ICAI Notes- Business Cycles | Business Economics for CA Foundation PDF Download

 Page 1


 
 
LEARNING OUTCOMES 
 
 
 
 
 
 
 
After studying this unit, you would be able to:  
? Explain the Meaning of Business Cycles. 
? Describe the Different Phases of Business Cycles. 
? Explain the Features of Business Cycles. 
? Explain the General Causes behind these Cycles.  
? Elucidate the relevance of Business Cycles in Business Decision 
Making. 
  
 
BUSINESS CYCLES
 
 
 
 
 
    
 
 
CHAPTER 
5 
© The Institute of Chartered Accountants of India
Page 2


 
 
LEARNING OUTCOMES 
 
 
 
 
 
 
 
After studying this unit, you would be able to:  
? Explain the Meaning of Business Cycles. 
? Describe the Different Phases of Business Cycles. 
? Explain the Features of Business Cycles. 
? Explain the General Causes behind these Cycles.  
? Elucidate the relevance of Business Cycles in Business Decision 
Making. 
  
 
BUSINESS CYCLES
 
 
 
 
 
    
 
 
CHAPTER 
5 
© The Institute of Chartered Accountants of India
1.2  
 
 
BUSINESS ECONOMICS  
 5.2 
  
 
 
5.0 INTRODUCTION 
Consider the following:  
1. During 1920s, UK saw rapid growth in Gross Domestic Product (GDP), production 
levels and living standards. The growth was fuelled by new technologies and 
production processes such as the assembly line. The economic growth also 
caused an unprecedented rise in stock market values.  
2. China’s recent economic slowdown and financial mayhem are fostering a cycle of 
decline and panic across much of the world, as countries of nearly every continent 
see escalating risks of prolonged slumps, political disruption and financial losses. 
What are these? These are examples of business cycles. The first example shows that the UK 
economy was going through boom during 1920s while the second example of the recent 
slowdown in China indicates the beginning of a recessionary phase. 
BUSINESS CYCLES
Meaning Phases
? Expansion
? Peak
? Contraction
? Trough
Features
Causes
Internal
? Fluctunations in Effective
Demand
? Fluctunations in Investment
Variations in Government
Spending
? Macro Economic Policies
? Money Supply
? Psychological Factors 
External
? War
? Post War
Reconstruction
? Technology
Shocks
? Natural Factors
? Population Growth
Relevance in Business 
Decision Making
CHAPTER OVERVIEW 
 
© The Institute of Chartered Accountants of India
Page 3


 
 
LEARNING OUTCOMES 
 
 
 
 
 
 
 
After studying this unit, you would be able to:  
? Explain the Meaning of Business Cycles. 
? Describe the Different Phases of Business Cycles. 
? Explain the Features of Business Cycles. 
? Explain the General Causes behind these Cycles.  
? Elucidate the relevance of Business Cycles in Business Decision 
Making. 
  
 
BUSINESS CYCLES
 
 
 
 
 
    
 
 
CHAPTER 
5 
© The Institute of Chartered Accountants of India
1.2  
 
 
BUSINESS ECONOMICS  
 5.2 
  
 
 
5.0 INTRODUCTION 
Consider the following:  
1. During 1920s, UK saw rapid growth in Gross Domestic Product (GDP), production 
levels and living standards. The growth was fuelled by new technologies and 
production processes such as the assembly line. The economic growth also 
caused an unprecedented rise in stock market values.  
2. China’s recent economic slowdown and financial mayhem are fostering a cycle of 
decline and panic across much of the world, as countries of nearly every continent 
see escalating risks of prolonged slumps, political disruption and financial losses. 
What are these? These are examples of business cycles. The first example shows that the UK 
economy was going through boom during 1920s while the second example of the recent 
slowdown in China indicates the beginning of a recessionary phase. 
BUSINESS CYCLES
Meaning Phases
? Expansion
? Peak
? Contraction
? Trough
Features
Causes
Internal
? Fluctunations in Effective
Demand
? Fluctunations in Investment
Variations in Government
Spending
? Macro Economic Policies
? Money Supply
? Psychological Factors 
External
? War
? Post War
Reconstruction
? Technology
Shocks
? Natural Factors
? Population Growth
Relevance in Business 
Decision Making
CHAPTER OVERVIEW 
 
