The business cycle or economic cycle refers to the ups and downs seen somewhat simultaneously in most parts of an economy. The cycle involves shifts over time between periods of relatively rapid growth of output (recovery and prosperity), alternating with periods of relative stagnation or decline (contraction or recession). These fluctuations are often measured using the real gross domestic product.
To call those alternances “cycles” is rather misleading, as they don’t tend to repeat at fairly regular time intervals. Most observers find that their lengths (from peak to peak, or from trough to trough) vary, so that cycles are not mechanical in their regularity. Since no two cycles are alike in their details, some economists dispute the existence of cycles and use the word “fluctuations” instead. Others see enough similarities between cycles that the cycle is a valid basis of studying the state of the economy. A key question is whether or not there are similar mechanisms that generate recessions and/or booms that exist in capitalist economies so that the dynamics that appear as a cycle will be seen again and again.
Just as there is no regularity in the timing of business cycles, there is no reason why cycles have to occur at all. The prevailing view among economists is that there is a level of economic activity, often referred to as full employment, at which the economy theoretically could stay forever. Full employment refers to a level of production at which all the inputs to the production process are being used, but not so intensively that they wear out, break down, or insist on higher wages and more vacations. If nothing disturbs the economy, the full-employment level of output, which naturally tends to grow as the population increases and new technologies are discovered, can be maintained forever. There is no reason why a time of full employment has to give way to either a full-fledged boom or a recession.
Business Cycle, term used in economics to designate changes in the economy. Ever since the Industrial Revolution, the level of business activity in industrialized capitalist countries has veered from high to low, taking the economy with it.
Characteristics of business cycle are:
-A trade cycle is wave like movement.
-Cyclical fluctuations are recurrent in nature.
-Expansion and contraction in a trade cycle are cumulative in effect.
-Trade cycles are all pervading in their impact.
-It is characterized by the presence of crisis i.e. downward movement is more sudden and violent than the change from downward to 0upward.
-Cycles differ in timing and amplitude they have a common pattern of phases, which are sequential in nature.
Phases Of Business Cycles:
The ups and downs in the economy are reflected by the fluctuations in aggregate economic activities such as production, investment, employment, prices, wages, bank credits etc. The various phases of the trade cycles are:
Prosperity: Expansion And Peak.
This phase begins with the rise in the national output, consumer and capital expenditure, level of employment and inventories. Debtors find it more convenient to pay off their debts. Bank rate increases so credit facilities, idle funds for investment in production since stock prices increases due to increase in profitability and dividend. Purchasing power continues to flow in and out of all kinds of economic activities. Expansion continues with the multiplier process.
In earlier/ later stages additional workers can be obtained by giving higher wage than prevailing in the market. Input prices increases rapidly which leads to increase in cost of production. As a result price increases and cost of living increases which lower the consumption rate. The demand for new houses, cement, iron, labor tends to halt and same is for furniture, automobiles etc. This makes reaching the peak. To summarize we can say that:
-It is a turning point in the business cycle – the end of expansion
-Economy at or close to full employment
-Capital and Labor Utilization at a high
-Prices and cost rise at a moderate rates
-Firms profit at high
-Interest rates rise
-Consumers and firms expectations favorable
Turning Point And Recession.
After reaching the peak, demand starts declining. Producer unaware of this fact continues to increase production and investment. But after sometime they realize that their inventories are pilling up and they have indulged in over-investment. Consequently further investment plans will be given up-order for new machinery, raw materials. Demand for labor ceases. Temporary and casual workers are removed. Producers of capital goods and raw materials cancel their order. This is the turning point and beginning of recession.
Further the income of wage and interest earners also decreases. This causes demand recession. Producer lower down the prices to get rid of inventories but consumer expects further decreases in price and hence postpones their purchase. Investments starts declining leading to decrease in income and consumption, bank credit shrink and prices decrease. At this stage the process of recession is complete and the economy enters the phase of depression. To summarize this:
-Consumer spending falls
-Investment spending falls
-Firms profit’s decline
-Business Failure increase
Depression And Trough.
This is the phase of relativity low economic activity. It indicates fall in production, increased unemployment and a rapid fall in the general price index. Workers lose their job, debtors find it difficult to pay off their debts, and investment in stock becomes less profitable. At the depth of depression, all economic activities touch the bottom and phase of trough is reached. Weaker firms are eliminated from the industry. At this point, the process of depression is complete.
Due to unemployment, labor starts working at lower wages. Consumer expects no further decline in price and start spending. Hence demand picks up. Stock prices fall during recession; the prices of raw material fall faster than the prices of the finished products. Therefore profitability tends to increase after the trough.
