperity or boom;
Recession;
Depression or slump; and
Recovery

6. Prosperity or boom or peak:
 it is a phase of economic activity characterized by rising
demand, rising prices, rising investment, rising employment,
rising incomes, rising purchasing power and hence rising
demand and so on.
 The investors, therefore, voluntarily undertake risks and go in
for investment, this further energies boom conditions through
the working of the multiplier effect.

7. Recession:
 during the boom period, the economy may get over- heated and the
monetary authorities, the financial institutions and the business itself
may begin to play cautious.
 There may be cuts in investment, resulting in cuts in
employment, fall in incomes, decline in purchasing power and
demand.
 Prices may begin to fall.

8. Depression or slump or trough:
 if the effective corrective measures cannot be undertaken, the
economy may find itself go into depression.
 It is a stage when the business confidence is at its lowest.
 Investment, employment, output, income and prices touch the
bottom.

9. Recovery or expansion
 As the economy moves out of depression, it enters the phase of
recovery.
 Sustained recovery will find the level of investment, employment,
output, income and prices moving upwards.
 This may finally results in boom conditions in the economy.

10. Macroeconomic Problems and Policy Instruments:
The Macroeconomic policy challenges are
 To boost economic growth
 To stabilize the business cycle (fluctuation)
 To reduce unemployment
 To keep inflation low
 To reduce both governmental and international deficits.

11. 3.2. Economic Growth versus Development
 Economic growth is the growth rate of the real GDP.
 It also is the expansion of the economy’s production.
 It can be pictured as an outward shift of PPC.
 Many people use economic growth and economic development
interchangeably.
 However, economic development or development is
multidimensional, which includes :
1. economic growth,
2. social development (employment rate, health, education, social
justice, etc),
3. political freedom and
4. environmental safety.

12. Types of GDP
1) Nominal GDP:- is the value of all final goods and service valued
at current year price
2) Real GDP: - is the value of all final goods and services valued at
base year price.
3) Potential GDP: is the GDP at full employment of resources.
 We use a base year price to remove the effect of change in price
and to see the real change.

13. Example: take 2010 & 2013 hypothetical data as follow
Commodity 2010 2013 Real value 2013
P Q value P Q value
A 10 100 1000 20 120 2400 1200=120x10
B 50 50 2500 60 50 3000 2500=50x50
GDP 3500 5400 3700=Real GDP
%
71
.
5
%
100
*
3500
3500
3700
%
100
*
GDP
GDP
GDP
Real
rate
growth
economic
Real
%
3
.
54
543
.
0
3500
3500
5400
GDP
GDP
GDP
rate
growth
economic
Nominal
2010
2010
2013
2010
2010
2013











The real economic growth here is due to quantity of product
of country increased in 2013.
However, economic growth change may be due to quality
improvement.

14. Uses of Economic Growth
 It helps to compare one country’s welfare with the other country’s
welfare at a point in time
 It also helps to see whether one country’s welfare is improving
overtime
 Ethiopia could not catch up USA on this 2.2 real GDP per capita growth while
Korea has the probability to catch up USA since it has real GDP per capita growth
of 7.7 which is greater than USA .
Country Year Real GDP
(million)
Real
economic
Growth (%)
Population
(million)
Population
growth (%)
(GDP)
per
capita
(GDP) per
Capita
growth (%)
USA 1999 9179401 5.25 278.7 1.2 32936.5 4.00
2000 9661320 282 34260
Korea 1999 384581 8.89 46.5 1.1 8270.6 7.7
2000 418770 47.00 8910
Ethiopia 1999 6080 5.263 62.14 3.0 97.84 2.21
2000 6400 64 100

16. 3.2.3. 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).

17. Diagram of Four Phases of Business Cycle
 The four phases of business cycles are shown in the following diagram: the X
and Y represents the time and GDP(PGDP & RGDP), respectively.

18. Business cycle
Figure . Business cycle
 Points: A1, A2 & A3 are peak & Points: B1, B2 & B3 are
through
Potential GDP
Real GDP
GDP
Time
A1
A2
B1
B2
A3
B3

19. Phases of Business Cycle-contd..
 The business cycle starts from a trough (lower point) and passes
through a recovery phase followed by a period of expansion
(upper turning point) and prosperity.
 After the peak point is reached there is a declining phase of
recession followed by a depression.
 Again the business cycle continues similarly with ups and
downs.

