Business Cycles

• Business cycle is a very complex economic phenomenon which associated with

MACROECONOMICS II
MODULE 3
Short-run Analysis
MANSOOR P
Assistant Professor
Department of Economics
Amal College of Advanced Studies, Nilambur
fluctuations in economic activity.
• These fluctuations in economic activity are occurring periodically and are more or
less regular in nature.
Definitions of Business Cycles
• W C Mitchell, “Business cycles are a species of fluctuations in the economic
activities of the organised communities. The adjective 'business' restricts the
concept of fluctuations in activities which are systematically conducted on a
commercial basis. The noun 'cycles' bars out fluctuations which do not recur with
a measure of regularity”.
• Keynes, "A trade cycle is composed of periods of good trade characterized by
rising prices and low unemployment percentages altering with periods of bad
trade characterized by falling prices and high unemployment percentages".

Causes of Business Cycles Types of Business Cycles

• Psychological factors or future expectations • Business cycles are classified mainly on the basis of their intensity, periodicity,
• Money and credit supply length, regularity and so on.
• Marginal efficiency of capital • Prof. Arthur James, in his book "Business Cycles: Their Nature, Causes and
• Interest rate Control” (1941) has classified business cycles under the following heads;
• Multiplier effect 1. Major and Minor Cycles
• Accelerator effect • Major cycles are the fluctuations of business activity occurring between
successive crisis.
• Natural factors
• Major cycles are also known as Juglar Cycles which introduced by Clement Juglar.
• Wars
• Juglar Cycles is defined as fixed investment cycle of 7 to 11 years, and with an
• Political factors average duration of 8.33 years.
• Population explosion • Minor cycles are generally coincide with changes in business inventories and
• International factors lasting an average of 40 months.
• Economic policies
2. Building Cycles
• Introduced by two American economists, George F Warren and Frank A Pearson in
their article "World Prices and the Building Industry" (1937).
• Business cycle occurs in the duration of an average of 18 years.
3. Kondratieff Cycles
• Introduced by Soviet economist Nikolai Kondratieff in his book "The Major
Economic Cycles" (1925).
• It is a very long business cycle with wave above 50 years.
• He has identified three phases in the cycle; expansion, stagnation and recession.
4. Kuznets Cycle
• Simon Kuznets suggested cycle of economic activity lasting between 15 and 20
years.
3. Contraction or Recession
• Contraction starts in one sector and spreads to other sectors.
• Fall in employment opportunities, income, expenditure, investment, etc.
4. Depression
• Depression is a severe and prolonged downturn in economic activity.
• Fall in employment, credit, output, prices, profit, wage, investment, GDP, standard of
living, etc.
• A depression is an extreme form of recession and finally economy reaches at minimum
point of economic activity which is called trough.
• Trough is period of most severe strain on the economy.
5. Recovery
• Stage of increasing business activity showing the end of recession
• The recovery should be initiated by new innovations government expenditure changes
in production techniques investment in new regions and so on.
• Interest rates are low which milk stimulates investment and creates more jobs
• Production will increase, profit will rise and unemployment will fall.
Phases of Business Cycles
1. Expansion
• Increase in employment, production, economic growth, demand for capital and
consumer goods, prices of factors of production, output, GNP, etc.
• The gap between potential GNP and actual GNP is zero and production is at a
maximum.
• Full employment of resources.
• There is no involuntary unemployment.
• Frictional and structural unemployment may prevail.
2. Peak or Boom
• Economy is producing at the maximum level of output
• Highest point in the business cycle
• Income employment output and price level reaches the maximum level.
• A sharp inflationary rise in prices
• Once reached boom additional investment will not result in increase in GNP.
• Increase in the production will leads to increase in the factor prices.
Monetary Theories of Trade Cycle
1) Hawtray's Pure monetary theory of trade cycle
• Ralph George- 'Good and Bad Trade' (1913).
• The theory relate to the economy under gold standard.
• Trade cycle is a purely monetary phenomenon.
• Based upon the classical quantity theory of money.
• An elastic money supply is the basic cause of operation of business cycle.
• Instability of the monetary and credit system is the real reason for creating
business cycles.
• If interest rate is low employment opportunities will increase, income and
consumer spending will also increase, and ultimately production and investment
will also rise.
• During this time import will increase.
• If interest rate increases which will result in foreign investment production
employment income demand and prices- this is how contraction starts in an
economy.
• During contraction import will fall.
• Non monetary factors like strikes floods earthquakes drought, war, etc cause a
partial depression but not a general depression.
• A liberal credit policy during depression may lead only to a change in the
composition of assets of bank and not helping to increase investment.
Criticism
• 1. It is an incomplete theory of business cycle, it neglets non monetary factors.
• 2. The theory gives too much importance to interest sensitivity of demand for
credit.
• 3. The theory giving undue importance to monetary policy.
• 4. Neglect the role of expectation.
• 2) Mises’s Theory of Money and Credit which was put forward by Ludwig Von
Mises in his book “The Theory of Money and Credit, 1912” .
• Mises point out that the lowering of money (market) rate of interest by the banks
is responsible for over investment in the economy.
• 3) Bohm Bawek's Theory of Capital, 1891.
• Rate of interest evolved because people prefer present over the future.
• 4) Cantillion Effect by Richard Cantillion.
• Expansionary monetary policy transfers purchasing power away from those who
hold old money to whoever gets new money.
• 5) Ricardo Effect by Hayek in 1939.
• A rise in wages encourage capitalists to substitute machinery for labour and vice
versa.
• On the basis of the above building blocks Hayek made distinction between natural
rate of interest and market rate of interest.
2) Hayek's Monetary Over-Investment Theory
• F A Hayek, Austrian Economist, "Monetary Theory and Trade Cycle” (1933).
• Monetary factors are the main cause of fluctuations in business cycle.
