Module 3

Business cycle

Meaning of business cycle

Business Cycle The business cycle is the natural expansion and contraction of the production
and output of goods and services that happens over a period of time . It can be said to be the
economic rise and fall of a firm in the economy .
The business cycle or trade cycle refers to fluctuations in economic activity that occurs more
or less in regular time sequence in all capitalist societies .
The business cycle is nothing but upward and downward of economic activity , going one
after another in a cyclical way . The business cycle is associated with sweeping fluctuations
in economic activities such as production , prices , income , employment , exports , imports ,
etc.
It is most importantly a tool to understand the economic conditions of the firm and the
economy in general . The firm can use this analysis to make necessary changes to their
policies .
Business cycles are a natural phenomenon that occurs over time . Every firm will go through
the cycles . No firm can have a constant growth or decline over its life cycle . There are
always ups and downs in the economic activities of the firm .

The different phases of business cycles

1. Expansion
2. Peak
3. Recession
4. Depression
5. Trough
6. Recovery
1. Expansion

The first stage in the business cycle is expansion. In this stage, there is an increase in positive
economic indicators such as employment, income, output, wages, profits, demand, and
supply of goods and services. Debtors are generally paying their debts on time, the velocity
of the money supply is high, and investment is high. This process continues as long as
economic conditions are favourable for expansion.

2. Peak

The economy then reaches a saturation point, or peak, which is the second stage of the
business cycle. The maximum limit of growth is attained. The economic indicators do not
grow further and are at their highest. Prices are at their peak. This stage marks the reversal
point in the trend of economic growth. Consumers tend to restructure their budgets at this
point.

3. Recession

The recession is the stage that follows the peak phase. The demand for goods and services
starts declining rapidly and steadily in this phase. Producers do not notice the decrease in
demand instantly and go on producing, which creates a situation of excess supply in the
market. Prices tend to fall. All positive economic indicators such as income, output, wages,
etc., consequently start to fall.

4. Depression

There is a commensurate rise in unemployment. The growth in the economy continues to

decline, and as this falls below the steady growth line, the stage is called a depression.

5. Trough

In the depression stage, the economy’s growth rate becomes negative. There is further decline
until the prices of factors, as well as the demand and supply of goods and services, contract
to reach their lowest point. The economy eventually reaches the trough. It is the negative
saturation point for an economy. There is extensive depletion of national income and
expenditure.

6. Recovery

After the trough, the economy moves to the stage of recovery. In this phase, there is a
turnaround in the economy, and it begins to recover from the negative growth rate. Demand
starts to pick up due to low prices and, consequently, supply begins to increase. The
population develops a positive attitude towards investment and employment and production
starts increasing.

Employment begins to rise and, due to accumulated cash balances with the bankers, lending
also shows positive signals. In this phase, depreciated capital is replaced, leading to new
investments in the production process. Recovery continues until the economy returns to
steady growth levels. 
This completes one full business cycle of boom and contraction. The extreme points are the
peak and the trough.

Characteristics of business cycle

1] Occur Periodically

As we saw, these phases occur from time to time. However they do not occur in for specific
times, their time periods will vary according to the industries and the economic conditions.
Their duration may vary from anywhere between two to ten or even twelve years. Even the
intensity of the phases will be different. For example, the firm may see tremendous growth
followed by a shallow short - lived depression phase.

2] They are Synchronic

Another one of the features of business cycles is that they are synchronic. Business cycles are
not limited to one firm or one industry. They originate in the free economy and are pervasive
in nature.

A disturbance in one industry quickly spreads to all the other industries and finally affects the
economy as a whole. For example , a recession in the steel industry will set off a chain
reaction until there is a recession in the entire economy .

3] All Sectors are Affected

All major sectors of the economy will face the adverse effects of a business cycle . Some
industries like the capital goods industry, consumer goods industry may be disproportionately
affected. So the investment and the consumption of capital goods and durable consumer
goods face the maximum brunt of the cyclic fluctuations. Non - durable goods do not face
such problems generally.

4] Complex Phenomenon

Business cycles are a very complex and dynamic phenomenon. They do not have any
uniformity. There are no set causes for business cycles as well. So it is nearly impossible to
predict or prepare for these business cycles.

5] Affect all Departments

Trade cycles are not only limited to the output of goods and services. It has an effect on all
other variables as well such as employment, the rate of interest , price levels , investment
activity etc.