© The Institute of Chartered Accountants of India
.3  1.3 
 
 5.3 
 
 
5.3 
BUSINESS CYCLES 
We have seen in chapter 1 that Economics is concerned with fluctuations in economic 
activities. The economic history of nearly all countries point towards the fact that they have 
gone through fluctuations in economic activities i.e. there have been periods of prosperity 
alternating with periods of economic downturns. These rhythmic fluctuations in aggregate 
economic activity that an economy experiences over a period of time are called business 
cycles or trade cycles. A trade cycle is composed of periods of good trade characterised by 
rising prices and low unemployment percentage, altering with periods of bad trade 
characterised by falling prices and high unemployment percentages. In other words, 
business cycle refers to alternate expansion and contraction of overall business activity as 
manifested in fluctuations in measures of aggregate economic activity, such as, gross 
national product, employment and income.  
A noteworthy characteristic of these economic fluctuations is that they are recurrent and 
occur periodically. That is, they occur again and again but not always at regular intervals, nor 
are they of the same length. It has been observed that some business cycles have been long, 
lasting for several years while others have been short ending in two to three years.   
5.1 PHASES OF BUSINESS CYCLE 
We have seen above that business cycles or the periodic booms and slumps in economic 
activities reflect the upward and downward movements in economic variables.  A typical 
business cycle has four distinct phases. These are: 
1. Expansion (also called Boom or Upswing) 
2. Peak or boom or Prosperity 
3. Contraction (also called Downswing or Recession) 
4. Trough or Depression 
The four phases of business cycle are shown in Figure 1. The broken line (marked ‘trend’) 
represents the steady growth line or the growth of the economy when there are no business 
cycles. The figure starts with ‘trough’ when the overall economic activities i.e. production 
and employment, are at the lowest level. As production and employment expand, the 
economy revives, and it moves into the expansion path. However, since expansion cannot go 
on indefinitely, after reaching the ‘peak’, the economy starts contracting. The contraction or 
downturn continues till it reaches the lowest turning point i.e. ‘trough’. However, after 
remaining at this point for some time, the economy revives again and a new cycle starts.      
© The Institute of Chartered Accountants of India
Page 4


 
 
LEARNING OUTCOMES 
 
 
 
 
 
 
 
After studying this unit, you would be able to:  
? Explain the Meaning of Business Cycles. 
? Describe the Different Phases of Business Cycles. 
? Explain the Features of Business Cycles. 
? Explain the General Causes behind these Cycles.  
? Elucidate the relevance of Business Cycles in Business Decision 
Making. 
  
 
BUSINESS CYCLES
 
 
 
 
 
    
 
 
CHAPTER 
5 
© The Institute of Chartered Accountants of India
1.2  
 
 
BUSINESS ECONOMICS  
 5.2 
  
 
 
5.0 INTRODUCTION 
Consider the following:  
1. During 1920s, UK saw rapid growth in Gross Domestic Product (GDP), production 
levels and living standards. The growth was fuelled by new technologies and 
production processes such as the assembly line. The economic growth also 
caused an unprecedented rise in stock market values.  
2. China’s recent economic slowdown and financial mayhem are fostering a cycle of 
decline and panic across much of the world, as countries of nearly every continent 
see escalating risks of prolonged slumps, political disruption and financial losses. 
What are these? These are examples of business cycles. The first example shows that the UK 
economy was going through boom during 1920s while the second example of the recent 
slowdown in China indicates the beginning of a recessionary phase. 
BUSINESS CYCLES
Meaning Phases
? Expansion
? Peak
? Contraction
? Trough
Features
Causes
Internal
? Fluctunations in Effective
Demand
? Fluctunations in Investment
Variations in Government
Spending
? Macro Economic Policies
? Money Supply
? Psychological Factors 
External
? War
? Post War
Reconstruction
? Technology
Shocks
? Natural Factors
? Population Growth
Relevance in Business 
Decision Making
CHAPTER OVERVIEW 
 
