3.

Economic performance and business cycle

3.1. Economic Performance (Economic Growth)
3.2. Business Cycle
3.2.1.Definition and Concepts
3.2. 2. Types of business cycle
3.2.3.Theories of business cycle
3.2.4. Phases of business cycle
3.2.5. Causes and Effects of business cycle
3.2.6.Measures to control business cycle
3. Economic Performance and Business Cycle
3.1. Definition and Concepts of Business Cycle
3.2. Phases of Business Cycle
3.3. Causes and Effects of business cycle
3.4. Theories of business cycle
3.4.1. Keynesian theory
3.4.2. Monetarist Theory of Business Cycle
3.4.3. Rational Expectation Theory
3.4.4. Real Business Cycle Theory (RBC)
3.4.5. Political Business Cycle
 3.1. Definition and Concepts
Macroeconomic objectives: The major macroeconomic objectives
are:
 To boost economic growth
 To stabilize the business cycle (fluctuation)
 To reduce unemployment
 To keep inflation low
 To reduce both governmental and international deficits.
 3.1. Economic Growth versus Development
 Economic growth is the growth rate of the real GDP.
 It also is the expansion of the economy’s production.
 It can be pictured as an outward shift of PPC.
 Many people use economic growth and economic development
interchangeably.
 However, economic development or development is
multidimensional, which includes
1. Economic growth,
2. Social development (employment rate, health, education, social
justice, etc),
3. Political freedom and
4. Environmental safety.
 Types of GDP
1) Nominal GDP:- is the value of all final goods and
service valued at current year price
2) Real GDP: - is the value of all final goods and
services valued at base year price.
3) Potential GDP: is the GDP at full employment of
resources.
 We use a base year price to remove the effect of
change in price and to see the real change.
 Example: take 2010 & 2013 hypothetical data as follow

Commodity 2010 2013 Real value 2013

P Q value P Q value
A 10 100 1000 20 120 2400 1200=120x10
B 50 50 2500 60 50 3000 2500=50x50
GDP 3500 5400 3700=Real GDP

GDP2013  GDP2010 5400  3500

Nominal economic growth rate    0.543  54.3%
GDP2010 3500
Real GDP2013  GDP2010 3700  3500
Real economic growth rate  *100%  *100%  5.71%
GDP2010 3500
 The real economic growth here is due to quantity of product of
country increased in 2013.
 However, economic growth change may be due to quality
improvement.
 It helps to compare one country’s welfare with the other country’s
welfare at a point in time
 It also helps to see whether one country’s welfare is improving
overtime
Country Year Real GDP Real Population Population (GDP) (GDP) per
(million) economic (million) growth (%) per Capita
Growth (%) capita growth (%)

USA 1999 9179401 5.25 278.7 1.2 32936.5 4.00

2000 9661320 282 34260
Korea 1999 384581 8.89 46.5 1.1 8270.6 7.7
2000 418770 47.00 8910
Ethiopia 1999 6080 5.263 62.14 3.0 97.84 2.21
2000 6400 64 100

 Ethiopia could not catch up USA on this 2.2 real GDP per capita growth while
Korea has the probability to catch up USA since it has real GDP per capita growth
of 7.7 which is greater than USA .
 3.2. Business cycle
3.2.1.Definition and Concepts
1. Keynes
 “A trade cycle is composed of periods of goods trade
characterized by rising prices and low redundancy percentages.”

2. Gordon
 “Business Cycles consist of recurring alteration of expansion and
contraction in aggregate economic activity, the alternating
movements in each direction being self reinforcing and pervading
virtually all parts of the economy.”
 3.2.1.Definition and Concepts
3. Estey:-
 “Cyclical fluctuations are characterized by altering waves of expansion and
contractions.
 They do not have a fixed rhythm they are cycles of contraction and expansion
recur frequently and in fairly similar patterns.”
 An important point:-” no cycle in perfect regular with uniform frequency

 Thus, business cycles are recurrent fluctuations in aggregate

employment, income, and output and price level.
Business cycle
To relate business cycle with economic growth, we have to see
potential GDP.
 Potential GDP: is the GDP at full employment of resources.
 Business cycle: is an irregular up and downs of real GDP around
potential GDP.
 It is simply fluctuations of the real GDP around potential GDP.
 It has two things in common.
These are four phases
1. Expansion (Recovery & prosperity)
2. Contraction (Recession & depression)
There are two turning points
1. A peak
2. A through
 3.2.3. Phases of Business Cycle
Business Cycle (or Trade Cycle) is divided into the following four
phases:

1. Prosperity Phase: Expansion or Boom or Upswing of economy.

2. Recession Phase: from prosperity to recession (upper turning

point).

