Business Cycles

Dr. Akshay Dhume

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 Introduction
• Business Cycle refers to a period of high growth and prosperity in the
economy followed by a period of sharp economic slowdown and depression

• During the phase of prosperity, the economy experiences high growth rates
in national income – rates above potential growth rate. The economy also
experiences high growth rate in per capita income, investments and
employment. The phase is also characterized by reasonably high inflation
rates

• During the period of slowdown/recession, the economy experiences decline

in growth rates in national income, per capita income, investments and
employment. Growth rates turn negative in the period of depression with
real economic activities declining. The phase is generally accompanies with
fall in the overall price level.

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 Phases of Business Cycles
• Expansion
• Peak
• Recession
• Trough
• Recovery and Expansion

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Phases of Business Cycles (contd.)

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 Phases of Business Cycles (contd.)
• The Steady Growth Line shows potential growth of the economy with increase
in productive resources and no economic fluctuations.

• Various phases of business cycles are shown the ‘Line of Cycle’ which fluctuates
around the Steady Growth Line

• The line of cycle moving above the steady growth line marks the beginning of
period of Expansion/Prosperity in the economy.
– This phase is characterized by increase in output, employment, investment,
aggregate demand, sales, profits, bank credits, wholesale and retail prices, per
capita output and betterment of living standards

• Growth rate eventually slows and reaches a Peak.

– This phase is characterized by slackening in expansion rate, highest level of
prosperity and decline in real economic activity
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 Phases of Business Cycles (contd.)
• Recession begins when the downward trend in growth rate becomes rapid.
– Output, employment, prices level, etc. register decline, though the realized
growth rate is above the steady growth line.
– The economy enjoys period of prosperity (high/low) as long as actual growth
rate exceed or is equal to steady growth rate

• Depression in the economy begins when growth rate falls below steady growth
rate. The span of depression over the period that growth rate stays below the
steady growth rate

• Trough is a phase of depression during which downward trend in the economy

slows down and eventually stops. It is a period of most severe strain on the
economy.

• Economic activities once again register an upward movement – Recovery Phase

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Theories of Business Cycles

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 Pure Monetary Theory of Business Cycle

• Emphasis on monetary factors and credit system.

• Main cause of business fluctuations is the instability

of monetary and credit system

• Fluctuations in money supply and bank credit are

basic causal factors in cyclical process

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 Pure Monetary Theory of Business Cycle
(contd.)
• Prof. R. G. Hawtrey is the main proponent of this approach
• According to Hawtrey
– Business cycles are successive phases of inflation and
deflation
– Changes in levels of economic activities are caused by
changes in money flow
– Money Supply expands – prices rise, profits increase and
total output increases.
– Money Supply falls – prices decrease , profits decrease,
and production falls

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 Pure Monetary Theory of Business Cycle
(contd.)
• According to Hawtrey
– Principal factor affecting money supply is the volume of credit created
by banking system
– Upward swing of the cycle begins with the expansion of bank credit
and continues as long as credit expansion continues
– Bank expands credit as long as the banks find it profitable to lend to
businesses
– Availability of credit at a relatively lower interest rate induces
entrepreneurs to take up productive activities leading to capital
formation
– Bank credit continues to expand even if interest rates rise due to an
increase in profitability
– This process of credit expansion and investment leads to economic
prosperity
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 Pure Monetary Theory of Business Cycle
(contd.)
• According to Hawtrey
– Process of prosperity brought about by banking credit mechanism is
reversed when banks find it difficult to expand credit further at
prevailing rates
– Reasons for credit deficiency – depletion of excess reserves due to
• Increase in loans and advances
• Reduced inflow of deposits
• Withdrawal of deposits for quick returns and more profitable uses
– Credit expansion comes to an end – businesses cannot obtain required
bank credit at lower interest rates – leads to difficulties in meeting
obligations and maintain inventories – inventories deplete – orders for
purchase of inputs are cancelled – leads to beginning of downswing

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 Pure Monetary Theory of Business Cycle
(contd.)
• Hawtrey’s Approach – Criticism
– While monetary factors are important they are not the sole
factors that determine business cycles. Economic activities also
respond to changes in aggregate demand, demand for new
investments, changes in cost structures, etc.
– Monetary factors play an important role in accelerating the
process of expansion and contraction, but they do not fully
explain the turning points. Non-monetary factors explain
turning points better
– Monetary theorist’s conviction that businesses are highly
sensitive to the changes in interest rates is highly doubtful.
Changes in business prospects and marginal efficiency of
capital play a central role in explaining economic fluctuations
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 Over-Investment Theory
• Over time, investment varies more than that of total output of final goods and
services and consumption