20. Explanation of Four Phases of Business Cycle
1. The features of prosperity Phase are:
1. High level of output and trade.
2. High level of effective demand.
3. High level of income and employment.
4. Rising interest rates.
5. Inflation.
6. Large expansion of bank credit.
7. Overall business optimism.
8. A high level of MEC (Marginal efficiency of capital) and investment.

21. 1. Prosperity Phase-contd…
 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.
 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.

22. Contraction/recession
During a period of contraction:
 Businesses cut back production and layoff people
 Unemployment increases
 Number of jobs decline
 People are pessimistic (negative) and stop spending money
 Banks stop lending money
 A prolonged contraction is called a recession (contraction for over 6
months)
 A recession of more than one year is called a depression.

23. Recession-contd…
 The turning point from prosperity to depression is termed as Recession Phase.
 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.

24. 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.
2. Fall in income and rise in unemployment.
3. Decline in consumption and demand.
4. Fall in interest rate.
5. Deflation.
6. Contraction of bank credit.
7. Overall business pessimism.
8. Fall in MEC (Marginal efficiency of capital) and investment.
 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).

25. 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.

26. 4. Recovery Phase-contd…
 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.

27. Turning Points:-peak and trough
 There are two turning points: The business cycle is characterized
by two turning points namely peaks and troughs ;and four phases.
Peak : The peak is the highest level of real GDP in the cycle.
 Each peak indicates an economy operating at close to full
capacity, so that national product and national income corresponds
to a very high degree of utilization of labor, factories and offices.
 During a peak of the cycle, there are likely to be shortage of
labor, parts and materials in certain markets.

28. Peak
 When the economic cycle peaks:
 The economy stops growing (reached the top)
 GDP reaches maximum
 Businesses can’t produce any more or hire more people
 Cycle begins to contract

29. Through
 A trough is the lowest level of GDP observed over the business
cycle.
 A trough is reached when the economy begins to pull out of
recession.
 During this time there is an excessive amount of unemployment
and idle productive capacity.
 Businesses are more likely to fail because of low demand for their
products.
 When the economic cycle reaches a trough:
 Economy “bottoms-out” (reaches lowest point)
 High unemployment and low spending
 Stock prices drop

30. Peak
Trough
One cycle
Real
GDP
per
year
Time
Peak
Business Cycle-one cycle through 4 phases

31. Characteristic of Business Cycle
From the definitions given above we can gather the features of
business cycle.
(i) It occurs periodically:
 It occurs periodically in a regular fashion.
 This means the prosperity will be occurring alternatively.
(ii) It is all embracing:
 prosperity or depression effect of the phase will be affecting all
industries in the entire economy and also affecting the economies
of other countries.
 It is international in character.
 The Great Depression of 1929 is an example of this.

32. Characteristic of Business Cycle-contd….
(iii) It is wave-like:
 It will have a set pattern of movements which is analogous to waves.
 Rising prices, production, employment and prosperity will become the
features of upward movement: Falling prices, employment will become
the features of the downward movement.
 (iv) The process is cumulative and self-reinforcing:
 The upward movement and downward movement are cumulative in their
process.
 When once the upward movement starts, it creates further movement in
the same direction by feeding on itself.
 This momentum will persist till the forces accumulate to alter the
direction and create the downward movement.
 When downward movement starts, it persists in the same direction
leading to the worst depression and stagnation till it is retrieved to gain
an upward movement.

33. Characteristic of Business Cycle-contd….
(v) The cycles will be similar but not identical:
 Different cycles and waves in the business cycles will be similar in
general feature, but they are not identical in all respects.
 “A typical cycle constructed by making, as it is where, a composite
photograph of all the recorded cycles would not materially differ in
form varies widely from any one of them.
 But this typical cycle is not an exact replica of any individual cycle.
 The rhythm is rough and imperfect.
 All the recorded cycles are members of the same family, about
among them are no twins”.

34. Causes of Business Cycle-external vs internal factors
1. Interest rates. Changes in the interest rate affect consumer spending
and economic growth.
2. Consumer and business confidence. People are easily influenced
by external events. Economic growth encourages consumers to
borrow and banks to lend.
3. Multiplier effect:-The multiplier effect states that a fall in injections
may cause a bigger final fall in real GDP. This theory suggests
investment is quite volatile and small changes in the rate of growth
have a big effect on investment levels.
4. Inventory cycle. Some argue that there is a natural inventory cycle.