6] International in Character

Trade cycles are contagious. They do not limit themselves to one country or one economy.
Once they start in one country they will spread to other countries and economies via trade
relations and international trade practices. We have an actual example of this when the Great
Depression of 1929 in the USA, later on, had an adverse effect on the entire global economy.
So in an integrated global economy like today's the effects of a trade cycle spread far and
wide.

Causes of Business Cycles

Internal Causes of Business Cycles

1] Changes in Demand

Keynes economists believe that a change in demand causes a change in the economic
activities. When the demand in an economy increases the firms start producing more goods to
meet the demand.

There is more output , more employment , more income , and higher profits . This will lead to
a boom in the economy . But excessive demand may also cause inflation .

On the other hand , if the demand falls , so does the economic activity . This may lead to a
bust , which if it continues for a longer period of time may even lead to depression in the
economy .

2 ] Fluctuations in Investments

Just as fluctuations in demand , fluctuations in investment is one of the main causes of

business cycles . The investments will fluctuate on the basis of a lot of factors such as the rate
of interest in the economy , entrepreneurial interest , profit expectation , etc.

An increase in investment will lead to an increase in economic activities and cause expansion
. A decrease in investment will have the opposite effect and may cause a trough or even
depression

3 ] Macroeconomic Policies

The monetary policies and the economic policies of a nation will also result in changes in the
phases of a business cycle . So if the monetary policies are looking to expand economic
activities by promoting investment , then the economy booms . On the other hand , if there is
an increase in taxes or interest rates we will see a slowdown or a recession in the economy .

4 ] Supply of Money There is another belief that says that business cycles are purely
monetary phenomena . So changes in the money supply will bring about the trade cycles . An
increase of money in the market will cause growth and expansion .

But too much money supply may also cause inflation which is adverse . And the decrease in
the supply of money will initiate a recession in the economy .

External Causes of Business Cycles

1 ] Wars
During times of wars and unrest , the economic resources are put to use to make special
goods like weapons , arms , and other such war goods . The focus shifts from consumer
products and capital goods . This will lead to a fall in income , employment , and economic
activity . So the economy will face a downturn during war times .

And later post - war the focus will be on rebuilding . Infrastructure needs to be reconstructed
( houses , roads , bridges , etc ) . This will help the economy pick up again as progress is
being made . Economic activity will increase as effective demand will increase .

2 ] Technology Shocks

Some exciting and new technology is always a boost to the economy . New technology will
telecom industry . mean new investment , increased employment , and subsequently higher
incomes and profits . For example , the invention of the modern mobile phone was the reason
for a huge boost in the telecome industry

3 ] Natural Factors

Natural disasters like floods , droughts , hurricanes , etc can cause damage to the crops and
huge losses to the agricultural sector . Shortage of food will cause a surge in prices and high
inflation . Capital goods may see a reduction in demand as well .

4 ] Population Expansion

If the population growth is out of control that might be a problem for the economy .
Basically of the population growth is higher than the economic growth the total savings of an
economy will start dwindling . Then the investments will reduce as well and the economy
will face depression or a slowdown .

Measures to Control Business Cycle

Business cycles are very harmful to the economy because they create economic fluctuations .
During the period of prosperity , prices rise , leading to inflation . During depression there
will be large scale unemployment . Prices fall and income will fall . Hence business cycles
are not desirable .

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

6. Price Adjustment Policy

7. Price Control , Price Support and Rationing

8. Anti - cyclical budgeting

9. Unemployment insurance

10. Automatic Stabilizers

1. Monetary Policy A Control of Business Cycle

Monetary policy as measure to control business cycle fluctuation refers to all those measures
which are taken with a view to control money and credit supply in the country . When we are
in the state of full employment and we are facing inflation , a deflationary policy may be
adopted . The central bank can reduced the quantity of money in circulation . The bank can
adopt different measures for this purpose , like increase in the bank rate , selling of securities
in the market , increasing the reserve ratio of the member banks etc.

On the other hand , in case of deflation the central bank can 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 central bank 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 .

2. Fiscal Policy

Measure to Control of Business Cycle Fiscal policy refers to all the decisions and measures
of the government to change its taxes and expenditures .

During the boom and inflationary situation , government may increase its taxes and reduce
public expenditures ; this creates budget surplus and control inflation . On the other hand
during recession government cuts down its taxes and increases its expenditures on public
works . It creates deficit in budget which help government to eliminate recession . When
there is prosperity without inflation , government usually keeps its budget balanced which
causes no inflation o & inflation in the economy .