3. Depression Phase: Contraction or Downswing of economy.

4. Recovery Phase: from depression to prosperity (lower turning

Point).
 Diagram of Four Phases of Business Cycle
 The four phases of business cycles are shown in the following diagram: the X and Y
represents the time and GDP(PGDP & RGDP), respectively.
Business cycle
GDP

Real GDP

A2 A3 Potential GDP

A1
B3
B2

B1
Time

Figure . Business cycle

 Points: A1, A2 & A3 are peak & Points: B1, B2 & B3 are
through
Phases of Business Cycle-contd..

 The business cycle starts from a trough (lower point) and

passes through a recovery phase followed by a period of
expansion (upper turning point) and prosperity.
 After the peak point is reached there is a declining phase
of recession followed by a depression.
 Again the business cycle continues similarly with ups and
downs.
 Explanation of Four Phases of Business Cycle
1. The features of prosperity Phase are:
1. High level of output and trade.
2. High level of effective demand.
3. High level of income and employment.
4. Rising interest rates.
5. Inflation.
6. Large expansion of bank credit.
7. Overall business optimism.
8. A high level of MEC (Marginal efficiency of
capital) and investment.
1. Prosperity Phase-contd…
 When there is an expansion of output, income,
employment, prices and profits, there is also a
rise in the standard of living.
 This period is termed as Prosperity phase.
 Due to full employment of resources, the level of
production is Maximum and there is a rise
in GNP (Gross National Product).
 Due to a high level of economic activity, it causes a
rise in prices and profits.
 There is an upswing in the economic activity and
economy reaches its Peak.
 This is also called as a Boom Period.
 Contraction/recession
During a period of contraction:
 Businesses cut back production and layoff people
 Unemployment increases
 Number of jobs decline
 People are pessimistic (negative) and stop spending money
 Banks stop lending money

 A prolonged contraction is called a recession

(contraction for over 6 months)
 A recession of more than one year is called a depression.
Recession-contd…
 The turning point from prosperity to depression is termed as Recession Phase.
 During a recession period, the economic activities slow down.
 When demand starts falling, the overproduction and future investment plans are
also given up.
 There is a steady decline in the output, income, employment, prices and profits.
 The businessmen lose confidence and become pessimistic (Negative).
 It reduces investment.
 The banks and the people try to get greater liquidity, so credit also contracts.
 Expansion of business stops, stock market falls.
 The increase in unemployment causes a sharp decline in income and aggregate
demand.
 Generally, recession lasts for a short period.
 3. Depression Phase
 When there is a continuous decrease of output, income,
employment, prices and profits, there is a fall in the standard of
living and depression sets in. The features of depression are:
1. Fall in volume of output and trade.
2. Fall in income and rise in unemployment.
3. Decline in consumption and demand.
4. Fall in interest rate.
5. Deflation.
6. Contraction of bank credit.
7. Overall business pessimism.
8. Fall in MEC (Marginal efficiency of capital) and investment.
 In depression, there is under-utilization of resources and fall in
GNP (Gross National Product).
 The aggregate economic activity is at the lowest, causing a
decline in prices and profits until the economy reaches
its Trough (low point).
 4. Recovery Phase
The turning point from depression to expansion is termed as
Recovery or Revival Phase.
 During the period of revival or recovery, there are expansions and
rise in economic activities.
 When demand starts rising, production increases and this causes
an increase in investment.
 There is a steady rise in output, income, employment, prices and
profits.
 The businessmen gain confidence and become optimistic
(Positive).
 This increases investments.
 4. Recovery Phase-contd…
 The stimulation of investment brings about the revival or
recovery of the economy.
 The banks expand credit, business expansion takes place and
stock markets are activated.
 There is an increase in employment, production, income and
aggregate demand, prices and profits start rising, and business
expands.
 Revival slowly emerges into prosperity, and the business cycle
is repeated.
 Thus, we see that, during the expansionary or prosperity phase,
there is inflation and during the contraction or depression phase,
there is a deflation.
 Turning Points:-peak and trough
 There are two turning points: The business cycle is
characterized by two turning points namely peaks and
troughs ;and four phases.
Peak
 The peak is the highest level of real GDP in the cycle.
 Each peak indicates an economy operating at close to full
capacity, so that national product and national income
corresponds to a very high degree of utilization of labor,
factories and offices.
 During a peak of the cycle, there are likely to be shortage of
labor, parts and materials in certain markets.
 Peak
 When the economic cycle peaks:
The economy stops growing
(reached the top)
GDP reaches maximum
Businesses can’t produce any more
or hire more people
Cycle begins to contract
 Through
 A trough is the lowest level of GDP observed over the
business cycle.
 A trough is reached when the economy begins to pull out
of recession.
 During this time there is an excessive amount of
unemployment and idle productive capacity.
 Businesses are more likely to fail because of low demand
for their products.
 When the economic cycle reaches a trough:
 Economy “bottoms-out” (reaches lowest point)
 High unemployment and low spending
 Stock prices drop

