Business Cycle and Trade Cycle

Business Cycle / Trade Cycle

In a capitalistic system, economic activities fluctuate, experiencing periods of brisk business and sluggish activity. These ups and downs in national income, employment, and living standards are known as business cycles or trade cycles.

Definitions of Trade Cycle

Prof. Keynes: A trade cycle consists of periods of good trade with rising prices and low unemployment, alternating with periods of bad trade characterized by falling prices and high unemployment.
Prof. Hanson: A trade cycle is a fluctuation in employment, production, and prices.
Prof. Haberler: Business cycles are the names of prosperity and adversity; good trade and bad trade.
Prof. W.C. Mitchell: Trade cycles are the fluctuations in aggregate economic activity, starting from depression, entering revival, converting into boom, and finally turning into recession. Such fluctuations are common in capitalistic economies.

These definitions indicate that economies experience fluctuations, alternating between prosperity, recession, slump, and revival, completing a cycle.

Phases of the Business Cycle

There are four phases of a trade cycle:

Depression or slump
Recovery or revival
Boom or prosperity
Recession or contraction

1. Depression or Slump

Economic activities slow down significantly. Production of goods and services is very low, leading to the lowest levels of income and employment. Demand for goods and services falls, causing a decrease in the general price level. Entrepreneurs experience minimal profits or losses, leading to business closures. Banks' deposits decrease, restricting loan expansion, and firms hesitate to borrow, resulting in lower interest rates. Overall, prices, consumption, income, employment, wages, and interest rates reach their lowest points.

2. Recovery or Expansion

Following the depression, a revival phase begins due to various factors. Demand for goods starts to rise, prompting production units to increase production. Firms replace existing machinery. Employment, national income, and consumption begin to rise. Entrepreneurs become optimistic, increasing investment, leading to increased employment, production, and profits. Prices, wages, interest rates, and production gradually increase.

3. Boom or Prosperity

The recovery phase transitions into a boom or prosperity. Incomes rise, leading to increased demand for goods and services. Employment and living standards rise sharply. Production, income, and investment increase rapidly. Interest rates increase. Entrepreneurs obtain more loans from banks for investment, driven by high profits. Demand for labor increases, resulting in higher wages. Prices of goods and production costs increase. The economy surpasses full employment, with national income, individual incomes, wages, profits, prices, employment, and living standards reaching their peak.

4. Recession

During prosperity, producers maximize production, sometimes exceeding market demand. This leads to a closure of production units, causing job losses and decreased purchasing power. Entrepreneurs lower prices to sell excess goods, resulting in falling profits and potential losses. Investment decreases, and new factories are not established, while existing ones reduce production. Banks demand debt payments, further contracting investment. Recession marks the transition from prosperity to slump.

Diagram of Phases of Trade Cycle

The business activity graph illustrates the cyclical nature of boom, recession, depression and recovery. Each phase transitions into the next. Boom and depression are turning points, while recession and recovery are longer phases.

Main Characteristics of Business Cycle

Identical in Duration: Boom or depression appears in almost all industries around the same time due to interconnectedness.
International in Nature: The global economy is interconnected, so depression in one country can affect others through trade and competition.
Difference in Degree: The intensity of boom or depression may vary across different industries.
Regular Intervals: Trade cycle phases follow one another at regular intervals, typically completing in 8 to 12 years.
Difference in Ups and Downs: Recovery from depression is slow, while the transition from boom to recession is rapid.
Features of Boom and Depression: Prices, wages, interest rates, profits, incomes, production, and employment all increase during a boom and decrease during a depression.
Cause of End: The extremes of boom and depression lead to their own end. Overproduction ends the boom, and exhausted production during depression leads to recovery.
Difference in Trade Cycles: Each trade cycle is different, although they share common features.
Difference in the Duration of Trade Cycles: Duration varies. Prof. Kitchen suggests some cycles complete in 3 years and 4 months, Prof. Jugglar suggests 9 to 10 years, and Prof. Kondratieff suggests 50 to 60 years.

Theories of Business Cycles

Economists have various theories on why trade cycles occur.

1. Theory of Sun-Spot or Climatic Change

Proposed by Prof. Jevons and Henry L. Moor, this theory suggests that changes in climate and weather cause trade cycles. Sunspots affect the heat and energy reaching Earth, impacting crops and agricultural production, which in turn affects industrial production. Recession starts, and eventually spots disappear, leading to an agriculture boom and economic recovery.

Henry L. Moor suggests that rainfall variations influence agricultural and industrial production, causing economic fluctuations and trade cycles.

Criticism:

The theory doesn't explain the four phases of the trade cycle.
It neglects the economic causes of fluctuations.
Trade cycles are not solely due to climatic changes.

2. Psychological Theory

Proposed by Prof. Pigou and Bagehot, this theory suggests that business cycles occur due to the psychological behavior of businessmen, who become optimistic or pessimistic about future business prospects.

Prof. Pigou notes that waves of pessimism and optimism generated by human nature and conditions of modern business life drive trade cycles. Optimism leads to increased production and investment, causing a boom. Pessimism leads to reduced investment, causing a depression.

Criticism:

The theory doesn't explain how people become optimistic or pessimistic.
It doesn't explain all four phases of the business cycle.
It overlooks the primary role of economic factors.