In case of inflation the governments reduces the public work programs , imposing heavy
taxes on business profits to discourage private investment , reduces purchasers power , taking
loans from the people . prepares surplus budget to reduce public debt . All these fiscal
measures greatly help in reducing the inflationary trend in the economy .

If the economy facing depression , the government increases it expenditure on public works
programs like construction of new canals , new roads , buildings etc. Increase in government
expenditure , income , employment , profit and consumption of the people . In order to
encourage private investment the government reduces taxes on profit . The government also
prepares deficit budget and the deficit is met by loans . All these fiscal measures to control
business cycle sets in upswing in the economy .

3. State Control of Private Investment

Some economists have suggested that if a government takes control of private investment is a
tool to control of business cycle fluctuations can be controlled within the 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 . 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 .

The government should control private investment in order to prevent over improvement and
thereby the boom .

Though the government has taken a number of steps , business cycles could not be controlled.
The business cycle seems to have become an almost natural feature of the present economic
order so that none of these remedies can be expected to root it out . However , to get desirable
results both monetary and fiscal policies should be combined and implemented effectively .

4. International Measures Control of Business Cycle

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 . The example of great
depression can be given . Business cycle is an international phenomenon and it should be
tackled on international level . Different measures to control business cycle fluctuations have
been suggested by some well - known economists these are :

 Control of International Production

 International Bill Stock Control
 International Investment Control

5. 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 .

Socialists recommended replacement or capitalist economy by a socialistic system of

production and distribution . When this is done , there would be a completely planned
economy and all fears of over - investment and over production would be brought to an end .

6. Price Adjustment Policy

Those who regard market price variations as major causes of instability advocate a policy of
encouraging price flexibility as one of the important weapons of stabilization . They argue
that it would curb profit inflation reduce the duration of recessions and inflation by reducing
the disparities between controlled and uncontrolled price . But to lay down and to follow a
suitable price policy is by no means an easy task . It has its own limitations .
Firstly , a downward price adjustment may increase output and employment in particular
industries with elastic demands without having any favorable effects on the economy as a
whole .

Secondly , if prices of commodities and factors fall simultaneously leaving the price - cost
relation unaffected , the inducement to investment will get a setback .

Thirdly , even if a rise in the marginal efficiency of capital takes place on account of the fall
in factor prices without a corresponding fall in the prices of the output , it is offset by the fall
in aggregate demand .

Even if price flexibility could raise employment it would be temporary unless proper
monetary and fiscal measures are also adopted at the same time . Price - cost policy may be
important in those sectors of the economy where price movements are of strategic
importance.

7. Price Control and Price Support

Many countries adopted price control rationing during war and post - war periods to meet the
usual situation of inflation and adopted price supports to arrest a downward trend of prices .
Price control aims at fixing the upper limit beyond which prices may not rise . This measure
became popular during periods of runaway inflation and profiteering . But it has a few
limitations .

It may lead to contrived shortages and inequality in the distribution of goods . Thus price
controls must be accompanied by restrictions on purchasing power . Rationing is disliked on
the ground that it leads to wastage of resources and also impairs freedom of consumption .

Price support on the other hand aims at not allowing prices to fall below a certain minimum
when that happens ; the government comes to the rescue of the producers by entering the
market as the single bulk purchaser at statutorily fixed prices . This policy has been followed
in India to support the prices of agricultural commodities . The success of such a policy ,
however , depends on the possession of vast resources honest and efficient administration .

8. Unemployment insurance

During the period of prosperity the employers pay taxes to the government at enhanced rates
but the Government does not pay unemployment allowances to the unemployment persons
because there is hardly any unemployment worth the name at such a time . Money therefore
accumulates with the Government .

On the other - hand during the period of depression the Government lowers the taxes but pays
out unemployment allowances to the unemployed persons thereby making available more
money to the people , which automatically tend to offset the reduction in the circuit flow .

9. Automatic Stabilisers :

In this case the economists have suggested the introduction of a number of automatic
stabilisers or ( built in stabilisers ) to deal with the business cycle . An automatic stabiliser or
( built - in - stabiliser ) is an economic stock - absorber that helps smooth the cyclical
business fluctuations of its own accord , without requiring deliberate action on the part of the
government .

