Business Cycle

1. Business Cycle
Prof. Nithin Kumar S
Assistant Professor
Department of Economics
JSS Banashankari Arts, commerce and
Shantikumar Gubbi Science College
Vidyagiri, Dharwad - 580004

2. Introduction
An important feature of A capitalist economy is
the periodic fluctuations in the economic
activities at more or less regular intervals
Sometimes income, employment, output and
prices rising all together while at other times they
are all moving downward more or less
simultaneously
Such upward and downward movements in
economic activities occurring at regular intervals
have been referred as business or trade cycles
2

3. Definitions
J. M 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”
3

4. Continued…
• Wesley Clair Mitchel, “Business cycles are a species of
fluctuations in the economic activities of organized
economies. The adjective ‘business’ restricts the
concept of fluctuations in the activities which are
systematically conducted on a commercial basis. The
noun ‘cycles’ bars out fluctuations which do not recur
with a measure of regularity”
4

5. Continued…
Prof. Heberler, “the business cycle in the
general sense may be defined as an
alteration of periods of prosperity and
depression of good and bad trade
5

6. Continued…
J R Hicks, “ Trade cycle represents fluctuations
in the real national income of the economy.
Such fluctuations occur because of Eco-
growth, innovations and inventions, capital
accumulation and natural resources”
6

7. Continued…
 Parkin and Bade, “the business cycle is the periodic
but irregular up and down movements in economic
activity measured by fluctuations in real GDP and other
macroeconomic variables. A business cycle is not a
regular, predictable or repeating phenomenon like the
swing of the pendulum of a clock. Its timing is random
and to a large degree unpredictable”
7

8. Continued…
Gordon, “Business cycles consist of a recurring
alteration of expansion and contraction in
aggregate economic activity, the alternating
movements in each direction being self –
reinforcing and pervading virtually, all parts of
the economy”
8

9. Features of Business Cycles
1. They occur in regular periods
2. Movement in economic activity
3. The cyclical fluctuations are recurring in nature
4. They are characterised by synchronism
5. They are international in effect
6. They affect unequally
7. They are dynamic in nature
8. The phases are cumulative
9. Duration of trade cycle is not uniform
9

10. Types of Business Cycles
Dynamic forces operating in a capitalist economy
create various kinds of economic fluctuations
These fluctuations can be classified as follows
1. Minor Trade Cycles
2. Major Trade Cycles
3. The Very Long Period Cycle
4. Kuznet Cycle
5. Building Cycle
6. Seasonal Fluctuations
7. Irregular or Random Fluctuations
8. Cyclic Fluctuation
10

11. 1. Minor Cycle
It occurs for a short period of time
This is also known as ‘Kitchin Cycle’
This has gained popularity after the name of
British Economist Joseph Kitchin
He made research and came to this conclusion
that a cycle takes place within a duration
approximately 30 to 40 months
11

12. 2. Major Cycle
This has been emphasised as the fluctuations of
business activity between successive crisis
This is also known as “The Long Jugler Cycle”
A French Economist Clement Jugler showed that
the periods of prosperity, crisis and liquidation
followed each other always within a span of the
average of nine and half years
12

13. 3. The Very Long Period Cycle
This is also known as Kondratieff Cycle
This was propounded by N D Kondratieff the
Russian Economist in the year 1925
He has written that there are longer waves of
cycles of more than fifty years duration
13

14. 4. Kuznet Cycles
This type of Business Cycle was propounded by
the famous American Economist Prof. Simon
Kuznet
His view was that the secular swing of the cycle
generally occurs in between 7 to 11 years and this
can show effect within that period
14

15. 5. Building Cycles
Building Cycles are associated with the name
of Two American Economists namely Warren
and Pearson
Their view was that business cycle occurs in
the duration of an average of 18 years and the
cost of such cycle has major effect on building
construction and on the business
development
15

16. 6. Seasonal Fluctuations
This refers to trade cycles, which take place
due to seasonal changes in the economy
For example – Failure of Monsoon can cause a
downtrend in the economy which may be
followed by a good monsoon and up to trend
16

17. 7. 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
17

18. 8. Cyclic Fluctuations
These fluctuations are wavelike 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 of various other factors
18

19. Phases of Business Cycles
 A typical business cycle is characterised by Five different
stages or Phases. They are
1. Depression
2. Revival or recovery
3. Prosperity or full employment
4. Boom or over full employment
5. Recession
 Revival and Prosperity are the upward swing of the trade
cycle
 Recession and depression are the downward swings
 The boom is the peak point of the business cycle
 The Phases of business cycle is shown in the following
diagram
19

