BUSINESS CYCLE THEORY

By:
ALIT WAHYUNINGSIH (1607531041)
PUTU AYU FITRIANI (1607531043)
I GEDE AGUNG SUKAMARA (1607531118)

INTRODUCTION TO MACROECONOMICS SUBJECT

LECTURE: Dr. I GEDE SUDJANA BUDHI

UNDERGRADUATE STUDENT
FACULTY OF ECONOMY AND BUSSINESS
UDAYANA UNIVERSITY
2017
 Foreword

Praise and Gratitude we always pray to God, because thanks to His mercy and grace we
can finish this paper. The purpose and our goal here to present some of the things that become
material from our paper. This paper discusses the Business Cycle Theory. This paper also uses a
language that is easy to understand for its readers. We realize that in our paper there are still many
shortcomings, we expect criticism and suggestions to improve our paper for better and can be as
useful as possible. Finally, we would like to thank all those who have assisted in the process of
preparing and refining this paper.

Denpasar, May 2017

Compilers
 CHAPTER 1

INTRODUCTION

1.1 Background
Many free enterprise capitalist countries such as USA and Great Britain have registered
rapid economic growth during the last two centuries. But economic growth in these countries has
not followed steady and smooth upward trend. There has been a long-run upward trend in Gross
National Product (GNP), but periodically there have been large short-run fluctuations in economic
activity, that is, changes in output, income, employment and prices around this long- term trend.
The period of high income, output and employment has been called the period of expansion,
upswing or prosperity, and the period of low income, output and employment has been described
as contraction, recession, downswing or depression. The economic history of the free market
capitalist countries has shown that the period of economic prosperity or expansion alternates with
the period of contraction or recession. These alternating periods of expansion and contraction in
economic activity has been called business cycles. They are also known as trade cycles. For more
details, will be explained in this paper.
1.2 Problems
1. What is the meaning of business cycle?
2. What are the phases of business cycle?
3. What are the theories of business cycle?
4. How is the management of business cycle?
5. How is the example of study case about business cycle?
1.3 Goals
1. Know the definition of business cycle
2. Know the phases of business cycle
3. Know the phases of business cycle
4. Assist the government in managing the business cycle
5. Identify the business cycle case
1.4 Benefits
1. Understanding the meaning of business cycle
2. Understanding the phases of business cycle
3. Knowing the phases of business cycle
4. Can be the reference for government in solving business cycle problem
5. Can assist government in identifying the business cycle case
 CHAPTER II

CONTENT

2.1 The Meaning of Business Cycle

J.M. Keynes writes, “A trade cycle is composed of periods of good trade characterised by
rising prices and low unemployment percentages with periods of bad trade characterised by falling
prices and high unemployment percentages.” A noteworthy feature about these fluctuations in
economic activity is that they are recurrent and have been occurring periodically in a more or less
regular fashion. Therefore, these fluctuations have been called business cycles. It may be noted
that calling these fluctuations as ‘cycles’ mean they are periodic and occur regularly, though
perfect regularity has not been observed.
The duration of a business cycle has not been of the same length; it has varied from a
minimum of two years to a maximum of ten to twelve years, though in the past it was often
assumed that fluctuations of output and other economic indicators around the trend showed
repetitive and regular pattern of alternating periods of expansion and contraction. However,
actually there has been no clear evidence of very regular cycles of the same definite duration. Some
business cycles have been very short lasting for only two to three years, while others have lasted
for several years. Further, in some cycles there have been large swings away from trend and in
others these swings have been of moderate nature.

2.2 The Phases of Business Cycle

Business cycles have shown distinct phases the study of which is useful to understand their
underlying causes. These phases nave been called by different names by different economists.
Generally, the following phases of business cycles have been distinguished:
1. Expansion (Boom, Upswing or Prosperity)
2. Peak (upper turning point)
3. Contraction (Downswing, Recession or Depression)
4. Trough (lower turning point)
The four phases of business cycles have been shown in Fig. 27.1 where we start from trough
or depression when the level of economic activity i.e., level of production and employment is at
the lowest level. With the revival of economic activity the economy moves into the expansion
phase, but due to the causes explained below, the expansion cannot continue indefinitely, and after
reaching peak, contraction or downswing starts. When the contraction gathers momentum, we have
a depression.

