1.

Volatility of Investment Spending

Variations in investment spending are one of the important factors in business cycles. Investment
spending is considered the most volatile component of the aggregate or total demand (it varies much
more from year to year than the largest component of the aggregate demand, the consumption
spending), and empirical studies by economists have revealed that the volatility of the investment
component is an important factor in explaining business cycles in the United States. According to these
studies, increases in investment spur a subsequent increase in aggregate demand, leading to economic
expansion. Decreases in investment have the opposite effect. Indeed, economists can point to several
points in American history in which the importance of investment spending was made quite evident. The
Great Depression, for instance, was caused by a collapse in investment spending in the aftermath of the
stock market crash of 1929. Similarly, prosperity of the late 1950s was attributed to a capital goods
boom.

There are several reasons for the volatility that can often be seen in investment spending. One generic
reason is the pace at which investment accelerates in response to upward trends in sales. This linkage,
which is called the acceleration principle by economists, can be briefly explained as follows. Suppose a
firm is operating at full capacity. When sales of its goods increase, output will have to be increased by
increasing plant capacity through further investment. As a result, changes in sales result in magnified
percentage changes in investment expenditures. This accelerates the pace of economic expansion,
which generates greater income in the economy, leading to further increases in sales. Thus, once the
expansion starts, the pace of investment spending accelerates. In more concrete terms, the response of
the investment spending is related to the rate at which sales are increasing. In general, if an increase in
sales is expanding, investment spending rises. If an increase in sales has peaked and is beginning to slow,
investment spending falls. Thus, the pace of investment spending is influenced by changes in the rate of
sales.

2. Momentum

Economists cite a certain "follow-the-leader" mentality in consumer spending. In situations where

consumer confidence is high and people adopt more free-spending habits, other customers are deemed
to be more likely to increase their spending. Conversely, downturns in spending tend to be imitated as
well.

3. Technological Innovations

Technological innovations can have an acute impact on business cycles. Indeed, technological
breakthroughs in communication, transportation, manufacturing, and other operational areas can have
a ripple effect throughout an industry or an economy. Technological innovations may relate to
production and use of a new product or production of an existing product using a new process. The
video imaging and personal computer industries, for instance, have undergone immense technological
innovations in recent years, and the latter industry in particular has had a pronounced impact on the
business operations of countless organizations. However, technological innovations and consequent
increases in investment take place at irregular intervals. Fluctuating investments, due to variations in the
pace of technological innovations, lead to business fluctuations in the economy. There are many reasons
why the pace of technological innovations varies. Major innovations do not occur every day. Nor do they
take place at a constant rate. Chance factors greatly influence the timing of major innovations, as well as
the number of innovations in a particular year. Economists consider the variations in technological
innovations as random (with no systematic pattern). Thus, irregularity in the pace of innovations in new
products or processes becomes a source of business fluctuations.

4. Variations in Inventories

Expansion and contraction in the level of inventories of goods kept by businesses also contribute to
business cycles. Inventories are the stocks of goods firms keep on hand to meet the demand for their
products. Usually, during a business downturn, firms let their inventories decline. As inventories
dwindle, businesses ultimately find themselves short of inventories. As a result, they start increasing
inventory levels by producing output greater than sales, leading to an economic expansion. This
expansion continues as long as the rate of increase in sales holds up and producers continue to increase
inventories at the preceding rate. However, as the rate of increase in sales slows, firms begin to cut back
on their inventory accumulation. The subsequent reduction in inventory investment dampens the
economic expansion, and eventually causes an economic downturn. The process then repeats itself all
over again. It should be noted that while variations in inventory levels impact overall rates of economic
growth, the resulting business cycles are not really long. The business cycles generated by fluctuations in
inventories are called minor or short business cycles. These periods, which usually last about two to four
years, are sometimes also called inventory cycles.