But, when we hit bottom, no where to go but up!

UNLESS….
 Business
Business Cycle-one
Cycle-one cycle
cycle through
through 44 phases
phases
Real GDP

Peak Peak
per year

ry
ve
Re

co
ce

Re
ss
io
n

Trough

One cycle Time

 Characteristic of Business Cycle
From the definitions given above we can gather the features
of business cycle.
(i) It occurs periodically:
 It occurs periodically in a regular fashion.
 This means the prosperity will be occurring alternatively.

(ii) It is all embracing:

 prosperity or depression effect of the phase will be
affecting all industries in the entire economy and also
affecting the economies of other countries.
 It is international in character.
 The Great Depression of 1929 is an example of this.
 Characteristic of Business Cycle-contd….
(iii) It is wave-like:
 It will have a set pattern of movements which is analogous to
waves.
 Rising prices, production, employment and prosperity will become
the features of upward movement: Falling prices, employment will
become the features of the downward movement.
 (iv) The process is cumulative and self-reinforcing:
 The upward movement and downward movement are cumulative in
their process.
 When once the upward movement starts, it creates further
movement in the same direction by feeding on itself.
 This momentum will persist till the forces accumulate to alter the
direction and create the downward movement.
 When downward movement starts, it persists in the same direction
leading to the worst depression and stagnation till it is retrieved to
gain an upward movement.
Characteristic of Business Cycle-contd….
(v) The cycles will be similar but not identical:
identical
 Different cycles and waves in the business cycles will be
similar in general feature, but they are not identical in all
respects.
 “A typical cycle constructed by making, as it is where, a
composite photograph of all the recorded cycles would not
materially differ in form varies widely from any one of them.
 But this typical cycle is not an exact replica of any individual
cycle.
 The rhythm is rough and imperfect.
 All the recorded cycles are members of the same family, about
among them are no twins”.
 Causes of Business Cycle-external vs internal factors

1. Interest rates. Changes in the interest rate affect consumer

spending and economic growth.

2. Consumer and business confidence. People are easily

influenced by external events. Economic growth encourages
consumers to borrow and banks to lend.

3. Multiplier effect:-The multiplier effect states that a fall in

injections may cause a bigger final fall in real GDP. This theory
suggests investment is quite volatile and small changes in the
rate of growth have a big effect on investment levels.