© The Institute of Chartered Accountants of India
.3  1.3 
 
 5.3 
 
 
5.3 
BUSINESS CYCLES 
We have seen in chapter 1 that Economics is concerned with fluctuations in economic 
activities. The economic history of nearly all countries point towards the fact that they have 
gone through fluctuations in economic activities i.e. there have been periods of prosperity 
alternating with periods of economic downturns. These rhythmic fluctuations in aggregate 
economic activity that an economy experiences over a period of time are called business 
cycles or trade cycles. A trade cycle is composed of periods of good trade characterised by 
rising prices and low unemployment percentage, altering with periods of bad trade 
characterised by falling prices and high unemployment percentages. In other words, 
business cycle refers to alternate expansion and contraction of overall business activity as 
manifested in fluctuations in measures of aggregate economic activity, such as, gross 
national product, employment and income.  
A noteworthy characteristic of these economic fluctuations is that they are recurrent and 
occur periodically. That is, they occur again and again but not always at regular intervals, nor 
are they of the same length. It has been observed that some business cycles have been long, 
lasting for several years while others have been short ending in two to three years.   
5.1 PHASES OF BUSINESS CYCLE 
We have seen above that business cycles or the periodic booms and slumps in economic 
activities reflect the upward and downward movements in economic variables.  A typical 
business cycle has four distinct phases. These are: 
1. Expansion (also called Boom or Upswing) 
2. Peak or boom or Prosperity 
3. Contraction (also called Downswing or Recession) 
4. Trough or Depression 
The four phases of business cycle are shown in Figure 1. The broken line (marked ‘trend’) 
represents the steady growth line or the growth of the economy when there are no business 
cycles. The figure starts with ‘trough’ when the overall economic activities i.e. production 
and employment, are at the lowest level. As production and employment expand, the 
economy revives, and it moves into the expansion path. However, since expansion cannot go 
on indefinitely, after reaching the ‘peak’, the economy starts contracting. The contraction or 
downturn continues till it reaches the lowest turning point i.e. ‘trough’. However, after 
remaining at this point for some time, the economy revives again and a new cycle starts.      
© The Institute of Chartered Accountants of India
1.4  
 
 
BUSINESS ECONOMICS  
 5.4 
 
Figure 1 Phases of Business Cycle 
? Expansion: The expansion phase is characterised by increase in national output, 
employment, aggregate demand, capital and consumer expenditure, sales, profits, 
rising stock prices and bank credit. This state continues till there is full employment 
of resources and production is at its maximum possible level using the available 
productive resources. Involuntary unemployment is almost zero and whatever 
unemployment is there is either frictional (i.e. due to change of jobs, or suspended 
work due to strikes or due to imperfect mobility of labour) or structural (i.e. 
unemployment caused due to structural changes in the economy). Prices and costs 
also tend to rise faster. Good amounts of net investment occur, and demand for all 
types of goods and services rises.  There is altogether increasing prosperity and 
people enjoy high standard of living due to high levels of consumer spending, 
business confidence, production, factor incomes, profits and investment. The growth 
rate eventually slows down and reaches its peak.  
? Peak: The term peak refers to the top or the highest point of the business cycle. In 
the later stages of expansion, inputs are difficult to find as they are short of their 
demand and therefore input prices increase. Output prices also rise rapidly leading to 
increased cost of living and greater strain on fixed income earners. Consumers begin 
to review their consumption expenditure on housing, durable goods etc. Actual 
demand stagnates. This is the end of expansion and it occurs when economic growth 
has reached a point where it will stabilize for a short time and then move in the 
reverse direction.  
 
