Business Cycles

Business Cycles These are oscillations in national income or the level of aggregate output which have often been observed to follow a wave like pattern with certain measure of regularity or periodicity in terms of time, duration and sequence. Task at hand of the Experts  What factors trigger business cycles ?  How are booms and recessions caused?  How does aggregate business activity expand and reach a peak?  How does a market crash?  What generates recession and what factors determine its duration?  How does an economy recover from a trough or depression and takes an upturn?

Nature of Business Cycles These are the swings in national income, output and employment causing expansion and contraction in most of the sectors of the economy.  Cyclical patterns are neither smooth nor regular.  These cyclical patterns are observed over a long time period, most generally from 20 to 30 yrs. Samuelson Nordhaus Comments [1998] 

…….No

exact formula, such as might apply to the revolutions of the planets or of a pendulum, can be used to predict the duration and timing of business cycles. Rather, in their irregularities, business cycles more closely resemble the fluctuations of the weather…… The cycles are like mountain ranges, with different levels of hills and valleys. Some valleys are very deep and broad………..

Amplitude and Frequency Amplitude is the maximum distance by which national income deviates from the trend line.This amplitude varies as the cycle proceeds with irregular pattern. Frequency refers to the number of times the cycle repeats itself over a period of time. One cycle is completed between two consecutive peaks.

Damped & Explosive Cycles On a damped cycle, the amplitude declines and the national income eventually converges with the trend line. In explosive cycle, the amplitude increases as the cycle proceeds and the oscillations above and below the trend line become wider and wider so that the economy reaches a crisis point requiring urgent public policy intervention.

PEAK High degree of capacity utilisation [matching demand] Further increase in demand---Increased in price & not output As capacity utilisation levels are already high How output can be raised? Through new Investment---High cost of input [Due to scarcity] But what about prices? Prices are also high PROFITABILITY

CRASH  Momentum of the pick period is broken But how it is possible? External Shock  Massive withdrawal of foreign investment  Sudden increase in the price of some raw materials [crude petroleum]  A political change in the country  A natural calamity LEADING TO….. Uncertain economic conditions Rife speculation What a business men will do? WAIT & WATCH POLICY Postponement of all important decisions No expansion of emerging projects

Recession A nightmare of a Business Manager Possible consequences

Variable

Consequences

Agg. Demand

Falling

Pdn. & employment

Falling

Credit Demand Falling Competition

Rising ?

Imports

Falling

Exports

Falling

National Income Falling

Interest rate

Falling

Exchange rate

Uncertain

TROUGH & DEPRESSION  It is a lower level of economic activity  Consumer demand is abysmally low  Unemployment is high  Huge industrial excess capacity  Postponement of new business decisions What’s about its duration? It takes a long time for the economy to settle, a decade or even more [Great Depression of 1930’s] How it will be set right?

Through strong macroeconomic Policy decisions and a structural shake-up More emphasis on generation of more income avenues Switch over from heavy industry to small scale and cottage industries. RECOVERY It is a transitional stage between Trough and Expansion If sustained , leads to ………Expansion  Future expectation are positive and optimistic  Business confidence picks up momentum  Replacement of worn-out machinery  New flow of investment Is there any chance of the economy to revert back to slump? YES, THEN HOW? Misfiring of macroeconomic policy A natural calamity

EXPANSION     

Phase of Prosperity Business optimism all around Rising capacity utilisation levels Falling inventory levels Growth picks up momentum Economy approaches to full employment level

1. Increse in supply of Money/ Fall in thecash balance of the household

2. Pumping of Money

EXPANSION

5.Increased Price & Profit Margin

4.Increased Demand

3.Increased income & expenditure

5.Restriction of Bank Credit/ Multiplier Effect

1.Scarce & more Expensive Resource

2.Strained Infrastructure/ Pdn. Bottlenecks 4.Increased Factor Price/High Demand for CreditHigh Credit- Deposit Ratio

3.Increased Demand for Factors

5.Issuance of fresh Credit by Banks

1.Contractionary induces sluggish investment of business sector

2.Transaction Demand fo money goes down 4.Comfortable credit-deposit ratio

3.Credit payments are made

Multiplier-Accelerator Mechanism Accelerator: Rate of investment in an economy depends basically on the rate of change in output. High rate of growth High rate of Investment K=a.Y………..1 a [accelerator co-efficient]=capital-output ratio-depends on level of technology ∆K=a. ∆Y, where ∆ denotes change and or, I= a. ∆Y………2, where I denotes investment. If ∆Y=100 and a=4 then an investment of 400 will be caused. Accelerator-Rises and falls in aggregate demand or output produce corresponding changes in investment. Multiplier-And changes in investment, as per multiplier mechanism, produce multiplier mechanism, produce multiple changes in the level of output.

Interpretation: The combined impact of multiplier and accelerator is capable of producing significant fluctuation in an economy. Multiplier-accelerator interaction has the power to explain a complete business cycle including the cumulative nature of expansion and contraction processes, floors and ceilings and the upper and lower turning points. Floors and Ceilings [Role of Accelerator] Expansion Phase Expansion Phase---constrained factors-supply bottlenecks---escalating costs----squeezing Profit margins---slows down rate of growth of output----ACCELERATOR in action---fall in Investment in new plant & machinery---Fall in income & consumer demand----EXCESS CAPACITY---further fall in inv.-----Growth momentum broken-----------------

CEILING is hit

Floors Rapid contraction process----Deep Recession Should the economy collapse? If not why? Presence of Minimum Aggregate demand [past savings or debt] Social security measures Household Sector Expansionary fiscal policy Business Sector Investment is needed for Replace worn out capital New innovations New business opportunities This sets in the floor & the economy settles in the low-level equilibrium.

UPPER AND LOWER TURNING POINTS

Inv.

GDP3

GDP ,

Turning Points: Expansion---Contraction Contraction---Expansion

GDP1 GDP2

I

3

I1 I2 Time

Upper Turning Point: Falling rate of growth of –Income [Ceiling]—Fall in Investment [ACCELERATOR]----MULTIPLIER----Upper Turning Point -----Expansion to Contraction Trough-----replacement of Inv. demend’/Govt. expenditure [Exp. Fiscal Policy]---Multiplier----rise in Investment & Income----ACCELERATOR-----Lower turning Point -----Contraction to Expansion

Policy-Induced Cycles Recession----Govt. Expenditure, if overdose What would be the consequence? Multiplier-Accelerator Interaction High AD & Supply Constraints INFLATION Fiscal Policy Cuts in Govt.Exp If , Govt. intervention is large RECESSION Ill-timed stabilisation Policy Time gestationRole of Endogenous forces

Political Business Cycles Welfare Projects Infrastructure Projects New Public works Direct employment generation Programmes

Expansion

Imported Cyclical Fluctuations Exogenous factors and Global LINKAGES Exports Perspective FDI Perspective