ICAI Notes- Introduction: Business Cycles - CA Foundation PDF Download

Introduction

• During the 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.
• 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 a boom during the 1920s while the second example of the recent slowdown in China indicates the beginning of a recessionary phase.
• Economics is concerned with fluctuations in economic activities. The economic history of nearly all countries points 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 percentages, altering with periods of bad trade characterised by falling prices and high unemployment percentages.
• In other words, the 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. 

Phases of Business Cycle 

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 the business cycle are shown in Figure 1. The dashed 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. Let's now discuss the different phases of business cycle in detail.

Expansion 

• The expansion phase is characterised by an 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 a 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 of 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 marks 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.

[Question: 890460]

Contraction

• An economy cannot continue to grow endlessly. 
• As mentioned above, once a peak is reached, an increase in demand is halted and starts decreasing in certain sectors. 
• During contraction, there is a 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 the 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, the 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 shut down several production facilities. 
• Since companies are unable to sustain their workforce, unemployment increases, 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, people’s demand for holding liquid money (i.e. in cash) increases. 
• Despite lower interest rates, the demand for credit declines because investors' confidence has fallen. 
• Often, it also happens that the availability of credit also falls due to possible banking or financial crisis. 
• Industries, especially capital and consumer durable goods industry, suffer from excess capacity. Large number of bankruptcies and liquidation significantly reduce the magnitude of trade and commerce. 
• At the depth of depression, all economic activities touch the bottom and the phase of trough is reached. It is a very agonizing period causing lots of distress for all. 
• The great depression of 1929-33 is still cited for the enormous misery and human sufferings it caused.

Recovery 

• The economy cannot continue to contract endlessly. 
• As it reaches the lowest level of economic activity called trough the economy starts recovering. 
• Troughs generally last for some time and marks the end of pessimism and the beginning of optimism. This reverses the process. 
• The process of reversal is initially felt in the labour market. Pervasive unemployment forces the workers to accept wages lower than the prevailing rates. 
• Producers anticipate lower costs and a better business environment. A time comes when business confidence takes off and gets better, consequently they start to invest again and to build stocks; the banking system starts expanding credit; technological advancements require fresh investments into new types of machines and capital goods; employment increases, aggregate demand picks up and prices gradually rise. 
• Besides, the price mechanism acts as a self-correcting process in a free enterprise economy. 
• The spurring of investment causes recovery of the economy. This acts as a turning point from depression to expansion. 
• As investment rises, production increases, employment improves, income improves and consumers begin to increase their expenditure. Increased spending causes increased aggregate demand and in order to fulfil the demand more, goods and services are produced. Employment of labour increases, unemployment falls and expansion takes place in the economic activity.
• It is to be reemphasized that no economy follows a perfectly timed cycle and that the business cycles are anything but regular. They vary in intensity and length. There is no set pattern which they follow. Some cycles may have longer periods of boom, others may have longer periods of depression.
• It is very difficult to predict the turning points of business cycles. Economists use changes in a variety of activities to measure the business cycle and to predict where the economy is headed towards. These are called indicators. A leading indicator is a measurable economic factor that changes before the economy starts to follow a particular pattern or trend. In other words, those variables that change before the real output changes are called ‘Leading indicators’. 
• Leading indicators often change prior to large economic adjustments. Changes in stock prices, profit margins and profits, indices such as housing, interest rates and prices are generally seen as precursors of upturns or downturns. Similarly, value of new orders for consumer goods, new orders for plant and equipment, building permits for private houses, fraction of companies reporting slower deliveries, index of consumer confidence and money growth rate are also used for tracking and forecasting changes in business cycles. 
• Leading indicators, though widely used to predict changes in the economy, are not always accurate. Even experts disagree on the timing of these so-called leading indicators. It may be weeks or months after a stock market crash before the economy begins to show signs of receding. Nevertheless, it may never happen.
• Lagging indicators reflect the economy’s historical performance and changes in these indicators are observable only after an economic trend or pattern has already occurred. In other words, variables that change after the real output changes are called ‘Lagging indicators’. 
• If leading indicators signal the onset of business cycles, lagging indicators confirm these trends. Lagging indicators consist of measures that change after an economy has entered a period of fluctuation. Some examples of lagging indicators are unemployment, corporate profits, labour cost per unit of output, interest rates, the consumer price index and commercial lending activity.
• A third type of indicator is coincident indicator. Coincident economic indicators, also called concurrent indicators, coincide or occur simultaneously with the business-cycle movements. Since they coincide fairly closely with changes in the cycle of economic activity, they describe the current state of the business cycle. In other words, these indicators give information about the rate of change of the expansion or contraction of an economy more or less at the same point of time it happens. 
• A few examples of coincident indicators are Gross Domestic Product, industrial production, inflation, personal income, retail sales and financial market trends such as stock market prices.