The downswing continues till the lowest turning point which is also called trough is reached. In
this way cycle is complete. However, after remaining at the trough for some time the economy
revives and again the new cycle starts.
Haberler in his important work on business cycles has named the four phases of business
cycles as: upswing, upper turning point, downswing, and lower turning point. There are two types
of patterns of cyclic changes. One pattern is shown in Fig. 27.1 where fluctuations occur around a
stable equilibrium position as shown by the horizontal line. It is a case of dynamic stability which
depicts change but without growth or trend. The second pattern of cyclical fluctuations is shown
in Fig. 27.2 where cyclical changes in economic activity take place around a growth path (i.e.,
rising trend). J.R. Hicks in his model of business cycles explains such a pattern of fluctuations with
long-run rising trend in economic activity by imposing factors such as autonomous investment due
to population growth and technological progress causing economic growth on the otherwise
stationary state. We briefly explain below various phases of business cycles.
2.2.1 Expansion and Prosperity
In its expansion phase, both output and employment increase till we have full employment
of resources and production is at the highest possible level with the given productive resources.
There is no involuntary unemployment and whatever unemployment prevails is only of frictional
and structural types. Thus, when expansion gathers momentum and we have prosperity, the gap
between potential GNP and actual GNP is zero, that is, the level of production is at the maximum
production level. A good amount of net investment is occurring and demand for durable consumer
goods is also high. Prices also generally rise during the expansion phase but due to high level of
economic activity people enjoy a high standard of living.
Then something may occur, whether banks start reducing credit or profit expectations
change adversely and businessmen become pessimistic about future state of the economy that bring
an end to the expansion or prosperity phase. As shall be explained below, economists differ
regarding the possible causes of the end of prosperity and start of downswing in economic activity.
Monetarists have argued that contraction in bank credit may cause downswing. Keynes have
argued that sudden collapse of expected rate of profit (which he calls marginal efficiency of capital,
MEC) caused by adverse changes in expectations of entrepreneurs lowers investment in the
economy. This fall in investment, according to him, causes downswing in economic activity.
2.2.2 Contraction and Depression
As stated above, expansion or prosperity is followed by contraction or depression. During
contraction, not only there is a fall in GNP but also level of employment is reduced. As a result,
involuntary unemployment appears on a large scale. Investment also decreases causing further fall
in consumption of goods and services. At times of contraction or depression prices also generally
fall due to fall in aggregate demand. A significant feature of depression phase is the fall in rate of
interest. With lower rate of interest people’s demand for money holdings increases.
There is a lot of excess capacity as industries producing capital goods and consumer goods
work much below their capacity due to lack of demand. Capital goods and durable consumer goods
industries are especially hit hard during depression. Depression, it may be noted, occurs when
there is a severe contraction or recession of economic activities. The depression of 1929- 33 is still
remembered because of its great intensity which caused a lot of human suffering.
2.2.3 Trough and Revival
There is a limit to which level of economic activity can fall. The lowest level of economic
activity, generally called trough, lasts for some time. Capital stock is allowed to depreciate without
replacement. The progress in technology makes the existing capital stock obsolete. If the banking
system starts expanding credit or there is a spurt in investment activity due to the emergence of
scarcity of capital as a result of non-replacement of depreciated capital and also because of new
technology coming into existence requiring new types of marines and other capital goods. The
stimulation of investment brings about the revival or recovery of the economy.
The recovery is the turning point from depression into expansion. As investment rises, this
causes induced increase in consumption. As a result industries start producing more and excess
capacity is now put into full use due to the revival of aggregate demand. Employment of labour
increases and rate of unemployment falls. With this the cycle is complete.