• The theory explains the imbalance between actual and desired investment and how
the imbalances lead to economic fluctuations.
• The theory consider over investment of the resources in the capital goods sector as
the cause of business cycle.
• Hayek's monetary over investment theory is based on five building blocks;
• 1) The first one is related with Wicksell’s Theory of the Cumulative Process where price
changes are caused by the discrepancy between the market rate and the natural
(equilibrium) rate of interest.
• According to the idea of cumulative process, if the natural rate of interest was not
equal to the market rate, demand for investment and quantity of savings would not be
equal.
• If the market rate is lower than the natural rate, an economic expansion occurs and
prices rise. The resulting inflation depresses the real interest rate and causes further
expansion and further price increases.
• Natural rate of interest- rate at which savings equal investment.
• Market rate of interest- the interest rate which actually prevails in the market.
• When market rate of interest is equal to natural rate of interest the economy is in
equilibrium and its deviation causes instability in the economy.
• Boom is the result of monetary over investment of resources in the production of
capital goods.
• Over investment results in increasing the income of factors of production.
Criticism
• 1. Not a comprehensive explanation of business fluctuations.
• 2. The theory can be applied only in the case of full employment.
• 3. The theory consider rate of interest as a sole factor which influence investment.
3) Keynesian Theory of Business Cycle
• According to Keynes, in short run level of income output for employment is
determined by the level of effective demand.
• Effective demand is determined by aggregate demand function and aggregate
supply function.
• Investment is determined by marginal efficiency of capital and rate of interest.
• In short run investment is constant and marginal efficiency of capital will
determine the level of investment.
• MEC depends upon supply price and prospective yield.
• If MEC increases investment will also increase.
• The rate of change in aggregate income is depends upon multiplier.
• K= 1/(1-MPC)
• If investment for which will cause for reducing employment income production
output demand etc.
Contra Cyclical Policy Measures
• There are three ways to control business cycle like monetary policy, fiscal policy and
income policy.
1) Monetary Policy as a Counter Cyclical Measure
• Monetary policy refers to the policy of monetary authorities to control and regulate
the demand for and supply of money with intention of ensuring price stability
unemployment reduction correct balance of payments equilibrium achieving
economic growth and so on.
Instruments of Monetary Policy
i) Quantitative or General Credit Control Measures.
• Credit control is done by Central Bank which aims at controlling aggregate demand
and aggregate supply of money.
• The main quantitative measures of credit control are following;
a. Bank rate policy
• Bank rate is the rate fixed by Central Bank at which it rediscounts first class bills of
exchange and government securities held by the commercial banks.
• During inflation bank rate will be increased and during deflation bank rate will be
reduced.
• The fall of marginal efficiency of capital is the main reason for upper turning point
of business cycle and lower turning point from a recession to recovery is due to
the rise in marginal efficiency of capital.
• Change recommended government intervention and socially controlled rate of
investment as a weapon to fight depression and unemployment.
Criticism
• 1. Does not provide a complete and satisfactory explanation of trade cycle.
• 2. Ignored the role of accelerator in business cycle.
b. Open market operations
• It refers to the sale and purchase of securities bills and bonds of government as well as
private Financial institutions by Central Bank.
• During inflation Central Bank will sell such securities and during deflation Central Bank will
purchase such securities in order to control the flow of credit.
c. Cash reserve ratio (CRR)
• It is the percentage of total deposits which commercial banks are required to maintain with
the central bank as cash reserves.
ii) Qualitative or Selective Credit Control Measures
a) fixation of margin requirements- the central bank prescribes the margin which banks and
other lenders must maintain for the loans granted by them against the commodities stocks
and shares. Raising and lowering margins can control credit availability
b) regulation of consumer credit
c) Credit rationing
d) control through directives by the central bank
e) Moral suation- request, suggestions, advice, etc
f) Publicity
g) Direct action
2) Fiscal Policy as a Counter Cyclical Measure
• Fiscal policy is the policy of government regarding taxation public expenditure
borrowing public debt and so on.
Objectives of Fiscal Policy
• 1. To maintain and achieve full employment
• 2. To stabilize the price level
• 3.b to stabilize the growth rate of the economy
• 4. To maintain equilibrium in balance of payments
• 5. To promote economic development.
• There two types of fiscal policy, expansionary fiscal policy is adopted during
recession, and contractionary fiscal policy which is adopted during boom.
Instruments of Fiscal Policy
• a) Taxation
• There are two types of taxes direct tax and indirect tax.During depression
government will reduce the tax rate and during inflation government will increase
the tax rate.
• b) Government Expenditure
• During depression government will increase the the expenditure and during
inflation government will reduce the expenditure.
• c) Public Debt
• When government precious more than it spend it is called surplus.
• When government spends more than its income it is called deficit.
• Government can borrow from both internal and external sources.
• During inflation government borrows to take away the excess purchasing power
from the public.
• During depression debt is using to fight depression and unemployment

• c) Budgetary Policy
• When government expenditure and revenue or equal it is called balanced budget
policy.
• When covered man spends more than its revenue it is called deficit budget.
• Deficit financing is fall out during depression to raise the level of income and
employment.
3) Income Policy as a Counter Cyclical Measure
• Income policy means wage and price controls in order to avoid inflationary
pressure.
• It includes all those measures through which government try to control income
wages and salaries, dividend and thus to control the prices without increasing
unemployment.
• It is adopted with the intention of ensuring economic growth and price stability.