20. 20

21. In the diagram FE is the full employment line
Five Phases of Business Cycle namely,
Depression, Revival, Prosperity, Boom and
Recession are shown in the diagram
In monetary terminology these phases are
called as deflation, reflation, inflation and
disinflation
The phases of business cycle can be explained
as follows
21

22. 1. Depression
 Depression is a situation of falling price and lowest level of
economic activity
 The remarkable features of depression as follows
a. The price level is very low
b. The volume of production and trade is falling
c. Unemployment is very high
d. Profit margin does not exist
e. Interest, wages and rents are all falling to a very low level
f. Aggregate expenditure and the effective demand are declining
g. Bank credit contracts
h. There is little or no opportunity to invest. Stock market is dull
and stock prices are falling to a low level
i. There is overall pessimism in the economy
j. The relative price structure is distorted because of fall in prices
22

23. 2. Revival or Recovery
Recovery stage leads to the rise in output,
employment and trade after the depression
stage
There is a revival of business and economic
activity
The following are the features of the revival
stage
23

24. Features of Revival Stage
a. The level of prices, production, employment and
income slowly and steadily rises
b. The stock market becomes more sensitive
c. The expectations of the businessmen will improve.
They start repay the bank loans
d. Bank loans and the demand for credit start rising
e. Industrial and agricultural sectors of the economy get
recovers
f. Through the multiplier and accelerator effects, the
economy proceeds upward steadily and rapidly
24

25. Continued…
The rate of revival depends upon the rate of
previous depression
The recovery could be initiated by new
innovations, government expenditure,
changes in production techniques, investment
in new regions, exploitations of new source of
energy etc.
25

26. 3. Prosperity or Full Employment
The cumulative process of revival or recovery
continues till the economy reaches the stage
of full employment
Full employment implies that all the available
resources are fully employed
Following are the some important features of
full employment
26

27. Features of Full Employment
a. There is an all-round economic stability, stability
of output, wages, prices and incomes
b. Propensity is characterised by high capital
investment, expansion of bank credit, high
prices, high wages and high profits
c. Output is the highest under given technological
conditions
d. Trade and commerce are extensive
e. Consumption and production expands very
quickly
27

28. Continued…
The stage of full employment is the stage of
economic prosperity
It is the most desirable goal of the national
economic policies of most of the countries of
the world at present
28

29. 4. Boom
Boom is the peak point of the Business Cycle
The period of boom is also called as period of
over full employment
The following are the features of Boom
29

30. Features of Boom
a. Over – Optimism is business psychology results in
over full employment of resources and raw materials
and it leads to inflationary rise in prices
b. A boom is a result of over optimism among the
businessmen and industrialists who make huge
investments
c. There develops a situation in which the number of
jobs exceeds the number of workers available. Such
situation is known as over full employment. Boom
conditions prevail everywhere, over optimism
prevails all over the economy
30

31. 5. Recession
The boom conditions carry with them the
seeds of self destruction
Bottlenecks begin to appear in various sectors
of the economy
Factors of Production, particularly raw
materials and labour becomes scarce and
command high prices
The cost of production goes up very high and
upsets the calculation of the entrepreneurs
31

32. Continued…
The feeling over – optimism of the boom
period is replaced by over – pessimism
The banks are also afraid and begin to
withdraw that loans from business enterprises
Once business and economic activity start
declining, it almost becomes difficult to stop
the downward trend
Prices of shares fall rapidly in the stock market
Finally ends in depression
32

33. Causes of Business Cycle
1. Climatic Factors
2. Human Psychology
3. Under Consumption
4. Innovation
5. Bank Credit
6. Interest Rates
7. Changes in Investments
8. Leverage Effect
33

34. Control of Business Cycle
1. Monetary Measures
2. Fiscal Policies
3. Economic Reforms
4. Automatic Stabilisers
5. Direct Controls
34

35. Theories of Business Cycle

36. HAWTREY’S THEORY OF BUSINESS
CYCLES
 Hawtrey’s theory is called the pure theory of the business
cycle.
 According to Prof.R.G Hawtrey, “the trade cycle is a purely
monetary phenomenon because general demand is itself
a monetary phenomenon”.
 In his view all changes in the economic activity are nothing
but reflections of changes in the flow of money
36

37. Assumptions
1. The changes in the rate of interest are a
powerful force in directing the economic
system.
2. The interest rate changes influence mainly
the volume of inventories ,not fixed capital
37

38. Explanation:
 Business cycles are caused by the expansion and contraction
of bank credit
 Traders play an important role in the economy.
 They are very sensitive to the change in the rate of interest
 According to Hawtrey, the upward phase of the business cycle
is brought about by an expansion of bank credit and also by
an increase in the velocity of circulation of money
38