2.3 Theories of Business Cycles

We have explained above the various phases of business cycles. Now, an important
question is what causes business cycles. Several theories of business cycles have been propounded
from time to time. Each of these theories spells out the factors which cause business cycles. Before
explaining the modern theories of business cycles we first explain below the earlier theories of
business cycles as they too contain important elements whose study is essential for proper
understanding of the causes of business cycles.
2.3.1 Sun-Spot Theory
This is perhaps’ the oldest theory of business cycles. Sun-spot theory was developed in
1875 by Stanley Jevons. Sun-spots are storms on the surface of the sun caused by violent nuclear
explosions there. Jevons argued that sun-spots affected weather on the earth. Since economies in
the olden world were heavily dependent on agriculture, changes in climatic conditions due to sun-
spots produced fluctuations in agricultural output. Changes in agricultural output through its
demand and input-output relations affect industry. Thus, swings in agricultural output spread
throughout the economy.
Other earlier economists also focused on changes in climatic or weather conditions in
addition to those caused by sun-spots. According to them, weather cycles cause fluctuations in
agricultural output which in turn cause instability in the whole economy. Even today weather is
considered important in a country like India where agriculture is still important. In the years when
due to lack of monsoon there are drought in the Indian agriculture, it affects the income of farmers
and therefore reduce demand for the products of industries. This causes industrial recession. Even
in USA in the year 1988 a severe drought in the farm belt drove up the food prices around the
world. It may be further noted that higher food prices reduce income available to be spent on
industrial goods.
2.3.2 Hawtrey’s Monetary Theory of Business Cycles
An old monetary theory of business cycles was put forward by Hawtrey. His monetary
theory of business cycles relates to the economy which is under gold standard. It will be
remembered that economy is said be under gold standard when either money in circulation consists
of gold coins or when paper notes are fully backed by gold reserves in the banking system.
According to Hawtrey, increases in the quantity of money raises the availability of bank credit for
investment. Thus, by increasing the supply of credit expansion in money supply causes rate of
interest to fall. The lower rate of interest induces businessmen to borrow more for investment in
capital goods and also for investment in keeping more inventories of goods.
Thus Hawtrey argues that lower rate of interest will lead to the expansion of goods and
services as a result of more investment in capital goods and inventories. Higher output, income
and employment caused by more investment induce more spending on consumer goods. Thus, as
a result of more investment made possible by increased supply of bank credit economy moves into
the expansion phase. The process of expansion continues for some time. Increases in aggregate
demand brought about by more investment also cause prices to rise. Rising prices lead to the
increase in output in two ways.
First, when prices begin to rise businessmen think they would rise further which induces
them to invest more and produce more because prospects of making profits increase with the rise
in prices. Secondly, the rising prices reduce the real value of idle money balances with the people
which induces them to spend more on goods and services. In this way rising prices sustain
expansion for some time. However, according to Hawtrey, the expansion process must end. He
argued that rise in incomes during the expansion phase induces more expenditure on domestically
produced goods as well as more on imports of foreign goods. He further assumes that domestic
output and income expand faster than foreign output.
As a result, imports of a country increase more than its exports causing trade deficit with
other countries. If exchange rate remains fixed, trade deficit means there will be outflow of gold
to settle its balance of payments deficit. Since the country is on gold standard, outflow of gold will
cause reduction in money supply in the economy. The decrease in money supply will reduce the
availability of bank credit. Reduction in the supply of bank credit will cause the rate of interest to
rise. Rising interest rate will reduce investment in physical capital goods. Reduction in investment
will cause the process of contraction to set in.
As a result of reduced order for inventories, producers will cut production which will lower
income and consumption of goods and services. In this state of reduced demand for goods and
services, prices of goods will fall. Once the prices begin to fall businessmen begin to expect that
they will fall further. In response to it traders will cut order of goods still causing further fall in
output. The fall in prices also causes real value of money balances to rise which induce people to
hold larger money holdings with them. In this way contraction process gathers momentum as
demand for goods start declining faster and with this economy plunges into depression.
But after a lapse of sometime depression will also come to an end and the economy will
start to recover. This happens because in the contraction process imports fall drastically due to