© The Institute of Chartered Accountants of India
Page 5


 
 
LEARNING OUTCOMES 
 
 
 
 
 
 
 
After studying this unit, you would be able to:  
? Explain the Meaning of Business Cycles. 
? Describe the Different Phases of Business Cycles. 
? Explain the Features of Business Cycles. 
? Explain the General Causes behind these Cycles.  
? Elucidate the relevance of Business Cycles in Business Decision 
Making. 
  
 
BUSINESS CYCLES
 
 
 
 
 
    
 
 
CHAPTER 
5 
© The Institute of Chartered Accountants of India
1.2  
 
 
BUSINESS ECONOMICS  
 5.2 
  
 
 
5.0 INTRODUCTION 
Consider the following:  
1. During 1920s, UK saw rapid growth in Gross Domestic Product (GDP), production 
levels and living standards. The growth was fuelled by new technologies and 
production processes such as the assembly line. The economic growth also 
caused an unprecedented rise in stock market values.  
2. China’s recent economic slowdown and financial mayhem are fostering a cycle of 
decline and panic across much of the world, as countries of nearly every continent 
see escalating risks of prolonged slumps, political disruption and financial losses. 
What are these? These are examples of business cycles. The first example shows that the UK 
economy was going through boom during 1920s while the second example of the recent 
slowdown in China indicates the beginning of a recessionary phase. 
BUSINESS CYCLES
Meaning Phases
? Expansion
? Peak
? Contraction
? Trough
Features
Causes
Internal
? Fluctunations in Effective
Demand
? Fluctunations in Investment
Variations in Government
Spending
? Macro Economic Policies
? Money Supply
? Psychological Factors 
External
? War
? Post War
Reconstruction
? Technology
Shocks
? Natural Factors
? Population Growth
Relevance in Business 
Decision Making
CHAPTER OVERVIEW 
 
© The Institute of Chartered Accountants of India
.3  1.3 
 
 5.3 
 
 
5.3 
BUSINESS CYCLES 
We have seen in chapter 1 that Economics is concerned with fluctuations in economic 
activities. The economic history of nearly all countries point towards the fact that they have 
gone through fluctuations in economic activities i.e. there have been periods of prosperity 
alternating with periods of economic downturns. These rhythmic fluctuations in aggregate 
economic activity that an economy experiences over a period of time are called business 
cycles or trade cycles. A trade cycle is composed of periods of good trade characterised by 
rising prices and low unemployment percentage, altering with periods of bad trade 
characterised by falling prices and high unemployment percentages. In other words, 
business cycle refers to alternate expansion and contraction of overall business activity as 
manifested in fluctuations in measures of aggregate economic activity, such as, gross 
national product, employment and income.  
A noteworthy characteristic of these economic fluctuations is that they are recurrent and 
occur periodically. That is, they occur again and again but not always at regular intervals, nor 
are they of the same length. It has been observed that some business cycles have been long, 
lasting for several years while others have been short ending in two to three years.   
5.1 PHASES OF BUSINESS CYCLE 
We have seen above that business cycles or the periodic booms and slumps in economic 
activities reflect the upward and downward movements in economic variables.  A typical 
business cycle has four distinct phases. These are: 
1. Expansion (also called Boom or Upswing) 
2. Peak or boom or Prosperity 
3. Contraction (also called Downswing or Recession) 
4. Trough or Depression 
The four phases of business cycle are shown in Figure 1. The broken line (marked ‘trend’) 
represents the steady growth line or the growth of the economy when there are no business 
cycles. The figure starts with ‘trough’ when the overall economic activities i.e. production 
and employment, are at the lowest level. As production and employment expand, the 
economy revives, and it moves into the expansion path. However, since expansion cannot go 
on indefinitely, after reaching the ‘peak’, the economy starts contracting. The contraction or 
downturn continues till it reaches the lowest turning point i.e. ‘trough’. However, after 
remaining at this point for some time, the economy revives again and a new cycle starts.      
© The Institute of Chartered Accountants of India
1.4  
 