For example : Such device in U.S.A. is the federal progressive income - tax . This tax is so
devised that people in higher income brackets are taxed at a progressively higher rate than
those in the lower income brackets .

Such a progressive type of income - tax trends automatically to offset cyclical fluctuations
because in an up saving when incomes are rising people would pay more taxes to the
government and thus their expenditure would be checked and in a down swing when incomes
are declining and tax percentage is low people would pay less taxes to the Government
leaving more funds for them to spend .

10. Anti - cyclical budgeting

The budgetary policy of the government should be in tune with the measures already
indicated to combat the instability created by business cycle . During times of depression , a
policy of deficit budgeting should be adopted . This will increase the flow of income in the
economy . During upswing , surplus budgeting should be adopted . Thus , the budgeting
should be done in anti - cyclical method

Hawtrey’s theory
Hawtrey's monetary theory of business cycle The British economist R.G. Hawtrey describes
the trade cycle as a purely monetary phenomenon , in this sense that all changes in the level
of economic activity are nothing but reflections of changes in the flow of money .

According to him , non - monetary factors like wars , earthquakes , strikes and crop failures
may cause partial and temporary depression in particular sectors of an economy . However ,
these non - monetary factors cannot cause full and permanent depression involving general
unemployment of the factors of production in a trade cycle . On the other hand , changes in
the flow of money are the exclusive and sufficient cause of changes in trade cycle .

In Hawtrey's opinion , the basic cause of trade cycle is the expansion and contraction of
money in a country . According to Hawtrey , changes in the volume of money are brought
about by changes in the rate of interest .

For instance , if banks reduce their rate of interest , producers and traders will be induced to
borrow more from banks so as to expand their business . Borrowing from banks will lead to
more bank money and rise in the price level and business activity .

On the other hand , if banks raise their rate of interest , producers and traders will reduce their
borrowing from banks . This will reduce the price level and business activity . Thus , in
Hawtrey's analysis , changes in interest rates lead to changes in borrowing from banks and ,
therefore , changes in the supply of money . Changes in the supply of money lead to changes
in business activity .
Trade Cycle is Just Inflation and Deflation

Hawtrey argues that the trade cycle is nothing but small - scale replica of an outright money
inflation and deflation . The upward phase of a trade cycle , such as revival , prosperity and
boom is brought about by an expansion of money and bank credit and also by increase in
circulation of money supply . On the other hand , the downward swing of money supply is
nothing but a monetary deflation .

Expansion

• Bank have high cash reserve

• Start giving loans/credit by reducing interest rate
• Investor borrow money as interest rate are low(flow of money increased)
• Investment done(investment increases)
• Demand for factors of production increases(land/labour)
• Generation of employment
• Increase income-increase demand-increase price-which increase profit of organization

Recession and depression

• As investor taking care credit from bank and investing

• Cash reserve goes down- hence interest rate are increased(flow of money
decreased)
• Investment goes down- production goes down
• Demand for factors of production goes down
• Hence, employment rate goes down (unemployment increases)
• Hence less income-less demand – less price

Recovery

• Again banking system reduces the interest rate

• But the investors borrow less due to pessimism in economic activity
• This is broken by cheap monetary policies by central bank

Criticisms of the theory

1. Neglects non-monetary causes

2. Over emphasis on the role of wholesalers
3. Rise in interest rate is not the cause of economic prosperity
4. Neglects the role of expectations

Schumpeter's Theory of Innovation

The innovation theory of a trade cycle is propounded by J.A. Schumpeter . He regards
innovations as the originating cause of trade cycles .
 The Schumpeter's theory of innovation advocates that business innovations are responsible
for rapid changes in investment and business fluctuations .

Joseph Schumpeter considered trade cycles to be the result of innovation activity of the
entrepreneurs in a competitive economy .

Innovation , however , does not arise spontaneously . It must be actively promoted by some
agency in the economic system . Such an agent , according to Schumpeter , is an "
entrepreneur " , entrepreneurs are innovators .

To carry cut his innovative function , the entrepreneur needs two things .

1. Technical knowledge for introducing innovations , and

2. Finance for completing his task .

Schumpeter instigates his study by assuming the balance state of the economic system
where all the factors of production are fully operated . Thus , every organization is producing
efficiently with average costs equivalent to the price . As a result , product prices are the
same as both average and marginal costs . Schumpeter calls this equilibrium state of the
economy a " circular flow " of economic activity that just recurrences itself after a period like
the rotation of blood in the animal organism .