decrease in income and consumption of households, whereas exports do not fall much. As a result,
trade surplus emerges which causes inflow of gold. The inflow of gold would lead to the expansion
of money supply and consequently availability of bank credit for investment will increase. With
this, the economy will recover from depression and move into the expansion phase. Thus, the cycle
is complete. The process, according to Hawtrey, will go on being repeated regularly.
2.3.3 Under-Consumption Theory
Under-consumption theory of business cycles is a very old one which dates back to the
1930s. Malthus and Sismodi criticised Say’s Law which states ‘supply creates its own demand’
and argued that consumption of goods and services could be too small to generate sufficient
demand for goods and services produced. They attribute overproduction of goods due to lack of
consumption demand for them. This overproduction causes piling up of inventories of goods which
results in recession. Under-consumption theory as propounded by Sismodi and Hobson was not a
theory of recurring business cycles. They made an attempt to explain how a free enterprise
economy could enter a long-run economic slowdown.
A crucial aspect of Sismodi and Hobson’s under-consumption theory is the distinction they
made between the rich and the poor. According to them, the rich sections in the society receive a
large part of their income from returns on financial assets and real property owned by them.
Further, they assume that the rich have a large propensity to save, that is, they save a relatively
large proportion of their income and therefore, consume a relatively smaller proportion of their
income. On the other hand, less well-off people in a society obtain most of their income from work,
that is, wages from labour and have a lower propensity to save.
Therefore, these less well-off people spend a relatively less proportion of their income
consumer goods and services. In their theory, they further assume that during the expansion
process, the incomes of the rich people increase relatively more than the wage-income. Thus,
during the expansion phase, income distribution changes in favour of the rich with the result that
average propensity to save falls, that is, in the expansion process saving increases and therefore
consumption demand declines.
According to Sismodi and Hobson, increase in saving during the expansion phase leads to
more investment expenditure on capital goods and after some time lag, the greater stock of capital
goods enables the economy to produce more consumer goods and services. But since society’s
propensity to consume continues to fall, consumption demand is not enough to absorb the
increased production of consumer goods. In this way, lack of demand for consumer goods or what
is called under-consumption emerges in the economy which halts the expansion of the economy.
Further, since supply or production of goods increases relatively more as compared to the
consumption demand for them, the prices fall. Prices continue falling and go even below the
average cost of production bring losses to the business firms. Thus, when under-consumption
appears, production of goods becomes unprofitable. Firms cut their production resulting in
recession or contraction in economic activity.
2.3.4 Over-Investment Theory
It has been observed that over time investment varies more than that of total output of final
goods and services and consumption. This has led economists to investigate the causes of variation
in investment and how it is responsible for business cycles. Two versions of over-investment
theory have been put forward. One theory offered by Hayek emphasises monetary forces in causing
fluctuations in investment. The second version of over-investment theory has been developed by
Knut Wickshell which emphasises spurts of investment brought about by innovation.
We explain below both these versions of over-investment theory. It is worth noting that in
both the versions of this theory distinction between natural rate of interest and money rate of
interest plays an important role. Natural rate of interest is defined as the rate at which saving
equal’s investment and this equilibrium interest rate reflects marginal revenue product of capital
or rate of return on capital. On the other hand, money rate of interest is the rate at which banks
give loans to the businessmen.
2.3.5 Wicksell’s Over-investment Theory
Over-investment theory developed by Wicksell is of non-monetary type. Instead of
focusing on monetary factors it attributes cyclical fluctuations to spurts of investment caused by
new innovations introduced by entrepreneurs themselves. The introduction of new innovations or
opening of new markets make some investment projects profitable by either reducing cost or
raising demand for the products. The expansion in investment is made possible because of the
availability of bank credit at a lower money rate of interest.
The expansion in economic activity ceases when investment exceeds saving. Again it may
be noted that there is over-investment because the level of saving is insufficient to finance the
desired level of investment. The end of investment expenditure causes the economy to go into
recession. However, another set of innovations occurs or more new markets are found which
stimulates investment. Thus, when investment picks up as a result of new innovations, the
economy revives and moves into the expansion phase once again.