5. Fluctuations in Government Spending

Variations in government spending are yet another source of business fluctuations. This may appear to
be an unlikely source, as the government is widely considered to be a stabilizing force in the economy
rather than a source of economic fluctuations or instability. Nevertheless, government spending has
been a major destabilizing force on several occasions, especially during and after wars. Government
spending increased by an enormous amount during World War II, leading to an economic expansion that
continued for several years after the war. Government spending also increased, though to a smaller
extent compared to World War II, during the Korean and Vietnam wars. These also led to economic
expansions. However, government spending not only contributes to economic expansions, but
economic contractions as well. In fact, the recession of 1953 - 54 was caused by the reduction in
government spending after the Korean War ended. The end of the Cold War resulted in a reduction in
defence spending by the United States that had a pronounced impact on certain defence-dependent
industries and geographic regions.

6. Politically generated Business Cycles

Economists have hypothesized that business cycles are the result of the politically motivated use of
macroeconomic policies (monetary and fiscal policies) that are designed to serve the interest of
politicians running for re-election. The theory of political business cycles is predicated on the belief that
elected officials (the president, members of congress, governors, etc.) have a tendency to engineer
expansionary macroeconomic policies in order to aid their re-election efforts.

7. Monetary Policies

Variations in the nation's monetary policies, independent of changes induced by political pressures, are
an important influence in business cycles as well. Use of fiscal policy to increase government spending
and/or tax cuts is the most common way of boosting aggregate demand, causing an economic
expansion. Moreover, the decisions of the Federal Reserve, which controls interest rates, can have a
dramatic impact on consumer and investor confidence as well.

8. Fluctuations in Export and Imports

The difference between exports and imports is the net foreign demand for goods and services, also
called net exports. Because net exports are a component of the aggregate demand in the economy,
variations in exports and imports can lead to business fluctuations as well. There are many reasons for
variations in exports and imports over time. Growth in the gross domestic product of an economy is the
most important determinant of its demand for imported goods. As people's incomes grow, their
appetite for additional goods and services, including goods produced abroad, increases. The opposite
holds when foreign economies are growing. Growth in incomes in foreign countries also leads to an
increased demand for imported goods by the residents of these countries. This, in turn, causes U.S.
exports to grow. Currency exchange rates can also have a dramatic impact on international trade and
hence, domestic business cycles as well.

Theories of Business Cycles

Non Monetary Theories

1. Psychological Theory

Business fluctuations are the result of waves of optimism and pessimism among businessman and
industrialist. At times big industrialist felt optimism about prospect of business and pass their optimism
by other in this way entire business community become optimist. They make new investment and it
leads to emergence of boom condition and other time businessman become pessimist and pass their
pessimism to other and entire business community become pessimist mind it. The boom and slumps
are due to alternating waves of optimism and pessimism on the part of business.

Criticism:

It does not furnish comprehensive explanation of business cycle and does not explain the causes for
these alternating waves of optimism and pessimism. The psychological factors are not the originating
factors of business cycles.

2. under consumption or Over saving Theory

The cause of depression is the inequality of income that prevails in a capitalistic economy. The upper
income group have too much wealth so they save and invest in business. The low income group do not
have adequate purchasing power to buy goods resulting in over production, fall in prices and
depression. Thus too much saving and too little consumption is the cause of business depression.

Criticism:

It is the prospects of profit not the mere existence of savings, which govern investment in a capitalist
economy. Also the theory explains only the onset of depression not the advent of boom. Thus, it is not a
full fledge theory of business cycle.

3. Innovation theory

This theory explains innovations in business as a main course of increase in investment in business
fluctuation; innovation may mean any of the following: 1) Introduction of mechanical innovation 2)
Introduction of technique of production 3) Development of new market for existing production 4)
Development of sources of raw material 5) Introduction of new method of management. According to
Schumpeter whenever an innovation takes places this causes disequilibrium in the existing economic
system. This disequilibrium continues till there is readjustment at some new equilibrium position. The
illustrate the upswing we assume that the economy is in the state of full employment of some
innovation takes place, the production cost of existing industry will increase, the establishment of new
industry will be financed to expansion of bank credit. The results will be sharp increase in prices of
product. When other firms immediate the innovations and acquire additional fund from the bank, an
inflation force sets in an economy beyond a certain level increase in output causing fall in prices and
profitability. Further innovations do not come by quickly. It leads to contract in money supply. Hence
prices fall. The process of recession begins and continues until equilibrium is again restored.

