BUSINESS CYCLES

Dr.James Manalel Professor, SMS

BUSINESS CYCLES

Economic fluctuations or business cycles occur in every economy. fluctuations in investment, output, income, employment, prices, wages etc. Upward and downward swings: Peaks& troughs in economic activities.

Boom and decline Boom = rise in prices, incomes, wages & costs. seeds contained in each ( seeds of boom contained in decline and vice versa). Some of these movements/fluctuations are continuous, some rhythmic, some short or isolated

CLASSIFICATION

Secular Trends Seasonal Fluctuations Cyclical Fluctuations: focused* * focused because their impact is very significant) Random Fluctuations Definition: Cyclical fluctuations are wavelike changes in economic activity characterized by recurring phases of expansion and contractionone full period of such ups and downs = cycle.

Four Phases:

All are inter related & follow a regular sequence & recurrentbut no definite time period for each. Prosperity (boom): overall optimism high level of out put, Demand, employment, wages, efficiency, full capacity utilisation tempo of one industry spurs other industriesmultiplier & accelerator effects Recession : boom carries seeds of decline costs rise + bottlenecks -over optimism Depression : lowest ebb total slump Recovery : seeds in depressioncosts so low

Economic activity

prosperity recession depression

recovery

Time
PHASES OF TRADE CYCLE
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Features of Trade Cycle

1. 2.

3.
4.

5.

Prices and Production move in same direction Expenditure on capital and durable goods fluctuate more sharply than consumption goods. Current expenditures on inventories fluctuate widely. Velocity of money varies directly with changes in total output and employment. Incomes generated from profits fluctuate more than the incomes generated from other sources.
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Theories of Trade Cycles

Many theories trying to explain trade or business cycles Business cycle is a complex phenomenon. Hence, not due to any single cause, but a host of factorsexogenous & endogenous.

Theories of Trade Cycles:

1. 2. 3. 4. 5.

6.

Climatic Theory: Sunspot theory like climatic cycles Psychological theory: Mill, Pigou etc. Optimism/pessimism is mood/sentiment Under-consumption theory (over-saving) (J.A. Hobson, Major Douglas) Monetary theory (R.G.Hawtrey) due to bank credit/money supply Over-Investment Theory (F.A.Hayek) boom occurs when there is over investment Keynes theory (Marginal Efficiency of Capital)
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Keynes theory (Marginal Efficiency of Capital):

General Theory of Employment Interest and Money -- Great Depression of 1930 --book in 1936. Fluctuations in economic activities are due to fluctuations in rate of investment due to fluctuations in MEC affects expected rate of profit in new investments

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General Observations on different theories

Due to so many factors How to identify the various phases of a business cycle and what remedial action to take: indicators : a basket of them Diffusion Index

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Business Policy/Strategy
What remedy? *** Economic stabilization is one of the main remedies Attain full employmentto maintain price stability. *** Tools used for this : Monetary and Fiscal Policy Instruments.

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MONETARY POLICY

Central Banks policy relating to the control of the availability, cost and use of money and credit, with the help of monetary measures ( instruments ) in order to achieve specific goals.

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Objectives of MP:

Manifold & all of them need not be mutually consistent and so prioritise. 1. Neutrality of Money: qty of money kept constant 2. Exchange Rate Stability (Int trade &confidence..FDI) 3. Price Stability: (but price incentive) 4. Full Employment: excess of saving over investment (so long as unemployed resources) 5. Economic Growth: growth with stability
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Efficacy of MP:
I II III IV

Bank Rate Policy Open Market Operations CRR Selective Credit Controls (Qualitative) V Moral Suasion: meetings of CEOs VI Direct Action: punishments-- DCP

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Bank Rate Policy

Rate at which RBI (Central Bank) makes advances (rediscounts eligible bills) to member com.banks (lender of last resort) Pace-setter of all interest rates Cost of credit By Changing the list of eligible securities for refinance (quantity) Now 6% (has varied from 3-12%) Mechanism But its success depends on a number of factors.

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Repo Rates
Whenever

the banks have any shortage of funds they can borrow it from RBI. Repo rate is the rate at which our banks borrow rupees from RBI. A reduction in the repo rate will help banks to get money at a cheaper rate. When the repo rate increases borrowing from RBI becomes more expensive
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Repo Rates
Repos = repurchase agreements Are contracts for sale and future repurchase of a financial asset, most often treasury securities On termination date, the seller repurchases the asset at the same price he sold it and pays interest for the use of the funds.

