BUSINESS CYCLES AND MACROECONOMIC POLICY INITIATIVES

BUSINESS CYCLE

Today we are faced with higher unemployment levels, deflation in farm prices, disinflation in industrial prices, and inflation almost everywhere else.

These are cycles in all spheres of human endeavor, from stocks and bonds to commodities and political preferences and are generally known as business or trade cycles.

In this chapter, we discuss:

Meaning of business or trade cycles

Types of cycles

Various phases of cycles

Three important theories on business cycle

Various remedial measures to rectify economic imbalances caused by these trade/business cycles

Various business indicators and their practical applications in:

Forecasting recession

Buying and selling of stocks

MEANING

Business cycle or trade cycle is a part of the capitalist system.  It refers to the phenomenon of cyclical booms and depressions.  Most acceptable definition is that given by Mitchell, "Business cycles are a type of fluctuations found in the aggregate economic activity of nations that organise their work mainly in business enterprises.  A cycle consists of expansions occurring at about the same time in many economic activities followed by similarly general recessions, contractions, and revivals which merge into the expansion phase of the next cycle; this sequence of changes is recurrent but not periodic....".

An important point to be noted in the case of business cycles is that business cycles are recurrent fluctuations (which are not perfectly regular with uniform frequency and amplitude) in aggregate employment, income, output and price level.

TYPES OF CYCLES

Business cycles are usually classified as under:

  1. The 'Long Jugler Cycle'- It showed that periods of prosperity, crisis and  liquidation followed each other always in the same order and the duration is on the average nine and a half years.

  1. The Short Kitchin Cycle.  Also known as the minor cycle which is of approximately 40 months duration.

  1. The Very Long Kondratieff Cycle. A very long cycle, of more than 50 years duration,  has come to be known as the Kondratieff wave.

  1. Building Cycles.   Another type of cycle relates to the construction of buildings which is of fairly regular duration.  Its duration is twice that of the major cycles and is on an average of 18 years' duration.

  1. Kuznets Cycle.   Simon Kuznets propounded a new type of cycle, the secular swing of 16-22 years which is so pronounced that it dwarfs the 7 to 11 years cycle into relative insignificance.

PHASES OF A BUSINESS CYCLE

A standard business cycle is characterised by four distinct phases.  They are (1) expansion or prosperity or the upswing or full employment, (2) recession or upper turning point, (3) contraction or depression or downswing, and (4) revival or recovery or lower turning point.

FIG. 1

Recovery or Revival Phase:

The "originating forces" or "starters" may be exogenous or endogenous forces.

For example, as the semi-durable goods wear out necessitating their replacement in the economy.  It leads to increased demand.  To meet this increased demand, investment and employment increase.  Industry begins to revive. Revival also starts in related capital goods industries.  The process of revival becomes cumulative.

Revival occurs in stages.

  • In early stages, there is considerable excess or idle capacity in the economy leading to increases in output without a proportionate increase in total costs.
  • In later stages, output becomes less elastic, bottlenecks appear with rising costs, deliveries are more difficult and plants may have to be expanded. It leads to credit expansion.
  • Thus the cumulative process of increase in investment, employment, output, income and prices will feed upon itself and becomes self-reinforcing.
  • Ultimately, revival enters the prosperity phase.

Prosperity or Full Employment : -

  • In the prosperity phase, demand, output, employment and income are at a high level leading to price rises.
  • But wages, salaries, interest rates, rentals and taxes do not rise in proportion to the rise in prices.  The gap between prices and costs increases the margin of profit.
  • 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.
  • Investments are mostly in fixed capital, plant, equipment and machinery.  They lead to considerable expansion in economic activity by increasing the demand for consumer goods and further raising the price level.
  • This encourages retailers, wholesalers and manufacturers to add to inventories.  In this way, the expansionary process becomes cumulative and self-reinforcing until the economy reaches a very high level of production, known as the peak or boom.