With skills and thirst for new developments , an entrepreneur can introduce something new
to his existing business system . He is not a capitalist but an organizer who can mobilize the
necessary cash for introducing his innovation .

The repeated flow of economic activity gets disturbed when an entrepreneur effectively
carries out an innovation .

Five methods of innovation :

Schumpeter suggest five different methods of innovation that will bring success for
organization ,

1.The introduction of a new product .

2.Implementation of a new method of production .

3.The opening up of a new market .

4.The expeditions for a new source of raw materials or semi - manufactured goods ; and

5. The reorganization of production process within a firm. Or change in the organization of

an industry, like the creation of a monopoly

Schumpeter theory consists two stages

1. First stage- deal with the early impact of the innovation which entrepreneur introduce
in their production process
 2. Second stage- follows as a consequence of the reaction of competitors to the early
effects of the innovation.

Introduction of an innovation spells a start for the business cycle. As the innovator-
entrepreneur begins bidding away resources from other industries, money incomes
increase and prices begin to rise thereby stimulating further investment. As the
innovation steps up production, the circular flow in the economy swells up. Supply
exceeds demand. The initial equilibrium is disturbed.

There is a wave of expansion of economic activity. This is what Schumpeter calls the
“primary wave”. This primary wave is followed by a “Secondary wave” of expansion.
This is due to the impact of the original innovation on the competitors.

As the original innovation proves profitable, other entrepreneurs follow it in “swarm-like

clusters.” Innovation in one line induces innovations in related lines. Money incomes and
prices rise. There is a cumulative expansion of economic activity. Since the purchasing
power of consumers increases, the demands for the products of the non-innovating
industries also go up and their prices are pushed up.

As potential profits in these industries increase, a wave of expansion in the whole

economy follows. This is the secondary wave of credit inflation that gets superimposed
on the primary wave of expansion. Over optimism and speculation add to the enthusiasm
for expansion under boom conditions.

The period of prosperity ends as soon as ‘new’ products induced by the waves of
innovations replace old ones. Since the demand for old products goes down, their prices
fall and consequently their producer-firms are forced to contract their output.

Some of them may be forced into liquidation. When the innovators begin repaying their
bank loan out of the newly-earned profits, the quantity of money in circulation is reduced
as a result of which prices tend to fall and profits decline.
In this atmosphere, uncertainty and risks increase. Depression sets in. The impulse for
further innovation is sapped up. The painful process of readjustment to the point of
“previous neighbor-hood of equilibrium” begins. The economy is on its way downward
into depression.

The economy cannot continue in depression for long. Innovation-minded entrepreneurs

continue their search for profitable innovations. The natural forces of recovery bring
about a revival. Schumpeter points out that the deflationary forces generated by
depression are gradually offset by certain other forces one of which is the ‘dilution or
diffusion of effects’.

This is the effect of bankruptcies, shut-downs and collapses of individual markets on

general economic activity.

The impact of these events goes on falling as these occur. Another factor reducing the
effect of depression is that the collapse of some firms enables remaining firms to expand
their operations to eater to the market fed by the collapsing firms.

These offsetting influences have a restorative effect. Further, the decline in aggregate
consumption throughout the downswing will be less than that in income which results in
the depletion of inventories to the point where there is a need to replenish them.

As fresh investments take place, some of the more adventurous entrepreneurs will start
innovating. Others follow and investment surges up again in a spurt and another boom
are on the way. This completes the phases of a full trade cycle.

Hick’s theory of business cycle

Hicks put forward a complete theory of business cycles based on the interaction between
the multiplier and accelerator.

Prof. J R hicks, in his book A contribution to the theory of the trade cycle

Has propounded the theory of business cycle based on interaction between multiplier and
accelerator

Multiplier: reflects how a change in investment affects income and employment. It is a

Ratio of change in income due to change in investment

Accelerator: reflects how a change in consumption affects investment. It is a Ratio of

change in investment due to change in consumption.