• Led economists to investigate the causes of variation in investment and how it

generates business cycle

• Pioneered by Prof. Friedrich August Von Hayek (Monetary Over-Investment

Theory) and Prof. Knut Wicksell

• Hayek emphasizes role of monetary forces in causing fluctuations in

investment

• Wicksell emphasizes role of spurts in investment brought about by innovation

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Monetary Over-Investment Theory (Contd.)
• According to Hayek
– Monetary forces cause fluctuations in investments leading to business cycles
– Assume the economy is in recession
– Business’ demand for credit is low
– Lower demand for bank credit pushes down interest rate below natural rate
– Business’ will be able to borrow funds at a rate which is below the expected
rate of return in an investment project
– Induces them to invest more by undertaking new projects – investment
expenditure on new capital goods increases
– Causes investment to exceed savings by amount of newly created bank credit
– Spurt in investment leads to expansion of economy, i.e. increase in income
and employment which in turn leads to rise in consumption expenditure
– Competition between capital and consumption goods for scarce resources
leads to increase in prices which creates inflationary pressures

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Monetary Over-Investment Theory (Contd.)
• According to Hayek (contd.)
– Process of expansion cannot continue indefinitely
– Reasons
• Excess reserves with banks decline
• Banks won’t give further loans for investment at prevailing rates
– Demand for credit keeps increasing
– Interest rate increases above the natural rate of interest
– New investments become unaffordable
– Investments decline leading to decline in employment, income and
consumption
– Economy experiences downswing leading to recession
– After a lapse of some period, lower demand for credit lowers interest rate
below natural rate – promotes new investment leading to recovery of the
economy
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Monetary Over-Investment Theory (Contd.)
• Wicksell’s Over-investment Theory
– Non-monetary in nature
– Attributes fluctuations to spurts in investment caused by innovations
– Innovations or opening up of new markets make investments profitable
by either reducing costs or increasing demand
– Expansion in investment is promoted by availability of credit at lower
interest rate
– Economic expansion ceases as investment increases beyond savings
(over-investment) – savings insufficient to finance investment – leads
to contraction of the economy – leads to recession
– Another set of innovation promotes investments – leads to expansion
of the economy

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Monetary Over-Investment Theory (Contd.)

• Appraisal
– Does not offer a satisfactory explanation for frequent changes
in investment
– Presumes market interest rate less than natural rate of interest
will lead to excess supply of funds – only true under the
situation of full employment – business cycles can occur even
when resources are underemployed
– Emphasis on interest rate as main determinant of investment –
ignores factors like profit expectations, cost structures, etc.
– Undue emphasis on imbalance between investment in capital
and consumer goods – such imbalances are auto-correcting in
modern economy

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Innovation Theory of Trade Cycles
• Pioneered by Prof. Joseph A. Schumpeter
• According to Schumpeter
– Business cycles are almost exclusively the result of
innovations in the industrial and commercial organizations
– Innovations are not the same as inventions
– Innovations – commercial application of new techniques,
material, means of transportation and sources of energy
– Innovations consist of changes in methods of production
and transportation, industrial organization, nature of
product or opening of a new market or new source of
material

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Innovation Theory of Trade Cycles (Contd.)

• According to Schumpeter
– Model developed in 2 stages called first approximations
and second approximation
– First Approximation:
• Starts with economic system in equilibrium
• No involuntary unemployment
• Each firm: MC=MR and price = AC for each firm
• No incentive/disincentive to change investment
• Under equilibrium: innovation in form of improved
production technique or introduction of new product is
financed through bank credit
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Innovation Theory of Trade Cycles (Contd.)

• According to Schumpeter (Contd.)

– First Approximation (Contd.):
• With additional funds available, innovating firms bid
higher prices for inputs in order to withdraw them
from other uses
• Increased spending leads to an increase in prices
• Process accelerated when other firms imitate the
innovation and acquire additional funds from the bank
• Widespread adoption of innovation leads to flow of
goods in the market – phase of expansion gets
underway
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Innovation Theory of Trade Cycles (Contd.)
• According to Schumpeter (Contd.)
– First Approximation (Contd.):
• Beyond a certain level of output, increase in production
leads to fall in price and profitability
• Further innovations do not come quickly – no additional
demand for funds – firms repay loans – leads to contraction
in money supply – leads to fall in prices
• Process of recession begins – continues until equilibrium is
restored
– First Approximation has 2 phases
• Expansion during innovation
• Recession until equilibrium is reached
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Innovation Theory of Trade Cycles (Contd.)

• According to Schumpeter (Contd.)

– Second Approximation:
• Analyzes secondary waves that are created by waves of
first approximation
• Main element of secondary wave is speculation
• Primary wave of expansion begins
– Investors, particularly in capital goods industries,
expect upswing to be permanent
– Given this expectation, existing firms borrow heavily
– Consumer, expecting higher prices in future, go into
debt to acquire consumer durables
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Innovation Theory of Trade Cycles (Contd.)