The peak or prosperity may lead the economy to over full employment and to inflationary rise in prices.  It is a symptom of the end of the prosperity phase and the beginning of the recession.


Recession: -

The seeds of recession are contained in the boom in the form of strains on the economic structure which act as brakes to the expansionary path.  They are:

  • Scarcities of labour, raw materials, etc. leading to rise in costs relative to prices; [This factor brings a decline in profit margins];
  • Rise in the rate of interest due to scarcity of capital, [This makes investments costly and along with the first factor, lowers business expectations]; and
  • Failure of consumption to rise due to rising prices and stable propensity to consume when incomes increase [Which leads to the piling up of inventories indicating that sales or consumption lags behind production].

These forces become cumulative and self-reinforcing.

Recession marks the turning period during which the forces that make for contraction finally win over the forces of expansion.  Its outward signs are:

liquidation in the stock market,

strain in the banking system and some liquidation of bank loans, and

beginning of the decline of prices.

As a result, profit-margins decline further because costs start overtaking prices.  Some firms close down while others reduce production and try to sell out of accumulated stocks.  Investment, employment, incomes and demand decline.  This process becomes cumulative.

Recession may be mild or severe.  The latter might lead to a sudden explosive situation emanating from the banking system or the stock exchange, and a panic or crisis occurs associated with a collapse of confidence and sudden demands for liquidity.  In the words of M.W. Lee, "A recession, once started, tends to build upon itself much as forest fire, once under way, tends to create its own draft and give internal impetus to its destructive ability."

Depression: -

Recession merges into depression when there is a general decline in economic activity.  A depression is characterised by:

  • mass unemployment;
  • general fail in prices, profits, wages, interest rate, consumption, expenditure, investment, bank deposits and loans;
  • factory closures; and
  • A halt in the construction of all types of capital goods, buildings, etc.

These forces are cumulative and self-reinforcing and the economy is at the trough.  The trough or depression may be short-lived or it may continue at the bottom for considerable time.  

But, sooner or later limiting forces are set in motion which ultimately tend to bring the contraction phase to end and pave the way for the revival.  A cycle is thus complete.

THEORIES OF BUSINESS CYCLE

The behaviour of a business cycle is difficult to determine.

Attempts to explain them have brought forth a large number of theories.

 

Hawtrey's Monetary Theory of the Trade Cycle -  "The trade cycle is a purely monetary phenomenon."  It is the changes in the flow of monetary demand on the part of businessmen that lead to prosperity, and depression in the economy.

In his opinion, non-monetary factors like strikes, floods, earthquakes, droughts, wars, etc. may at best cause a partial depression, but not a general depression.

Criticism  -  Monetarists like Friedman have supported Hawtrey's theory.  But the majority of economists have criticised him for over-emphasising monetary factors to the neglect of non-monetary factors in explaining cyclical fluctuations.

Schumpeter's Theory of Innovations - Innovations in the structure of an economy are the source of economic fluctuations and trade cycles are the outcome of economic development (innovations) in a capitalist society.  

criticism - Not all innovations form part of the functions of a joint stock company.

Innovations are regarded as the routine of industrial concerns and do not require an innovator as such.

Too much importance is given to bank credit.  But in the long run when the need for capital funds is much greater, bank credit is insufficient.  For this, business houses have to float fresh shares and debentures in the capital market.  Schumpeter's theory is weak in that it does not take these factors into consideration.

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Keynes's Theory of the Trade Cycle - The Keynesian theory of the trade cycle is an integral part of his theory of income, output and employment.

Trade cycles are periodic fluctuations of income, output and employment.

Keynes regards the trade cycle as mainly due to a cyclical change in the marginal efficiency of capital (MEC), though complicated and often aggravated by associated changes in the other significant short-period variables of the economic system.

Principal cause of depression and unemployment is the lack of aggregate demand.  Thus in the Keynesian explanation of the trade cycle, the cycle consists ...

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