According to J R Hicks – theory of acceleration and theory of multiplier are two aspects
of the theory of up and down
He introduced two concepts

Output ceiling- when all resources are fully occupied and income and output can not
increase beyond this

Floor or lower limit- below which income and output can not go because there is some
autonomous investment are being always made

Assumptions

• The value of multiplier and accelerator is constant throughout different stage

• There is progressive economy

• Relation between multiplier and accelerator is treated in a lagged manner

Formula

• Multiplier

K=ΔY/ ΔI

• Accelerator

V= ΔI / ΔC

• ΔI(Autonomous investment )----› ΔY ----› ΔC ----› ΔI (induced investment)

• P0 to p1 – expansion
 Autonomous investment –income increases --- consumption increases---induced
investment increases

• P1 to p2- peak

Factors of production fully occupied

• P2 to Q1- Recession/depression

Price of factors of production increase ----cost increases—induced investment

decreases

• Q1 to Q2---trough

Lowest point of declining phase

Due to constant rate of autonomous investment and further investment by

government, from Q2 recovery again starts

Again same process follows

Hicks’ theory of business cycles has been explained with the help of Fig. 13.7. In this
figure, AA line represents autonomous investment. Autonomous investment is that
investment which is not induced by changes in income and is made by entrepreneur as a
result of technological progress or innovations or population growth. Hicks assumes that
autonomous investment grows annually at a constant rate given by the slope of the line
AA.

Given the marginal propensity to consume, the simple multiplier is determined. Then the
magnitude of multiplier and autonomous investment together determine the equilibrium
path of income shown by the line LL. Hicks calls this the floor line as this sets the lower
limits below which income (output) cannot fall because of a given rate of growth of
autonomous investment and the given size of the multiplier. But induced investment has
not yet been taken into account.

If national income grows from one year to the next, as it would move along the line LL,
there is some amount of induced investment via accelerator. The line EE shows the
equilibrium growth path of national income determined by autonomous investment and
the combined effect of the multiplier and accelerator. FF is the full employment ceiling.
It is a line that shows the maximum national output at any period of time when all the
available resources of the economy are fully employed.

Given the constant growth of autonomous investment, the magnitude of multiplier and
the induced investment determined by the accelerator, the economy will be moving along
the equilibrium growth path line EE. Thus starting from point E, the economy will be in
equilibrium moving along the path EE determined by the combined effect of multiplier
and accelerator and the growing level of the autonomous investment.
Suppose when the economy reaches point P 0 along the path EE, there is an external
shock—say an outburst of investment due to certain innovation or jump in governmental
investment. When the economy experiences such an outburst of autonomous investment
it pushes the economy above the equilibrium growth path EE after point P 0.

The rise in autonomous investment due to external shock causes national income to
increase at a greater rate than that shown by the slope of EE. This greater increase in
national income will cause further increase in induced investment through acceleration
effect. This increase in induced investment causes national income to increase by a
magnified amount through multiplier.

So under the combined effect of multiplier and accelerator, national income or output
will rapidly expand along the path from P 0 to P1. Movement from P Q to P1 represents the
upswing or expansion phase of the business cycle. But this expansion must stop at
P1 because this is the full employment output ceiling. The limited human and material
resources of the economy do not permit a greater expansion of national income than
shown by the ceiling line CC.

Therefore, when point P 1 is reached the rapid growth of national income must come to an
end. Prof. Hicks assumes that the full employment ceiling grows at the same rate as
autonomous investment. Therefore, CC slopes gently unlike the very steep slope of the
line from P0 to P1. When point P1 is reached the economy must grow at the same rate as
the usual growth in autonomous investment.

For a short time the economy may crawl along the full employment ceiling CC. But
because national income has ceased to increase at the rapid rate, the induced investment
via accelerator falls off to the level consistent with the modest rate of growth determined
by the constant rate of growth of autonomous investment. But the economy cannot crawl
along its full employment ceiling for a long time.

The sharp decline in growth of income and consumption when the economy strikes the
ceiling causes a sharp decline in induced investment. Thus with the sharp decline in
induced investment when national income and hence consumption ceases to increase
rapidly, the contraction in the level of the income and business actually must begin.

Once the downswing starts, the accelerator works in the reverse direction. That is, since
the change in income is now negative the inducement to invest must begin to decrease.
Thus there is slackening off at point P 2 and national income starts moving toward
equilibrium growth path EE. This movement from P 2 downward therefore represents the
downswing or contraction phase of the business cycle.

In this downswing investment falls off rapidly and therefore multiplier works in the
reverse direction. The fall in national income and output resulting from the sharp fall in
induced investment will not stop on touching the level EE but will go further down. The
economy must consequently move all the way down from point P 2 to point Q1. But at
point Q1 the floor has been reached.