 
BUSINESS ECONOMICS  
 5.4 
 
Figure 1 Phases of Business Cycle 
? Expansion: The expansion phase is characterised by increase in national output, 
employment, aggregate demand, capital and consumer expenditure, sales, profits, 
rising stock prices and bank credit. This state continues till there is full employment 
of resources and production is at its maximum possible level using the available 
productive resources. Involuntary unemployment is almost zero and whatever 
unemployment is there is either frictional (i.e. due to change of jobs, or suspended 
work due to strikes or due to imperfect mobility of labour) or structural (i.e. 
unemployment caused due to structural changes in the economy). Prices and costs 
also tend to rise faster. Good amounts of net investment occur, and demand for all 
types of goods and services rises.  There is altogether increasing prosperity and 
people enjoy high standard of living due to high levels of consumer spending, 
business confidence, production, factor incomes, profits and investment. The growth 
rate eventually slows down and reaches its peak.  
? Peak: The term peak refers to the top or the highest point of the business cycle. In 
the later stages of expansion, inputs are difficult to find as they are short of their 
demand and therefore input prices increase. Output prices also rise rapidly leading to 
increased cost of living and greater strain on fixed income earners. Consumers begin 
to review their consumption expenditure on housing, durable goods etc. Actual 
demand stagnates. This is the end of expansion and it occurs when economic growth 
has reached a point where it will stabilize for a short time and then move in the 
reverse direction.  
 
© The Institute of Chartered Accountants of India
.5  1.5 
 
 5.5 
 
 
5.5 
BUSINESS CYCLES 
? Contraction: The economy cannot continue to grow endlessly. As mentioned above, 
once peak is reached, increase in demand is halted and starts decreasing in certain 
sectors. During contraction, there is fall in the levels of investment and employment. 
Producers do not instantaneously recognise the pulse of the economy and continue 
anticipating higher levels of demand, and therefore, maintain their existing levels of 
investment and production. The consequence is a discrepancy or mismatch between 
demand and supply. Supply far exceeds demand. Initially, this happens only in few 
sectors and at a slow pace, but rapidly spreads to all sectors. Producers being aware 
of the fact that they have indulged in excessive investment and over production, 
respond by holding back future investment plans, cancellation and stoppage of 
orders for equipments and all types of inputs including labour. This in turn generates 
a chain of reactions in the input markets and producers of capital goods and raw 
materials in turn respond by cancelling and curtailing their orders.  This is the turning 
point and the beginning of recession. 
 Decrease in input demand pulls input prices down; incomes of wage and interest 
earners gradually decline resulting in decreased demand for goods and services. 
Producers lower their prices in order to dispose off their inventories and for meeting 
their financial obligations. Consumers, in their turn, expect further decreases in prices 
and postpone their purchases. With reduced consumer spending, aggregate demand 
falls, generally causing fall in prices. The discrepancy between demand and supply 
gets widened further. This process gathers speed and recession becomes severe. 
Investments start declining; production and employment decline resulting in further 
decline in incomes, demand and consumption of both capital goods and consumer 
goods. Business firms become pessimistic about the future state of the economy and 
there is a fall in profit expectations which induces them to reduce investments. Bank 
credit shrinks as borrowings for investment declines, investor confidence is at its 
lowest, stock prices fall and unemployment increases despite fall in wage rates. The 
process of recession is complete and the severe contraction in the economic 
activities pushes the economy into the phase of depression.  
? Trough and Depression: Depression is the severe form of recession and is 
characterized by extremely sluggish economic activities.  During this phase of the 
business cycle, growth rate becomes negative and the level of national income and 
expenditure declines rapidly. Demand for products and services decreases, prices are 
at their lowest and decline rapidly forcing firms to shutdown several production 
facilities. Since companies are unable to sustain their work force, there is mounting 
unemployment which leaves the consumers with very little disposable income. A 
typical feature of depression is the fall in the interest rate. With lower rate of interest, 
© The Institute of Chartered Accountants of India