2.4 The Management of Business Cycle

When the economy is not at a steady state and instead is at a point of either overheating
(growing to fast) or slowing, the government and monetary authorities have policy mechanisms,
fiscal and monetary, respectively, at their disposal to help move the economy back to a steady state
growth trajectory. If the economy needs to be slowed, these policies are referred to as
contractionary and if the economy needs to be stimulated the policy prescription is expansionary.
The goal of economic policy is to keep the economy growing at a sustainable rate. It should be
strong enough to create jobs for everyone who wants one but slow enough to avoid inflation. Three
factors cause each phase of the business cycle. Those are the forces of supply and demand, the
availability of capital and consumer confidence. The most critical is confidence in the future. The
economy grows when there is faith in the future and in policymakers. It does the opposite when
confidence drops. See how this worked in each business cycles since 1929.
2.4.1 Expansionary Policy
Expansionary fiscal policy involves government spending exceeding tax revenue, and is
usually undertaken during recessions. Fiscal authorities will increase government spending in
order to revive the economy. Expansionary monetary policy relies on the central bank increasing
availability ofloanable funds through three mechanisms: open market operations, discount rate,
and the reserve ratio. As the supply of loanable funds increases, the interest rate is expected to
decrease and thereby increase the desire to borrow funds for consumption
and investment purposes.
2.4.2 Contractionary Policy
Contractionary fiscal policy is opposite of the action taken in an expansionary purpose, and
occurs when government spending is lower than tax revenue. Similarly, contractionary monetary
policy is the opposite of expansionary monetary policy and occurs when the supply of loanable
funds is limited, to reduce the access and availability to relatively inexpensive credit.

2.5 The Example of Study Case about Business Cycle

The 2008 recession was so nasty because the economy immediately contracted 2.7
percent in the first quarter of 2008. When it rebounded 2 percent in the second quarter, everyone
thought the downturn was over. But it contracted another 1.9 percent in the third quarter,
before plummeting a whopping 8.2 percent in the fourth quarter. The economy received another
wallop in the first quarter of 2009 when it contracted a brutal 5.4 percent. The unemployment
rate rose from 5.0 percent in January to 7.3 percent by December. See 2008 GDP Statistics. The
trough occurred in the second quarter of 2009, according to the NBER. GDP contracted 0.5
percent. Unemployment rose to 9.5 percent.
The expansion phase started in the third quarter of 2009 when GDP rose 1.3 percent. That
was thanks to the stimulus spending from the American Recovery and Reinvestment Act. The
unemployment rate continued to worsen, reaching 10.0 percent in October. Four years into the
expansion phase, the unemployment rate was still above 7 percent. That is because the
contraction phase was so harsh. The peak that preceded the 2008 recessions occurred in the third
quarter 2007. GDP growth was 2.7 percent. For other examples, see History of Recessions.
 CHAPTER 3

CLOSING

3.1 Conclusion

The business cycle is the natural rise and fall of economic growth that occurs over
time. The cycle is a useful tool for analyzing the economy. It can also help you make better
financial decisions.

Each business cycle has four phases. They are expansion, peak, contraction and
trough. They don’t occur at regular intervals. But they do have recognizable indicators.

There are five theories that stated about the cause of business cycle. They are Sun-Spot
Theory, Hawtrey’s Monetary Theory of Business Cycles, Under-Consumption Theory, Over-
Investment Theory, and Wicksell’s Over-investment Theory.

The government manages the business cycle and monetary authorities. They can use
expansionary Policy or contractionary Policy in managing the business cycle.

One of the example of study case about business cycle is the recession in 2008 which has
passed some stage of it.

3.2. Suggestion

The business cycle is a natural event that absolutely will occured in the country. Because
of that, the government and monetary authorities have to be prepared some solution in passing
some of business cycle stage, especially in downturn stage. Small business owners can take several
steps to help ensure that their establishments weather business cycles with a minimum of
uncertainty and damage. The concept of cycle management is earning adherents who agree that
strategies that work at the bottom of a cycle need to be adopted as much as those which work at
the top of a cycle. While there is no definitive formula for every company, the approaches generally
emphasize a long-term view focused on a company's core strengths and stressing the need to plan
with greater discretion at all times. Essentially, efforts are made to adjust a company's operations
in such a manner that it maintains an even keel through the ups and downs of a business cycle.
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