Criticism:

1) The basic assumption of the theory is unrealistic. Firstly, it assumes full employment in an economy.
Normally there is loss the full employment in capital economy. 2) Schumpeter aptitude to business cycle
innovation only business cycle being a complex to single factor only. 3) The theory assumes that every
innovation in business is finance through expansion of bank credit. Actually these are financed by
drawing upon development resources especially get for the purpose.

Monetary Theories

1. Pure Monetary Theory – Hautrey

According to this theory, the main cause of business fluctuation is unstable monetary and credit system.
The fluctuation in the supply of money and bank credit is the basic factor which causes cyclical process.
The fluctuation of the process begins with the expansion of bank credit and continues as long as credit
expands. Till this process continues, the general level of price rises because beyond a limit, demand rises
at the rate higher than the rate of increase in supply. Credit expansion accelerates the process of
economic expansion and rise in prices. The prosperity brought about by banking credit mechanism is
reversed when banks restrain their credit expansion because their cash reserves stand depleted due to
increase in loans and advances reduce inflow of deposits and withdrawal of deposits. As credit
expansion comes to an end the process of expansion is sloped down and demarks the beginning of
downswing.

Criticism:

1)Besides monetary factors, economic activity has also fluctuated because of changes in non monetary
factors. 2)Monetary factors do not fully explain the turning point of business cycle. 3)Besides interest
rate, other important factor in business decision is the marginal efficiency of capital.

2. Monetary Over Investment Theory– Hayek

This theory emphasizes the role of imbalance between desired and actual investment in economic
fluctuation. For economy to remain in equilibrium, it is necessary that voluntary savings are equal to
actual investment. The equilibrium of the economy would be upset by changes in money supply and
saving investment relation. If new investments are financed through increased bank credit, there will be
over investment mainly in capital good industry. There may be expansion of investment without
contraction in consumption. The existing rate of interest cannot be maintained because it has gone out
of balance with consumer demand. As consumer demand increases, profitability in consumer goods
industry become higher than that of the capital goods industry and it shifts investment from the latter to
the former. As a result, demand for bank credit increases in consumer goods industry. But due to
bankers’ unwillingness and inability to meet credit demand, a financial crisis develops leading to
downswing in business activities.

Criticism:

1) This theory fails to take in account the non monetary factors.

2) It stresses upon the changes in interest rates as the main determinant of investment and
ignores other factors.
3) It lays emphasis on imbalance between investment in capital goods and consumer goods but in
modern economy such imbalances are self corrected.

3. Kynes Theory of Marginal Efficiency of Capital

According to Kynes, the operation of business cycle is due to the fluctuation in volume of
investment. These fluctuations are due to fluctuations in marginal efficiency of capital (MEC). Thus
fluctuations in prospective returns determine MEC. An improvement in MEC leads to increased
investment, creates more employment output and income in the economy and starts the period of
prosperity. On the other hand, a decline in MEC through decreased investment leads to
unemployment and fall in income and output; which initiates the period of depression. The real
contribution of Kynes theory lies in explanation of the lower and upper turning points of business
cycle. The upper turning point or downturn MPC (Marginal Propensity to Consume) being less than
marginal consumption is less than savings increase and led to less demand for goods and hence less
 production and increase in employment level. The lower turning point is explained when income
and consumption levels are low but consumption does not fall in same proportion. Therefore
increase in demand leads to increase in production and rise in employment level.

Criticism: Kynes advocacy of low interest rate as a remedy to economic crisis is subject to criticism.