• According to Schumpeter (Contd.)

– Second Approximation (contd.):
• Leads to heavy indebtedness – causes problems
when prices begin to fall
• Debtors find it difficult to meet obligations
• Situation leads to panic and depression
• Lower turning comes when liquidation has been
completed, debt structure is brought to order and
loss-making firms are eliminated

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Innovation Theory of Trade Cycles (Contd.)

• Criticism
– Much of the arguments are based on sociological
rather than economic behavior – difficulty in
putting theory to test
– Not very different from investment theory – differs
only in respect of cause of variation in investment
when economy is in equilibrium
– Leaves out important factors causing fluctuations –
innovation is not the sole factor that causes
economic fluctuations
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 Effects of Business Cycles
• Prosperity/Expansion Business Cycle
– Credit
• Easier for small businesses to obtain credit because banks are willing to
lend.
• More startup companies and small businesses tend to open.
• Existing businesses often use this easily accessible capital to expand
operations and hire additional workers.
– Employment
• Businesses experience increasing profits and easy access to loans -
additional employees are hired in both retail and production industries.
• Employment increasing in all sectors – businesses are now competing for
employees – phase is marked by not only low levels of unemployment but
also increases in average wages
• High levels of employment and pay leads to increased consumer
confidence and a general feeling of optimism.
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Effects of Business Cycles (Contd.)
• Prosperity/Expansion Business Cycle (Contd.)
– Increasing Demand and Profits
• High employment and high wages lead to high levels of demand
• High demand leads to greater profits – need for increased production –
businesses hire more employees
• Phase most profitable for businesses and consumers alike.
– Inflation
• Increased demand and purchasing power leads to higher prices
• High levels of employment and wages can sustain inflated prices
initially
• Eventually prices become inflated – consumers cannot afford to buy as
many products as during the height of the prosperity
• Demand drops, profits decrease, labor is laid off and credit becomes
scarce – economy moves from the prosperity to recessionary phase

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Effects of Business Cycles (Contd.)
• Recessionary Business Cycle
– Unemployment
• A fall in economic output will cause a rise in unemployment.
• Reasons
– Firms will go bankrupt meaning workers will lose their jobs
– Firms will lay off workers to try and reduce costs
– Firms will cut back on hiring new workers
– Lower wages
• Firms try to reduce costs by keeping wages low.
• Workers, especially temporary workers without contracts, may see wage
cuts
• Under-employment: Workers may keep their job, but see reduction in hours
of work – Rather than working full time, they become part-time workers –
rise in unemployment may be muted, but many workers see substantial falls
in effective income
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Effects of Business Cycles (Contd.)
• Recessionary Business Cycle (Contd.)
– Higher government borrowing
• Governments will see a fall in tax revenue as a result of a recession
– Firms make less profit – government receive lower
corporation tax
– Workers receive lower-income, therefore government receive
lower income tax
– Lower house prices and fewer housing transaction lead to
lower stamp duty revenue.
– Lower expenditure, leading to lower indirect tax collection
• Government spending
– Rising government spending on welfare programs leading to
budget deficit and total government debt.

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Effects of Business Cycles (Contd.)
• Recessionary Business Cycle (Contd.)
– Falling asset prices
• Fall in oil prices because demand falls
– Bond Yields
• Government bond yields fall because in a recession,
saving tends to rise and people tend to ‘invest’ in
bonds rather than any other security
– Investments
• A recession leads to lower investment and therefore
can damage the long-term productive capacity of the
economy
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Effects of Business Cycles (Contd.)
• Recessionary Business Cycle (Contd.)
– Impact on Workers
• Unemployment can leave lasting negative impacts
– Create stress and damage the person’s morale, and health.
– Create social instability, leading to riots and vandalism
– Mass unemployment can threaten the social fabric of the
countries
– Loss in opportunity to gain skills and on-the-job training.
– Long-term unemployment can make it harder for the worker
to gain a job in the future
– People may drop out of the labor market completely.
– Cause a rise in social/health problems such as depression and
suicide.
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Effects of Business Cycles (Contd.)
• Recessionary Business Cycle (Contd.)
– Impact on Firms
• Firms will see a fall in demand and lower profits resulting in losses and
in extreme cases bankruptcy
• Large fall in demand for luxury goods
• Price Wars – Firms often seek to hang onto market share. This leads to
aggressive price cuts, which further reduce the profitability of business.
• Cost Cutting – The impact of declining profitability means companies
will be forced to look closely at reducing costs and maybe closing
unprofitable areas of the business. Companies may be forced to lay off
staff in an effort to reduce costs
– Rise in Inequality
• In a recession, inequality and relative poverty tend to worsen as
relative poverty rises (unemployed see fall in incomes)

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Strategies During Business Cycles
• Firms
– Large investments are curtailed as firms expect lower
return on investment during recession while investments
are increased during expansionary phase
– Firms financing pattern would follower an appropriate
debt-equity mix
– Creation of large inventory should be avoided
– Diversification of product and exploration of new
markets
– Flexible pricing in order to appropriately impact demand
without incurring losses
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Strategies During Business Cycles (Contd.)

