Business Cycle

Business cycle is also called Trade Cycle. The business is never steady.
There are always ups and downs in economic activity. This cyclical
movement both upwards and downwards is commonly called Trade Cycle.
This is a wave like movement in regular manner in business cycle. In
business, there are flourishing activities, which take economy to prosperity
and growth whereas there are periods when there is recession, which leads
to decline in the employment, income and output. When the economy goes
into downswing then there is a stage of recovery to reach a new boom.

According to Keynes, “Trade Cycle is composed of periods of good trade

characterized by rising price and low unemployment percentage altering
with periods of bad trade characterized by falling price and high
unemployment percentage.” In the simple words – Business Cycle is a
fluctuation of the economy characterized by periods of prosperity followed
by periods of depression.

Example:

The United States economy has experienced approximately 10 of these

boom-and-bust business cycles since 1945. They've varied in length from the
abbreviated six-month contraction that followed the five-year expansion from
1975 to 1980, to the 106-month expansion that spanned the 1960s. The
characteristics of economic cycles include:

 Fluctuations tend to affect durable manufactured goods more than

services.

 Wholesale and industrial prices tend to be affected more than retail

prices.

 Short-term interest rates track and amplify the cycles, moving in an

exaggerated manner along with the economy.
 Business cycles are also affected by seasons of the year, holidays and other
recurring events. Sunscreen, for example, sell well in spring and summer,
poorly in fall and winter. The opposite is true of coats and gloves. Less well-
known examples include fast-food outlets and other restaurants regularly
suffering sales declines in the winter and boosts in the summer, especially in
northern climes.

One of the best-known examples of the power of seasons on business is the

year-end holiday sales boom that packs half the year's sales into a few
months for many retailers. But the timing of holidays is even more sensitive
than it may appear. Holidays that don't occur on the same calendar date each
year may have different effects on business, depending on when they actually
take place.

Features of Trade Cycle

The characteristics or features of trade cycle are :-

1. Movement in Economic Activity : A trade cycle is a wave-like

movement in economic activity showing an upward trend and a
downward trend in the economy.
2. Periodical : Trade cycles occur periodically but they do not show the
same regularity.
3. Different Phases : Trade cycles have different phases such as
Prosperity, Recession, Depression and Recovery.
4. Different Types : There are minor and major trade cycles. Minor trade
cycles operate for 3-4 years, while major trade cycles operate for 4-8
years or more. Though trade cycles differ in timing, they have a common
pattern of sequential phases.
5. Duration : The duration of trade cycles may vary from a minimum of 2
years to a maximum of 12 years.
6. Dynamic : Business cycles cause changes in all sectors of the economy.
Fluctuations occur not only in production and income but also in other
variables like employment, investment, consumption, rate of interest,
price level, etc.
7. Phases are Cumulative : Expansion and contraction in a trade cycle are
cumulative, in effect, i.e. increasing or decreasing progressively.
8. Uncertainty to businessmen : There is uncertainty in the economy,
especially for the businessmen as profits fluctuate more than any other
type of income.
9. International Nature : Trade Cycles are international in character. For
e.g. Great Depression of 1930s.

Four 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 :-
Level of output

Time

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

The four phases of a business cycle are briefly explained as follows :-

1. Prosperity Phase
 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.

The features of prosperity 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.

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.

2. Recession Phase

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. Orders are cancelled and people start losing their
 jobs. 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. 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.
Innovation Theory of Business Cycle
The innovation theory of business cycle is associated with the name of
Schumpeter. His theory rests on the fluctuations in the level of investment
which is the most volatile of the determinants of the national income. He
takes into consideration bank credit but denies that his theory is a monetary
theory of business cycle.

Innovation is the most important cause of cyclical fluctuations. Had there

been no innovations, the capitalist economies would have settled down to
an economy of “circular flow” (stationary state). But innovations counter the
circular flow. Schumpeter’s theory is based on (1) entrepreneur and (2)
innovations plus the lumpiness or discontinuity of innovations.

Innovation means the introduction of (1) new product, (2) new process, (3)
new market, (4) new sources of raw material and (5) changes in the
operation of business.

In a static society with no changes in the methods of production, business

cycles could not exist. But the society is dynamic.

Its dynamic quality is derived from the operations of the entrepreneurs

whose main function is to innovate, that is to create new ways of doing
things, new products and new markets.

