Comprehensive Notes on Business Cycles

Business Cycles

Introduction

  • Modern dynamic economies experience various fluctuations in business and economic activities.
  • These fluctuations are due to dynamic forces operating within the economy.
  • Fluctuations occur in investment, output, income, and employment.
  • Economic fluctuations are classified into:
    • Secular trend
    • Seasonal fluctuation
    • Cyclical fluctuation
    • Random fluctuation
  • Cyclical fluctuations, also known as business cycles, are of particular interest to economists because they create significant disturbances and their causes are not easily understood.

Meaning and Definition

  • Capitalist economies are characterized by periodic fluctuations in economic activity at relatively regular intervals.
  • Economic indicators like income, employment, output, and prices often rise or fall together.
  • Economic growth experiences ups and downs, with periods of prosperity followed by depression.
  • Booms are succeeded by slumps, and expansions by contractions.
  • These alternating periods are referred to as trade or business cycles.

Characteristics of Business Cycles

  • Business cycles are wave-like movements characterized by alternating periods of expansion (prosperity) and contraction (depression).
  • Trade cycles are repetitive and rhythmic, with prosperity followed by depression and vice versa, resembling a pendulum's movement.
  • Business cycles are economy-wide phenomena, starting in one sector (e.g., industrial) and spreading to others (e.g., agriculture, trade, transport).
  • Business cycles are self-reinforcing; movements in one direction (prosperity or depression) tend to perpetuate themselves.
  • The duration of business cycles varies, ranging from 2-4 years to 8-10 years or more.
  • The upward and downward swings of cycles can also vary in length.
  • Prices and production generally rise or fall together during business cycles.
  • Profits fluctuate more than other forms of income.
  • Capital goods industries are more susceptible to business cycles than consumer goods industries.
  • Downward movements are typically more sudden and drastic than upward movements.
  • Different trade cycles are similar but not identical.
  • Prof. Pigou stated that all recorded trade cycles belong to the same family but are not identical.

Types of Business Cycle

Classification by Prof. James Arthur:
  • Major and Minor Trade Cycles:
    • Major trade cycles have long durations.
    • Minor trade cycles occur within major cycles.
    • Prof. Hanson defines major cycles as lasting between 8 and 33 years.
    • Two to three minor cycles occur during a major cycle.
    • Minor cycles have a period of approximately 40 months.
  • Building Cycles:
    • Related to the construction industry.
    • Last between 15 and 20 years.
    • Associated with economists Warren and Pearson, who published their research in "World prices and the Building Industry" (1937).
  • Long Waves:
    • Last approximately 50 years.
    • Discovered in 1925 by Russian economist Kondratief.
    • One or two major trade cycles occur during a long wave.
Classification by Schumpeter:
  • Short Kitchin Cycle:
    • Approximately 40 months in duration.
    • Named after British economist Joseph Kitchin.
    • Kitchin distinguished between major and minor cycles in 1923, concluding that a major cycle comprises two or three minor cycles.
  • Longer Juglar Cycle:
    • Averages 9.5 years in duration.
    • Considered a major cycle.
    • Named after French economist Clement Juglar, who established the cyclical nature of business fluctuations in 1862.
  • Very Long Kondratief Wave:
    • Takes more than 50 years to complete.