3. Under Consumption or Over Saving Theory

Favored by economists like Hobson, Foster, Catchings, and Dughlas, this theory suggests that trade cycles are caused by unequal distribution of income between the rich and the poor.

Prof. Hobson suggests that the rich save more than the poor, leading to increased investment and money supply. The poor are unable to buy the produced goods, leading to overproduction and decreasing prices, resulting in a depression.

Foster and Catchings suggest that if savings and investment remain equal, equilibrium is maintained. Increased savings lead to increased production but decreased consumption, causing prices to fall and leading to depression.

Criticism:

It fails to explain the boom phase.
It doesn't account for regular intervals and international trade activities.

4. Over Investment Theory

Presented by Hayek, Mises, and Cassel, this theory suggests that business cycles occur due to overinvestment in capitalistic countries. Low interest rates lead to increased investment, which leads to a boom. Rising demand for loans causes banks to increase interest rates, which contracts investment, leading to unemployment and depression.

Criticism:

It doesn't explain the causes of expansion and contraction in investment.
The basic cause of depression is decreased demand, not abundance of consumer goods.

5. Monetary Theory

Proposed by Prof. Hawtrey and Friedman, this theory suggests that trade cycles occur due to expansion and contraction in legal and credit money. During prosperity, entrepreneurs demand loans, and banks provide them by creating credit. Low interest rates encourage business expansion, leading to increased employment and demand. Banks then increase interest rates to overcome decreased cash reserves, leading to entrepreneurs selling stocks at low prices, resulting in depression.

During depression, banks lend money at low interest rates, leading to revival or expansion.

Criticism:

It overemphasizes the role of money supply changes.
It ignores the importance of capital goods.
It cannot influence whole of the world by change in loans taking place in one country.

6. Keynes' Theory of Business Cycle

According to Keynes, trade cycles are caused by changes in investment due to changes in the marginal efficiency of capital. The rate of interest and marginal efficiency of capital determine the level of investment. Marginal efficiency of capital means the expected rate of profit by investment.

High rates of profit increase incomes, employment, and demand, leading to an economic boom. However, prices of capital goods, raw materials, and wages increase, while prices of consumer goods decrease, leading to decreased marginal efficiency of capital and decreased investment, which results in a depression.

Criticism:

This theory explains only the phase of recession and fails to explain phase of prosperity.

7. Innovation Theory

Presented by Joseph Schumpeter, this theory suggests that technical innovations bring about trade cycles. Entrepreneurs introduce new products, adopt new techniques, and discover new resources, leading to increased demand and excessive profits, which prompts other entrepreneurs to imitate and produce goods, starting a boom.

Increased supply, rising costs, and decreasing profits lead to falling investment and rising unemployment, beginning a recession.

Criticism:

It fails to explain what helps maintain effects of trade cycles for an equal period.
It is difficult to explain the role of social factors in bringing about trade cycles.

8. Modern Theory of Business Cycles or Multiplier and Accelerator Interaction

Modern economists J.R. Hicks and Prof. Samuelson explain trade cycles by the interaction of multiplier and accelerator.

Concept of Multiplier:
With the increase in investment, income increases many times and with the decrease in investment, income decreases many times. Multiplier is number of times the income changes to a given amount of investment during a specific period. For example, if the income rises to Rs. 500/ with the investment of Rs. 100/, then value of the multiplier will be 5.

Concept of Accelerator:
Investment increases many times with the increase in income and investment decreases many times with the decrease in income. Accelerator is the numerical value of the relation between the change in income and the resulting change in investment. For example, if there is an increase of 100 rupees in consumption with the 100 rupees increase in income and investment of 500 rupees is needed to meet additional consumption then accelerator will be 5.

Under the influence of multiplier, national income increases many times as a result of increase in investment. While under the influence of accelerator, consumption increases as a result of increase in national income which causes many times increase in investment.

Remedial Measures to Check Trade Cycles

Economists have suggested measures to control trade cycles.

1. Prohibitive Measures

These measures are taken to control a trade cycle before its actual occurrence. They deal with the specific causes of trade cycles. For example, providing timely irrigation facilities to farmers in an agricultural economy to combat drought and prevent depression. Also, efforts should be made to control over-production.

2. Curative Measures

These measures are taken after a trade cycle has already appeared.

(i) Monetary Policy:

Central banks control the supply of money to check inflation by increasing bank rates, selling government securities, and increasing cash reserve ratios of commercial banks. Conversely, during depression, central banks decrease bank rates, buy government securities, and decrease cash reserve ratios to increase the money supply and combat deflation.

(ii) Fiscal Measures:

Government policies of income and expenditure are called fiscal policy. Fiscal measures to control trade cycles include:

Rise and Fall in Taxes: Increase taxes during inflation and decrease taxes during deflation to manage disposable incomes and demand.
Rise and Fall in Expenditures: Increase government expenditures during depression and cut them down during inflation.
Preparation of Budget: Make a deficit budget during depression and a surplus budget during boom.

(iii) International Measures:

International measures are necessary because trade cycles in one country affect the whole world. These include:

International Production Control: Control production of agricultural and industrial goods to avoid overproduction.
International Investment Control: Advanced countries should invest in backward countries to stabilize their economies. The international organizations e.g, international monetary fund, World Bank and other international organizations provide financial aid for investment to the backward countries.