[Question: 890461]

Examples of Business Cycles

Great Depression of 1930 

• The world economy suffered the longest, deepest, and the most widespread depression of the 20th century during 1930s. 
• It started in the US and became worldwide. 
• The global GDP fell by around 15% between 1929 and 1932. Production, employment and income fell. Jobless people on street
• As far as the causes of Great Depression are concerned, there is difference of opinion amongst economists. 
• While British economist John Maynard Keynes regarded lower aggregate expenditures in the economy to be the cause of massive decline in income and employment.
• Monetarists opined that the Great Depression was caused by the banking crisis and low money supply. Many other economists blamed deflation, over indebtedness, lower profits and pessimism to be the main causes of Great Depression. 
• Whatever may be the cause of the depression, it caused wide spread distress in the world as production, employment, income and expenditure fell. 
• The economies of the world began recovering in 1933. Increased money supply, huge international inflow of gold, increased governments’ spending due to World War II etc., were some of the factors which helped economies slowly come out of recession and enter the phase of expansion and upturn

Information Technology bubble burst of 2000

• Information Technology (IT) bubble or Dot Com bubble roughly covered the period 1997-2000. 
• During this period, many new Internet–based companies (commonly referred as dot-com companies) were started. 
• The low interest rates in 1998–99 encouraged the start-up internet companies to borrow from the markets. Due to rapid growth of internet and seeing vast scope in this area, venture capitalists invested huge amount in these companies. 
• Due to over optimism in the market, investors were less cautious. There was a great rise in their stock prices and in general, it was noticed, that companies could cause their stock prices to increase by simply adding an "e-" prefix to their name or a ".com" to the end. 
• These companies offered their services or end products for free with the expectation that they could build enough brand awareness to charge profitable rates for their services later.
•  As a result, these companies saw high growth and a type of bubble developed. 
• The "growth over profits" mentality led some companies to engage in lavish internal spending, such as elaborate business facilities. These companies could not sustain long. 
• The collapse of the bubble took place during 1999–2001. Many dot-com companies ran out of capital and were acquired or liquidated. Nearly half of the dot –com companies were either shut down or were taken over by other companies. Stock markets crashed and slowly the economies began feeling the downturn in their economic activities.

Global Economic Crisis (2008-09)

• The recent global economic crisis owes its origin to US financial markets. 
• Following Information Technology bubble burst of 2000, the US economy went into recession. 
• In order to take the economy out of recession, the US Federal Reserve (the Central Bank of US) reduced the rate of interest. This led to large liquidity or money supply with the banks. 
• With lower interest rates, credit became cheaper and the households, even with low creditworthiness, began to buy houses in increasing numbers. 
• Increased demand for houses led to increased prices for them. 
• The rising prices of housing led both households and banks to believe that prices would continue to rise. 
• Excess liquidity with banks and availability of new financial instruments led banks to lend without checking the creditworthiness of borrowers. 
• Loans were given even to sub-prime households and also to those persons who had no income or assets. Houses were built in excess during the boom period and due to their oversupply in the market, house prices began to decline in 2006. 
• Housing bubble got burst in the second half of 2007. With fall in prices of houses which were held as mortgage, the sub - prime households started defaulting on a large scale in paying off their instalments. This caused huge losses to the banks. 
• Losses in banks and other financial institutions had a chain effect and soon the whole US economy and the world economy at large felt its impact.

Features of Business Cycles 

1. Business cycles occur periodically although they do not exhibit the same regularity. The duration of these cycles vary. The intensity of fluctuations also varies.
2. Business cycles have distinct phases of expansion, peak, contraction and trough. These phases seldom display smoothness and regularity. The length of each phase is also not definite.
3. Business cycles generally originate in free market economies. They are pervasive as well. Disturbances in one or more sectors get easily transmitted to all other sectors.
4. Although all sectors are adversely affected by business cycles, some sectors such as capital goods industries, durable consumer goods industry etc, are disproportionately affected. Moreover, compared to agricultural sector, the industrials sector is more prone to the adverse effects of trade cycles.
5. Business cycles are exceedingly complex phenomena; they do not have uniform characteristics and causes. They are caused by varying factors. Therefore, it is difficult to make an accurate prediction of trade cycles before their occurrence.
6. Repercussions of business cycles get simultaneously felt on nearly all economic variables viz. output, employment, investment, consumption, interest, trade and price levels.
7. Business cycles are contagious and are international in character. They begin in one country and mostly spread to other countries through trade relations. For example, the great depression of 1930s in the USA and Great Britain affected almost all the countries, especially the capitalist countries of the world.
8. Business cycles have serious consequences on the well being of society.