4. Inventory cycle. Some argue that there is a natural inventory

cycle.
5. Changes in house prices. A rise in house prices creates a
wealth effect and leads to higher consumer spending while
fall in house prices causes lower consumer spending and
bank losses.
6. Accelerator effect:- This states that investment depends
on the rate of change of economic growth.
This theory suggests investment is quite volatile and small
changes in the rate of growth have a big effect on
investment levels.
 3.2. 2.Types of business cycle
1. The Short Kitchin Cycle
 It also called the minor cycle which is of just
about forty five months gap.
 It is well-known after the name of British
economist Joseph Kitchin who made a
difference among a major and a minor cycle
year nineteen twenty three.
three
 He came to the termination on the basic of his
research that a major cycle is composed of two
or three minor cycles of forty five months.
 2. The Long Jugler Cycle
 This cycle is also termed as the major
cycle.
 It is defined “as the fluctuation of business
presentation among successive crises.”
 Clement Jugler, French economist
presented those periods of prosperity,
crisis and liquidation adopted each other
always in the same order.
 Later economists have come to the end that
a Jugler cycle’s duration is on the
average nine and a half years.
3. The Very Long Kondratieff
 N.D.Kondratieff, the Russian economist
came to the conclusion that there are
longer waves of cycles of more than fifty
years duration made of six Jugler cycles.
 A very long cycle has come to be known
as the Kondratieff wave.
 4. Building Cycles
 another type of cycle associates to the
construction of buildings which is of fairly
regular duration.
 Its duration is twofold that of the major
cycles and is on average of eighteen
years duration.
 Such cycles are related with the names of
Warren and Pearson.
 5. Kuznets Cycle
 Simon Kuznets propounded a new type of
cycle the secular swing of sixteen to
twenty two years
 which is so propounded that it dwarfs the
seven to eleven years cycle into
associated insignificance.
 This has come to be known as the Kuznets
cycle.
 3.6. Effects/Impact of Business Cycle on Economy
 A volatile business cycle is considered bad for the
economy.
 A period of economic boom (rapid growth in
economy) invariably leads to inflation with various
economic costs.
 This inflationary growth tends to be unsustainable
and leads to a bust (recession).
 The biggest problem of the business cycle is that
recessions represent a large wastage of
resources.
 A prolonged period of unemployment can also lead
to a loss of labor productivity as workers get
discouraged and leave the labor market.
Effects/Impact of Business Cycle on Economy-contd…
 Monetary authorities tend to try and minimize fluctuations
in the business cycle through interest rate and money
supply.
 They seek to avoid inflation and avoid a recession.
 The government may also use fiscal policy.
 In a recession, the government could try increasing
government spending and cutting tax.
 Some economists argue that the business cycle is an
essential part of an economy.
 Even downturns have their role to play as it tends to
‘shakeup’ the economy and weed out ‘inefficient’ firms and
creating greater incentives to cut costs and be efficient.
 However, this view is controversial and other economists
argue that in a recession, even ‘good efficient’ firms can
go out of business leading to a permanent loss of
productive capacity
Theory Of Business Cycle
There are many types of trade theories namely :
 Climate or sun spot theory
 Over-investment theory
 The psychological theory
 Keynes theory
 Innovation theory
 Monitory theory
 Over production theory
Q. Discuss each of the theory
 Measures to control business cycle
The 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
 Monetary Policy
 Control money and credit supply
 Inflation-adopt deflationary policy-CB reduce
Money supply (increase in the bank rate, selling of
securities in the market, increasing the reserve
ratio of the member banks etc.)
 Deflation-CB 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 CB 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.
 Fiscal Policy
 nowadays is considered to be a powerful anti-
cycle weapon in the hands of the government.
 involves the process of shaping the public finance
(income and expenditure) with a view of reduce
fluctuations in the business cycle and attainment
of full employment without inflation.
 Inflation-adopt a reduction of G and/or increasing
of tax
 Deflation (depression)-adopt increasing of G
and/or reduction of tax
 State Control of Private Investment
 Some economists have suggested that if a government
takes control of private investment, it is a tool to control of
business cycle fluctuations can be controlled within the
limits.
 Government should control PI within a certain 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.
 No government intervention
 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.
 International Measures to Control of Business Cycle
Fluctuation

 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. E.g. great
depression
 Business cycle:-is an international phenomenon
 it should be tackled on international level.
 The different measures are:
1. Control of International Production
2. International Bill Stock Control
3. International Investment Control
 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. Great depression
 Recessions since 1950 show that duration and
depth are varied:
Period Duration in months Depth
(decline in real GDP)

1953-54 10 — 3.0%
1957-58 8 — 3.5%
1960-61 10 — 1.0%
1969-70 11 — 1.1%
1973-75 16 — 4.3%
1980 6 — 3.4%
1981-82 16 — 2.6%
1990-91 8 — 2.6%
2001 8 app. —3.3%
Causes
Causes of
of Fluctuations
Fluctuations
Innovation
Political events
Random events
Wars
Level of consumer spending
Seasonal fluctuations
Cyclical Impacts — durable and non durable
The Great Depression
The Great Depression [continued]
Great Depression Stats
Global Depression, 1929-1932

Ave. Unemployment Rate, 1925-1928

Ave. Unemployment Rate, 1929-1933

Percent Decrease in Prices, 1929-1932

 Six Million “Rosie the Riveters”
World War II Production of these items brought us out
of the Great Depression.
300,000 warplanes
124,000 ships
289,000 combat vehicles and tanks
36 billion yards of cotton goods
41 billion rounds of ammunition
2.4 million military trucks
111,527 tank guns and howitzers
•$288 billion was spent on the war,
•$100 billion in the first six months.
Unemployment hit an all-time low of 1.2%
and personal savings were 25.5%.