Keys to successful Business Cycle Management

Some measures can be taken to control the business cycle. Measures can be divided into two parts
namely:

 Preventive measures
 Relief measures

Preventive measures

Preventive measures are those measures which are adopted during the phase of prosperity for the
purpose of regulating business and to avoid unwise experience in the future. Preventive measures can
be further classified into various categories

 Conservation of assets : Conservation of assets can be done by three ways 1. Maximum

utilization 2. Minimum wastage 3. Proper allocation of resources
 Avoid increasing overhead cost : Businessmen should try to minimize their cost because this will
decrease profit of business and this man become cause of depression.
 Avoid excessive inventories.

In this phase, businessmen should anticipate the amount of goods that is to be produced i.e. how much
quantity to be produced as there may be possibility of cancellation of orders.

Attention to customers Attention to customer means providing better facility to customer. Businessmen
should try to win the confidence of customer so that the customer can become loyal towards the firm.

Relief measures

Relief measures are those measures which are formulated to help in the recovery of business during the
period of contraction. Relief measure can also be further divided into various parts

 Reduction in manufacturing cost: Businessmen should always try to reduce production cost
because it will help business in increasing the profit and that profit can be further invested into
production activities.
 Improving the quality of product : By improving the quality of products demand can be
enhanced that will subsequently increase the sales of business and it will help the firm in
recovering from depression.
 Development of plant, labour and organisation to make it flexible Development of
infrastructure will definitely attract more investors and that will result in more production.
  Long term planning: The firm should give importance and plan for its future developments. The
firm should also adopt cyclical pricing policy so that it can overcome the problem faced during
cyclical fluctuation.

Prosperity Phase:

The top business cycle is called Prosperity, peak or boom. In the boom period the overall business
activity is rising at a more rapid rate. There is a rise in real output and incomes of the people. The
industrial activity being both speculative and non speculative, shows remarkable expansion. The general
mood of the businessmen is that of optimism and commercial. Share markets give handsome gains to
the investors. Financial institutions tend to expand credit. In prosperity, unemployment remains low,
strong consumer confidence about the future leads to record purchases, and businesses expand to take
advantage of marketplace opportunities.

Recession Phase:

During a recession - a cyclical economic contraction, consumers frequently postpone major purchases
and shift buying patterns toward basic, functional products carrying low prices. Businesses mirror these
changes in the marketplace by slowing production, postponing expansion plans, reducing inventories,
and often cutting the size of their workforce. It is also known as contraction phase. A recession occurs if
a contraction is severe enough. Pessimism and hardship are widespread. If the loss of income is not too
severe it is called a recession. Sales are no longer expanding. The economy starts slowing down. As sales
stop increasing, inventories pile up. Companies can adjust to that by reducing orders for raw materials,
avoiding overtime and resorting to sales promotions. Suppliers start to feel the pinch and are forced to
lay off a few workers. Sales start to drop as consumer demand shies away. Fewer and fewer businesses
are started.

Depression Phase:

If the economic slowdown continues in a downward spiral over an extended period of time, the
economy falls into depression. A Depression is a large recession. Firms try to survive as they can sell off
the inventory on hand. More bankruptcies are observed, but the number and the size of the bankrupt
firms are bottoming out. All prices, interest rates and wages are at their lowest. Unemployment is
ubiquitous. The unemployed are ready to take any job. The contraction has run its course. The economy
has reached its trough.

Recovery Phase: In the recovery stage, the economy emerges from recession and consumer spending
picks up steam. Even through business often continue to rely on part time and other temporary workers
during the early stages of a recovery, unemployment begins to decline, as business activity accelerates
and firms seek additional workers to meet growing production demands. Gradually, the concerns of
recession begin to disappear, and consumers start purchasing more discretionary items such as
vacations and new computer equipment. The economy strengthens from a period of slow growth. Its
pace is still slow. It is important to note that recovery doesn't necessarily take place at a steady pace.