Producers’ start replacing worth-out capital, investment picks up and employment gradually increases. Following this demand increases, bank credit becomes easily available at a lower rate. Due to increase in income and consumption, the multiplier effect increases the economic activities. The phase of depression comes to an end over time depending on the speed of recovery. To summarize this:
-The turning point in the cycle – the end of contraction
-Characterized by high unemployment and low consumer demand relative to industry capacity
-Greatest period of excess capacity over the cycle
-Business profits are low or negative
-Some prices are falling other unchanged
-Consumers and firms expectations about future are bleak
It starts when prices further stop falling. Producers see no risk in undertaking production. Firms use idle capacity to increase production. This generates employment and income, which creates additional demand for consumer goods and services. Businessman when realize increase in profitability. Hence they speed up production machinery. Businessman starts increasing their inventories, consumer start buying more and more of durable goods and variety items. With this process catching up, the economy enters the phase of expansion and prosperity. The cycle is thus complete. To summarize this:
-Employment, production, prices and wages begin to rise at roughly the same time
-Expectations of consumers and firms optimistic or favorable
-Investment spending increases
-Consumer demand rises
Causes of Cycles.
Economists did not try to determine the causes of business cycles until the increasing severity of economic depressions became a major concern in the late 19th and early 20th centuries. Two external factors that have been suggested as possible causes are sunspots and psychological trends. The sunspot theory of the British economist William Jevons was once widely accepted. According to Jevons, sunspots affect meteorological conditions. That is, during periods of sunspots, weather conditions are often more severe. Jevons felt that sunspots affected the quantity and quality of harvested crops; thus, they affected the economy.
A psychological theory of business cycles, formulated by the British economist Arthur Pigou, states that the optimism or pessimism of business leaders may influence an economic trend. Some politicians have clearly subscribed to this theory. During the early years of the Great Depression, for instance, President Herbert Hoover tried to appear publicly optimistic about the inherent vigor of the American economy, thus hoping to stimulate an upsurge.
Several economic theories of the causes of business cycles have been developed. According to the under consumption theory, identified particularly with the British economist John Hobson, inequality of income causes economic declines. The market becomes glutted with goods because the poor cannot afford to buy, and the rich cannot consume all they can afford. Consequently, the rich accumulate savings that are not reinvested in production, because of insufficient demand for goods. This savings accumulation disrupts economic equilibrium and begins a cycle of production cutbacks.
The Austrian-American economist Joseph Schumpeter, a proponent of the innovation theory, related upswings of the business cycle to new inventions, which stimulate investment in capital-goods industries. Because new inventions are developed unevenly, business conditions must alternately be expansive and recessive.
The Austrian-born economists Friedrich von Hayek and Ludwig von Mises subscribed to the overinvestment theory. They suggested that instability is the logical consequence of expanding production to the point where less efficient resources are drawn upon. Production costs then rise, and, if these costs cannot be passed on to the consumer, the producer cuts back production and lays off workers.
A monetary theory of business cycles stresses the importance of the money supply in the economic system. Since many businesses must borrow money to operate or expand production, the availability and cost of money influence their decisions. Sir Ralph George Hawtrey suggested that changes in interest rates determine whether executives decrease or increase their capital investments, thus affecting the cycle.
Regulating the Cycle
Since the Great Depression, devices have been built into most economies to help prevent severe business declines. For instance, unemployment insurance provides most workers with some income when they are laid off. Social security and pensions paid by many organizations furnish some income to the increasing number of retired people. Although not as powerful as they once were, trade unions remain an obstacle against the cumulative wage drop that aggravated previous depressions. Schemes to support crop prices (such as the European Common Agricultural Policy) shield farmers from disastrous loss of income.
The government can also attempt direct intervention to counter a recession. There are three major techniques available: monetary policy, fiscal policy, and incomes policy. Economists differ sharply in their choice of technique
Some economists prefer monetary policy, including the American Milton Friedman and other advocates of monetarism, and is followed by most conservative governments. Monetary policy involves controlling, via the central bank, the money supply and interest rates. These determine the availability and costs of loans to businesses. Tightening the money supply theoretically helps to counteract inflation; loosening the supply helps recovery from a recession. When inflation and recession occur simultaneously–a phenomenon often called stagflation–it is difficult to know which monetary policy to apply.
Considered more effective by American economist John Kenneth Galbraith are fiscal measures, such as increased taxation of the wealthy, and an incomes policy, which seeks to hold wages and prices down to a level that reflects productivity growth. This latter policy has not had much success in the post-World War II period.
Thus we can say that the central idea of business-cycle literature, that the economy has regular and periodic waves–a cycle–lasting for several years, has few adherents today. Perhaps such cycles never existed, or perhaps they once did but no longer do because the government now plays an active role in the economy. However, the business-cycle approach remains useful because it is an easy way to introduce a number of macroeconomic topics, including the adjustment process that remains central in macroeconomics.