35. 5. Changes in house prices.
A rise in house prices creates a wealth effect and leads to higher consumer
spending while fall in house prices causes lower consumer spending
and bank losses.

36. 6. Accelerator effect:-This states that investment depends on the
rate of change of economic growth. This theory suggests
investment is quite volatile and small changes in the rate of
growth have a big effect on investment levels.

37. 3.6. Effects/Impact of Business Cycle on Economy
 A volatile business cycle is considered bad for the economy.
 A period of economic boom (rapid growth in economy) invariably
leads to inflation with various economic costs.
 This inflationary growth tends to be unsustainable and leads to a bust
(recession).
 The biggest problem of the business cycle is that recessions represent
a large wastage of resources.
 A prolonged period of unemployment can also lead to a loss of labor
productivity as workers get discouraged and leave the labor market.

38. Effects/Impact of Business Cycle on Economy-contd…
 Monetary authorities tend to try and minimize fluctuations in the
business cycle through interest rate and money supply.
 They seek to avoid inflation and avoid a recession.
 The government may also use fiscal policy.
 In a recession, the government could try increasing
government spending and cutting tax.
 Some economists argue that the business cycle is an essential part
of an economy.
 Even downturns have their role to play as it tends to ‘shakeup’ the
economy and weed out ‘inefficient’ firms and creating greater
incentives to cut costs and be efficient.
 However, this view is controversial and other economists argue
that in a recession, even ‘good efficient’ firms can go out of
business leading to a permanent loss of productive capacity

39. Theory Of Business Cycle
There are many types of trade theories namely :
 Climate or sun spot theory
 Over-investment theory
 The psychological theory
 Keynes theory
 Innovation theory
 Monitory theory
 Over production theory
Q. Discuss each of the theory

40. Measures to control business cycle
The following are the main measure which can be suggested for the
effective control of business cycle/fluctuation.
1. Monetary Policy
2. Fiscal Policy
3. State Control of Private Investment
4. International Measures to Control of Business Cycle Fluctuation
5. Reorganization of Economic System

41. Monetary Policy
 Control money and credit supply
 Inflation-adopt deflationary policy-CB reduce Money supply
(increase in the bank rate, selling of securities in the market,
increasing the reserve ratio of the member banks etc.)
 Deflation-CB adopt inflationary monetary policy by lowering the
bank rates or purchase of securities
Monetary policy has achieved a very limited success in the past,
because CB has not full power over the supply of money and
credit in the country.
Moreover, the quantity of money has failed during the world
depression of 1930s.

42. Fiscal Policy
 nowadays is considered to be a powerful anti-cycle weapon in the
hands of the government.
 involves the process of shaping the public finance (income and
expenditure) with a view of reduce fluctuations in the business cycle
and attainment of full employment without inflation.
 Inflation-adopt a reduction of G and/or increasing of tax
 Deflation (depression)-adopt increasing of G and/or reduction of tax

43. State Control of Private Investment
 Some economists have suggested that if a government takes control
of private investment, it is a tool to control of business cycle
fluctuations can be controlled within the limits.
 Government should control PI within a certain limits
 The other economists, who disagree with the above view state that if
a government takes control of private investment, private investment
will be discouraged.
 No government intervention
 Low investment will reduce employment and income. J.M Keynes is
of the view that if we adopt the middle way we can get control of
business cycle fluctuation.

44. International Measures to Control of Business Cycle
Fluctuation
 Today, every country has trade relations with the rest of the world.
 If there is inflation or deflation in one country, it can be easily
carried to other countries. E.g. great depression
 Business cycle:-is an international phenomenon
 it should be tackled on international level.
 The different measures are:
1. Control of International Production
2. International Bill Stock Control
3. International Investment Control

45. Reorganization of Economic System
 Some economists suggest that there should be
complete reorganization of the whole economic
system to control of business cycle/ fluctuation.
 The capitalistic system of production should be
replaced by the socialistic system of production.
 In socialistic economy, there are few chances of
cyclic fluctuations.
 In 1930, when all capitalist countries of the world
were suffering from depression, it was only socialist
countries which were free from such crisis. Great
depression

46. Innovation
Political events
Random events
Wars
Level of consumer spending
Seasonal fluctuations
Cyclical Impacts — durable and non durable
Causes of Fluctuations