39. When the banks have excess reserves, the rate of
interest is lowered producers and traders will be
induced to borrow more from banks
Borrowing at a low rate of interest leads to an
expansion in business activities and rise in the
price level
Producers employ more people this leads to
more income and production
The increased income is spent on consumer
goods, thus increase in demand for consumer
goods .
The increased demand leads to further expansion
of demand for investment goods
39

40.  In this way, cumulative expansion takes place during
prosperity.
 Banks grant more and more loans to business.
 As the volume of business expands and factors of
production are fully employed, prices rise further and
induce further business expansion, resulting an
inflationary conditions or boom conditions
40

41. With the expansion of credit, the banks reach the
maximum point beyond which they cannot lend
anymore loans.
The scarcity of cash forces banks to raise the rate
of interest and start withdrawing the short term
and call loans from their clients.
Eventually Central bank will start contracting
credit by raising the bank rate.
41

42.  This comes as a big shock to the business men who had
been enjoying the liberal policy of the banks
 In order to repay their outstanding loans, the businessmen,
begin to sell their stocks at whatever prices they can. This
depresses the market
 Prices start falling down.
 Some weak firms even fail to meet their financial
commitments.
 The failure of a few firms creates nervousness and even
panic among the remaining firms
42

43.  They curtail output, consumers reduce their purchases.
 The downswing of the business cycle comes into action
 Once the downward trend starts, it gathers momentum
with the lapse of time.
 There is an atmosphere of pessimism throughout the
economy.
 The depression is complete.
 In this way Hawtrey rests the roots of economic
fluctuations on the instability of monetary and credit
system
43

44. Criticisms
1. The rate of interest alone may not affect business
decisions
2. It is also incorrect to say that the actions of the banks
cause business fluctuations
3. It ignores non-monetary factors ,several non-
monetary factors, such as wars, crop failures, natural
calamities, expectations of business people etc. ,can
also produce changes in economic activities
4. It is pointed out that the mere expansion of credit is
not the remedy for business depression
5. Big business firms do not rely on bank credit to
expand their business activities
44

45. Hicks’s Theory of Business Cycle
Hicks Theory of business cycle was proposed by
J.R Hicks.
According to him, the business cycles have
historically occurred against the background of
economic growth and hence the theory of the
trade cycle should link with the growth theory
45

46. Assumptions
1. It is assumed that there is an equilibrium rate of growth in the
economy where the realized growth rate (Gr) is equal to the
natural growth rate (Gn).The autonomous investment increases
at a constant rate, which is always equal to the rate of increase in
the voluntary savings. Thus, the rate of autonomous investment
and voluntary savings determine the equilibrium growth rate
2. It is impossible for the output to expand beyond the full
employment level
46

47. Continued…
3. There are fixed values of the multiplier and accelerator throughout the
different phases of a cycle, i.e., consumption function and investment
are both assumed to be constant
4. Both the multiplier and accelerator are treated with a lag. Hicks treats
multiplier as a lagged relation so that consumption in period t is
regarded as a function of income of the previous period t-1 and not of
current period t. He also uses accelerator with a time lag, i.e., induced
investment in the present period also responds to output changes in
the previous period
47

48. Explanation
Hicksian Theory of business cycle includes the
Keynesian concept of saving investment relation
and the multiplier effect, Clarke’s principle of
acceleration, Samuelson’s multiplier-accelerator
interaction and Harrod-Domar growth model
Thus, these are the main ingredients of the Hick’s
model
48

49. Continued…
According to him “the theory of the multiplier
and the theory of the accelerator are the two
sides of the theory of fluctuations. Just as the
theory demand and the theory of supply are
two sides of the theory of value.”
49

50. Continued…
 Autonomous investment independent of variations in output.
 Hicks assumes that autonomous investment goes on increasing at a
regular rate in a progressive economy.
 Corresponding to the volume of autonomous investments, there
will be a certain precise level of money income; the ratio of income
to investment being determined by the multiplier and acceleration
effects.
 Money income thus grow at the same rate as the volume of
autonomous investment.
50

51. Continued…
 Induced investment is that investment which responds to changes in output.
 If for example, an Industry expands due to an expansion of demand for its
output, and if the expansion of demand is regarded to be a permanent
character, then the production of increased output would necessitate in some
degree the expansion of capital stock in the country.
 Thus increase in output induces investment. (i.e. Acceleration Principle)
 The Influence of the two types of investment on the level of income and
cyclical fluctuations can be explained with the help of a diagram
51

52. 52

53.  In the diagram X axis represents the number of years,
and the Y axis, the level of economic activity
 Line AA1 represents the progress of autonomous
investments over the years. Line EE1 represents
income (output) and FF1 represents the level of full
employment.
53