Repo is thus a ST interest bearing collateral loan.

The annualised rate of interest paid is = repo rate

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Use of Repos

Widely used to invest surplus funds for ST or for borrowing for ST against collateral. Dealers in securities use repos to manage their liquidity, finance their inventories, and for speculation Central Banks use repos to manage the aggregate reserves of the banking system. Present rates (Oct.2011): repo = 8.5% reverse repo = 7.5%
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Reverse Repo

Reverse Repo rate is the rate at which Reserve Bank of India (RBI) borrows money from banks. Banks are always happy to lend money to RBI since their money are in safe hands with a good interest. An increase in Reverse repo rate can cause the banks to transfer more funds to RBI due to this attractive interest rates. It can cause the money to be drawn out of the banking system.

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Repo/reverse repo rates andthe Liquidity Adjustment Facility (LAF)

Liquidity Adjustment Facility (LAF): Consists of daily infusion or absorption of liquidity on a repurchase basis, through repo (liquidity injection) and reverse repo (liquidity absorption) auction operations, using government securities as collateral. The LAF is operated through overnight fixed rate repo and reverse repo from November 2004.

Marginal Standing Facility (MSF)

a new Marginal Standing Facility (MSF) was instituted On 3rd May 2011 under which scheduled commercial banks (SCBs) could borrow overnight at their discretion up to one per cent of their respective NDTL at 100 basis points above the repo rate. The announcement of an explicit operating target, institution of an independently varying single policy rate and an interest rate corridor set by MSF and reverse repo will all improve the implementation of monetary policy in India.

The new operating procedure of monetary policy

Open Market Operations

Purchase and Sale of securities by the Central Bank Mechanism

availability of credit Affects Changes in prices of Govt Securitiesyieldinterest rates Not very popular in India (used esp in the late 90s) Now MSS (market stabilisation scheme) selling govt securities (short-dated government securities and treasury bills) to absorb the excess liquidity due to RBIs forex transactions.
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Cash Reserve Ratio

Very effective RBI can vary it from 3-15% Now no floor or ceiling level Liquidity position of banks immediately affected. Now 6%

SLR now 24%

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Selective Credit Controls

1. 2. 3. 4.

Qualitative credit control Influences the purpose/end use of credit Techniques: Fixing minimum margins for lending against specific securities Ceiling on amount of credit for certain purposes Discriminating rates of interest on certain types of advances. Directed credit programmes & priority sector lending targets.
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Moral Suasion

Meetings called of bank chairmen & explained about the rationale of Govts MP & SCC and co-operation asked

Periodic letters & circulars Very powerful

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Direct Action
Punishing errant banks Prohibiting from further lending Canceling licenses Directed Credit Programmes: Priority sector lending

CAS/CMA Tandon Committee/Chore for WC loans

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FISCAL POLICY
More direct impact in India Along with Monetary Policy

Refers to Govt spending, taxation, borrowing & debt management.

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Fiscal Policy

Policy of Govt relating to public revenue, public expenditure and public debt.

Implemented THROUGH: State Budget 1. Govt. spending and Public Debt Management 2. Taxes and Duties
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Objectives of Fiscal Policy

1. 2.

3.
4.

Strike a balance between govt revenue, expenditure, and borrowings Attain best possible level of economic development Achieve full employment Reduce inequality of income and wealth

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Tools of Fiscal Policy

Taxation Public expenditure Public debt Deficit financing Budget announcements

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To fight deflation:

increased public spending + more tax concessions + deficit financing

-- leading to expansion in aggregate economic activity. -- has both multiplier & accelerator impact. -- increase in consumption expenditures & consequent demand. -- increase in investment exp (accelerator effect).

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To fight inflation:
Pump priming reduce public spending: on public services, and infrastructure disincentives (increase taxation etc)

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Fiscal Policy has 2 important roles:

1.

Mobilisation of resources for development Ensure efficiency in resource allocation.

2.

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BOTH ARE NEEDED

Fiscal Policies affect the purchasing power in the hands of the public (DEMAND SIDE) while MP affects cost and availability of credit (SUPPLY SIDE). FP also brings about the required structural changes in economy and fixes national priorities.

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