• Government
– Objectives of Policies
• Stabilization - Controlling excessive economic
fluctuations without sacrificing long-term economic
growth
• Efficient utilization of productive resources
• Encouraging competitiveness with minimum interference
– Policy Measures
• Fiscal
• Monetary

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Strategies During Business Cycles (Contd.)

• Government (Contd.)
– Fiscal Policy
• Refers to planned changes made in taxation and
public expenditure
– Counter-cyclical fiscal policy – formulated to
increase purchasing power at time of depression
and reduce purchasing power at the time of
inflation – formulated on basis of the nature of
relationship of public expenditure and output and
that between tax and output
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Strategies During Business Cycles (Contd.)
• Government (Contd.)
– Public Expenditure and GDP
• ↑ in public expenditure → ↑ in output
• Public expenditure in form of purchase of goods and services,
↑ income of household in form of wages, rent and profits
• Impact of government expenditure multiplier leads t further
rise in output/income
– Taxation and GDP
• Taxes have a deflationary impact
• ↑ in taxes → ↓ disposable income, household spending and
consequently output
• Extent of ↓ in output depends on tax multiplier

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Strategies During Business Cycles (Contd.)
• Government (Contd.)
– Counter-Cyclical Fiscal Policy
• Two Types
– Automatic Stabilization
– Discretionary Fiscal Policy and Stabilization
• Automatic Stabilization/Built-in-Flexibility
– Takes place when fiscal policy has built-in flexibility –
budgetary changes follow automatic changes in output
– Output ↓ → Income ↓ & Consumption ↓ → government revenue
↓ → expenditure > receipts → budget deficit → output ↑ →
stimulates economy during recession
– Output ↑ → Income ↑ & Consumption ↑ → government revenue
↑ → expenditure < receipts → budget surplus → output ↓ →
prevent unduly fast rate of growth
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Strategies During Business Cycles (Contd.)

• Government (Contd.)
– Counter-Cyclical Fiscal Policy
• Two Types (Contd.)
– Automatic Stabilization
– Discretionary Fiscal Policy and Stabilization
• Discretionary Fiscal Policy and Stabilization
– Change made in tax structure and in the level and
pattern of public expenditure by the government
– Policy designed to arrest inflationary and
deflationary pressures

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 Strategies During Business Cycles (Contd.)
• Government (Contd.)
– Monetary Policy
• Changes made by central bank in the total supply of money and demand
for money to achieve certain pre-determined objectives
• Monetary Policy Instruments
– Open Market Operations
» During Inflationary Pressures: Sale of government bond and
securities to public → ↓ price of securities and results in transfer
of money from public to government → ↓ credit creation
capacity of banks → monetary contraction → ↓ overall price
level
» During Recession: Purchase of government bond and securities
to public → ↑ price of securities and results in transfer of money
from government to public → ↑ credit creation capacity of banks
→ monetary expansion → real economic activity is stimulated
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Strategies During Business Cycles (Contd.)
• Government (Contd.)
– Monetary Policy (Contd.)
• Monetary Policy Instruments (Contd.)
– Bank Rate and Repurchase (Repo) Rate
» During Inflationary Pressures: Central Banks ↑ bank
rate/repo rate → cost of borrowing from central bank ↑ →
commercial banks ↑ rate to borrowing for the public →
borrowing from commercial banks ↓ → slowdown real
economic activity and inflationary pressures
» During Recession: Central Banks ↓ bank rate/repo rate →
cost of borrowing from central bank ↓ → commercial
banks ↓ rate to borrowing for the public → borrowing
from commercial banks ↑ → stimulus real economic
activity
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Strategies During Business Cycles (Contd.)
• Government (Contd.)
– Monetary Policy (Contd.)
• Monetary Policy Instruments (Contd.)
– Cash Reserve Ratio
» During Inflationary Pressures: CRR ↑ → Banks capacity to
create credit ↓ → credit availability ↓ → overall price level ↓
» During Recession: CRR ↓ → Banks capacity to create credit ↑
→ credit availability ↑ → stimulus to real economic activity
– Moral Suasion
» Persuasive method to convince commercial banks to behave
in accordance to with the requirement of the time and in the
interest of the nation

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