54. The Process of Cyclical Fluctuations
Suppose the economy is at point ‘p’ and at
this point certain invention is introduced.
Autonomous investment will burst and the
induced investments will push output,
employment, etc.
upwards along the path PP1 in the diagram
from EE1 line.
The upward trend touches full employment
ceiling at p1 and it cannot rise any further.
54

55. Continued…
The initial burst of autonomous investment is
short lived and after a stage, it will fall to the
normal level.
But the induced investment which was the result
of autonomous investment and the initial
increase in output would continue and push
ahead on path pp1.
But the induced investment is not sufficient to
support an output which expands along the
equilibrium path EE1.
Output therefore will rebound from FF1 back
towards EE1
55

56. Continued…
The downward swing can be gradual along the
path P2RR1 or more rapid along P2RR2 .The
reason is that once the decline in output is
initiated, it gathers momentum and tends to
proceed at a faster rate
56

57. Continued…
 As the downward movement starts, it becomes increasingly
difficult to sell goods and consequently the burden of fixed
cost becomes harsh.
 Firm after firm becomes bankrupt; liquidity preference
records a sudden rise and reacts adversely on credit
conditions.
 The rigid condition of credit market tends to aggravate the
situation
57

58. Criticisms
1. The major weakness of the theory is its use of the
acceleration principle with a fixed value
2. It also implies a constant capital-output ratio throughout
the business cycle
3. In assuming a fixed value of the multiplier, Hicks assumed
a stable consumption function. Many recent studies have
shown that the value of the MPC changes from one stage
of the cycle to another
58

59. Continued…
4. Hicks fails to take note of the psychological
factors of uncertainty and expectations. These
play an important role in the dynamics of
investment
5. The Hicksian theory, is considered as highly
abstract and incapable of explaining the
fluctuations in real-life situations
59

60. INNOVATION THEORY OF BUSINESS
CYCLES
The innovation theory of business cycles was
given by J.A Schumpeter.
According to him innovations in the structure of
an economy are the source of economic
fluctuations.
He states that business cycles are the outcome of
economic development in a capitalist society.
60

61.  An innovation may consists of a
1. Introduction of new type of goods
2. Introduction of new methods of production
3. Opening of new markets
4. Discovering of new sources of raw materials
5. Change in the organisation of an industry, like the creation of a
monopoly, trust, breaking up of a monopoly
 In other words an innovation is anything which is
introduced by an entrepreneur to change the supply and
demand conditions
61

62. Explanation
 Schumpeter starts his analysis by assuming the equilibrium state of
the economic system where all the factors of production are fully
employed.
 Product prices are equal to both average and marginal costs. Profits
are zero
 There is no net saving and no net investment.
 Schumpeter calls this equilibrium state of the economy as ‘circular
flow’ of economic activity.
 The circular flow of economic activity gets disturbed when an
entrepreneur successfully carries out an innovation
62

63. Suppose the economy is at full employment and
an innovation in the form of a new product has
been introduced.
Since economy is already working at full
employment level, the new product can be
produced only through the withdrawing of labour
and other resources by promising higher rewards
from the existing products.
As a result rewards as a whole will increase
63

64.  Since the factors of production are getting higher
rewards, their purchasing power increases.
 As a result they will be demanding more goods and
services.
 This will result in a rise in prices.
 Thus the increased demand for and the simultaneous
decreased supply of old goods will push upwards the
prices of these goods resulting inflationary conditions
64

65.  As the new product introduced in the market becomes commercially
successful and brings profit for promoters, similar products are introduced by
the rival competing firms
 As new products start competing with old products, consumer buy new
products.
 Consequently the demand for old products start declining. Their prices fall.
 The old firms contract output and some are even forced to run into
liquidation.
 The innovators start repaying bank loans out of profits, the quantity of money
decreased and prices tend to fall.
 Uncertainty and risks increase
65

66.  The impulse for innovation is reduced and eventually
comes to an end.
 The demand for goods and services is reduced due to
the fall in purchasing power.
 Consequently supply exceeds demand.
 Prices and cost of production of goods start declining.
 Recession sets in and the process of readjustment to
the point of equilibrium begins
66

67. Criticisms
1. Schumpeter attributes trade cycles to the phenomenon of innovations only.
But, the trade cycle being a complex phenomenon cannot be attributed to a
single factor alone
2. The theory is based on the assumption of full employment of resources in the
economic system
3. Schumpeter unrealistically assumes that innovations are financed solely by
means of bank credit
4. Its arguments are more based on sociological factors rather than the economic
factors
5. This theory leaves out other factors that cause fluctuations in the economy
67

68. 68