Every innovation increases the demand for capital and other resources.
Bank credits expand and prices rise. The process is accelerated if the
innovation is successful and a large number of new concerns are started.

This is the period of prosperity. But the forces which innovations set in
motion carry with them the seeds of their own destruction.

The innovation will substantially increase the supply of consumer’s goods

which will bring the period of expansion to an end. The increased output of
consumers’ goods will bring about a fall in prices, while factor costs would
rise due to pressure of demand for the production services.
The elimination of profits removes the impulse to further expansion. The
entrepreneurs curtail their activities, bank loans are paid off, unemployment
ensues and incomes reduced.

Thus the business cycle is the outcome of innovation. There is expansion

when innovations are being put into effect; there is contraction when
society adapts itself to the changes which innovations demand. Economic
progress is not a smooth line. It expresses itself in spurts and jerks of a
cyclical process.

Innovation engenders booms but booms are the cause of depression which
continues until readjustment required by innovation is carried through.
Schumpeter connects long waves with major innovations and short waves
with minor innovations.

Schumpeter assumes that the economy is in equilibrium (S = I), there is no

unemployment and only new firms can undertake innovations. The
upspring is a period when innovations are taking place, prices rising and
there is an outflow of new products. The Schumpeterian model starts from
an assumed equilibrium position of the economic system where every firm
is in equilibrium with its costs exactly equal to receipts.

The innovation disturbs this equilibrium. The innovator with bigger prospect
of his business turns towards banks for more funds and thus profit rates
rise.

Innovation oriented products enter the market at an increasing rate. They

compete with the old products which suffer in competition and their
producers’ revenue falls.

Forces of recession set in. The economic system finds its way back to a
new equilibrium through a period of adaptation by most of the old firms
through rationalisation and reconstruction.

The period of recession is necessary to allow the economic system to

adjust the innovations and establish a new equilibrium.
Criticism:
Schumpeter’s theory is criticised on the following grounds:

1. There are no “exceptional entrepreneurs” as such. Today innovations

and inventions are carried out by large corporations and not by any person.

2. Innovations are not sudden but gradual and in modern society

innovational shocks are less severe than in the past. Growth of big
business is the major reason for this since diversified business units can
better absorb and plan for the adjustments required by innovator.

3. There may be irregularity in the rate of innovations but there is no

discontinuity in them. History is a continuous process, so also innovations.

4. Schumpeter’s model is difficult to evaluate because there are

sociological factors in Schumpeter’s model which cannot always be tested
empirically.

Hicks’ theory of trade cycle:

Prof Hicks explains the phenomenon of trade cycles by combining the
principle of multiplier and acceleration. According to Hicks, investment is of
two types. (i) Autonomous investment and (ii) Induced investment.

Autonomous investment is independent of the variations in income, output

and consumption, while induced investment is determined by the
fluctuations in income, output and consumption.

The force of autonomous investment is expressed in multiplier while the

force of induced investment is expressed in acceleration.

Thus, according to Hicks, autonomous investment and induced investment

cause cyclical fluctuations in economic activity via multiplier and
accelerator respectively.

Let us assume that the initial equilibrium position of the economy is

disturbed by a change in autonomous investment.
This will lead to increase in income and output to the extent indicated by
the multiplier. Now this expansion of income and output will affect the
induced investment via the accelerator.

This gives rise to further expansion of income (multiplier) and investment

(accelerator) of the economy and so on.

In this way during this period of upswing, output increases faster than the
equilibrium rate. Investment also increases faster than the normal rate.

The expansion of income and output will continue till the economy reaches
the upper limit or ceiling determined by full employment.

After this ceiling, it starts declining. The rate of expansion in output and
income is slowed down to the natural rate.

This leads to decrease in the amount of induced investment. The multiplier

and accelerator forces will work in the reverse order.

A fall in investment reduces income at a faster rate and the reduced income
again reduce the level of investment and so on.

Now the level of output and income will not only reduce to the equilibrium
level but rather below it.

The reason is obvious as the multiplier and the accelerator work just in the
opposite directions. This will go on declining till it reaches the minimum
(lower) turning point.

Thus, the cycle is complete the main limitation of this theory lies in the use
of acceleration principle which the modern economists consider as a crude
tool.

This principle assumes that investment generated by a change in output is

independent of the absolute size of the change.