Phases or Stages of a Business Cycle

  • Business cycles are characterized by alternating periods of boom and collapse.
  • These fluctuations are divided into phases:
    • Upward phase (expansion or prosperity)
    • Downward phase (contraction or depression)
  • A typical business cycle consists of five recurring phases:
    • Depression
    • Recovery or Revival
    • Prosperity or Full Employment
    • Boom
    • Recession
1. Depression
  • A state of severely falling prices and low economic activity.
  • Business activities are significantly below normal.
  • Characterized by low output and high unemployment.
  • Prices decrease.
  • Savings decline due to reduced incomes, leading to fallen investments.
  • Wages and profits decrease.
  • Demand and expenditure decrease.
  • Massive unemployment occurs.
  • Key features include:
    • Very low price levels
    • Falling production and trade volumes
    • High unemployment
    • Firms incurring losses
    • Falling interest rates, wages, and rents
    • Declining aggregate expenditure and effective demand
    • Contracting bank credit
    • Limited investment opportunities
    • Dull stock market with falling prices
    • Standstill in construction activity
    • Consumer goods industries are least affected, while capital goods industries are severely impacted.
2. Revival or Recovery
  • Depression eventually transitions into revival or recovery.
  • Economic conditions begin to improve after reaching the lowest point of depression.
  • Business and economic activity revives.
  • Revival often begins in the capital goods industries.
  • Increased demand for capital goods leads to increased investment and employment.
  • Rising employment increases income, which boosts demand for goods and services.
  • Increased demand raises prices and profits, stimulating further investment, production, income, and savings.
  • The expansion gathers momentum.
  • Key features include:
    • Slow and steady rise in prices, production, employment, and income
    • More sensitive stock market
    • Rising profit margins
    • Increasing bank loans and credit demand
    • Recovery in the agricultural sector alongside the industrial sector
    • Increased business and factor income leading to increased expenditure, further boosting income and business activity.
    • Improved business expectations and growing optimism.
3. Full Employment or Prosperity Phase
  • Optimism and increased economic activity lead to prosperity.
  • The economy fully recovers and reaches an optimum level.
  • Stability in output, wages, prices, and income.
  • Full employment of all factors of production.
  • Characterized by high capital investment, expansion of bank credit, high prices, high wages, high profits, and the formation of new businesses.
  • Key features include:
    • High levels of output and trade
    • High effective demand
    • High employment and income
    • High wages, interest rates, and profits
    • Large expansion of bank credit
    • Few business failures
    • Heavy investment in durable capital goods industries.
4. Boom or Overfull Employment
  • The peak of the business cycle.
  • Business optimism stimulates further investment.
  • Increased investment strains available resources, leading to rising wages and prices.
  • The number of jobs exceeds the available workforce, resulting in overfull employment.
  • Prices, wages, interest rates, and profits move upward.
  • Businesses borrow and invest more, further fueling the boom.
  • Over-optimism prevails, but the boom contains the seeds of its own destruction.
  • Excess demand for factors of production increases their prices.
  • Increased prices reduce consumption, ultimately leading to a downturn.
  • Key characteristics include:
    • Rising investment in production
    • Rising prices of factors of production due to high demand
    • Rising product prices (inflation)
    • Rising wages, interest rates, and profits
    • Higher output, income, and employment, leading to a rise in living standards
    • Higher purchasing power
    • Over-optimism leading to over-investment and a rising cost of living
    • End of prosperity and the beginning of recession.
5. Recession
  • Follows the boom phase.
  • Over-optimism turns into over-pessimism.
  • A transition from boom to depression.
  • Generally a short period of declining economic activities.
  • First reflected in the stock market.
  • Business confidence declines.
  • Failure of some businesses discourages fresh investments.
  • Bank loans are withdrawn, leading to a sharp contraction in bank credit.
  • Declining production leads to unemployment, initially in basic industries and then spreading to others.
  • Increased unemployment further depresses the economy by reducing income, expenditure, prices, and profits.
  • A feeling of panic prevails.
  • Uncertainty about prices slows down business activity.
  • Prof. M. W. Lee remarks that a recession, once started, tends to build upon itself like a forest fire.
  • Key characteristics include:
    • Downfall in stock exchange activities
    • Failure of some businesses creates panic
    • No new ventures are undertaken
    • Banks curtail credit
    • Business expansion stops
    • Workers are laid off
    • Unemployment rises
    • Income, expenditure, prices, profits, industrial, and trade activities all decline.

Causes of Business Cycles

  • Expansion and contraction of loans by banks
  • Monetary disequilibrium
  • Changes in the volume of investment or decreases in the marginal efficiency of capital
  • Under consumption
  • Lack of adjustment between demand and supply
  • Feelings of entrepreneurs
  • Innovation
  • Seasonal fluctuations
  • Changes in the stock of capital
  • Other factors

Level of Business Activity

  • Diagram

Causes of Business cycle

  • Expansion of loans and contraction of loans by bank
  • Monetary disequilibrium
  • Change in the volume of investment or decrease in the marginal efficiency of capital
  • Under consumption
  • Lack of adjustment between demand and supply
  • Feelings of entrepreneurs
  • Innovation
  • Seasonal fluctuations
  • Changes in the stock of capital
  • Other factors