What is business cycle or trade cycle? Solved question

1-What do you mean by business cycle? Explain the phases of business cycle.

Ans:- Business cycle or trade cycle refers to the periodic fluctuations in aggregate economic activities (variables) like output, income, employment, price level etc. In other words, the frequent occurrence of prosperity after depression and depression after prosperity like the waves of water in the sea in capitalist economies is called a business cycle. The occurrence of a business cycle brings great changes in the variables like production, income, prices, employment etc. in the economy.

There are four phases of the business cycle. They are recovery, expansion or prosperity, recession and depression. These four phases are shown in the following figure and explained below.

1-Recovery:- The turning point from depression to expansion is termed as the recovery or revival phase. During the period of revival or recovery, there are expansions and rises in economic activities. When demand starts rising, production increases and this causes an increase in investment. There is a steady rise in output, income, employment, prices and profits. The businessmen gain confidence and become optimistic (Positive). This increases investments. The stimulation of investment brings about the revival or recovery of the economy. The banks expand credit, business expansion takes place and stock markets are activated. There is an increase in employment, production, income and aggregate demand, prices and profits start rising, and business expands. Revival slowly emerges into prosperity, and the business cycle is repeated.

2-Prosperity:- When there is an expansion of output, income, employment, prices and profits, there is also a rise in the standard of living. This period is termed as the Prosperity phase.

Due to full employment of resources, the level of production is Maximum and there is a rise in GNP (Gross National Product). Due to a high level of economic activities, it causes a rise in prices and profits. There is an upswing in economic activity and the economy reaches its Peak. This is also called a Boom Period.

The features of prosperity are high level of output and trade, high level of effective demand, high level of income and employment, rising interest rates, inflation, a large expansion of bank credit, overall business optimism, a high level of MEC (Marginal efficiency of capital) and investment etc.

3-Recession:- The turning point from prosperity to depression is termed the Recession Phase. During a recession period, the economic activities slow down. When demand starts falling, the overproduction and future investment plans are also given up. There is a steady decline in output, income, employment, prices and profits. The businessmen lose confidence and become pessimistic (Negative). It reduces investment. The banks and the people try to get greater liquidity, so credit also contracts. Expansion of business stops, stock market falls. Orders are canceled and people start losing their jobs. The increase in unemployment causes a sharp decline in income and aggregate demand. Generally, recession lasts for a short period.

4-Depression:- When there is a continuous decrease of output, income, employment, prices and profits, there is a fall in the standard of living and depression sets in.

The features of depression are a fall in volume of output and trade, a fall in income and rise in unemployment, a decline in consumption and demand, a fall in interest rate, deflation, a contraction of bank credit, overall business pessimism, a fall in MEC (Marginal efficiency of capital) and investment etc.

The phases of the business cycle are also shown in the following figure.

In the above figure various phases of business cycle are seen as follows.

T1 - T2 or A to B = Recovery phase,

T2 - T3 or B to C = Prosperity or expansion phase,

C = Boom,

T3 - T4 or C to D = Recession,

T4 = T5 or D to E = Depression,

E = Trough,

T5 - T6 or E to F = Recovery phase,

T6 - T7 or F to G = Prosperity and so no.

2-What do you mean by counter cyclical? Explain.

Ans: The counter cyclical measure or economic stabilization policy is the one which slackens the inflationary pressure and stimulates the recessionary pressure in the economy. Therefore, counter cyclical measures are used to attain economic stability in an economy. There are some counter cyclical or economic stabilization measures that a government adopts to run the economy fairly.

1- Fiscal policy measures

2- Monetary policy measures

1-Fiscal policy measures

Fiscal policy measures refer to the changes made in taxes and public expenditure by the government to achieve economic stabilization. These measures are categorized as below.

1- Automatic stabilization fiscal policy (Built - in - flexibility)

2- Discretionary fiscal policy

1-Automatic stabilization policy

This policy takes place when fiscal policy has "built – in – flexibility". Under this policy, budget, taxes and GDP are so arranged in such a way that a change in one variable changes the other itself and automatic stabilization takes place.

When GDP falls, income and consumption both decline. Consequently direct and indirect taxes decline but the government committed expenditure is remaining the same. Government expenditure exceeds its revenue. The budget automatically runs into deficit and the deficit budgeting automatically increases GDP. On the other hand, when GDP shoots up, tax-base income increases. Remaining the government expenditure the same, the budget runs into surplus which has a negative impact on GDP. This is how deficit and surplus resulting from fluctuation in GDP work as an automatic stabilizer of the economy.

2-Discretionary fiscal policy

Discretionary fiscal policy refers to the arbitrary changes made in taxes and public expenditure by the government to stabilize the economy. The discretionary changes are made to arrest inflationary and recessionary trends in the economy by changing the volume of aggregate demand. When inflationary pressure is high, the government pushes tax rate and cuts in its spending and on the other hand, at times of recessionary pressure, it cuts in tax rate and increases its spending. This is how the economic stabilization process is carried out through discretionary fiscal policy.

2-Monetary policy measures

Monetary policy measures refer to the change made in the quantity of money supply by the monetary authorities to achieve economic stabilization in the economy. The monetary policy measures are given below.

1- Increase in bank rate

2- Increase in cash reserve ratio

3- Open market operation

4- Increase in margin requirements

5- Selective instruments

Monetary measures are important tools used to stabilize the economy. When there is a high inflationary trend in the economy, the money supply is reduced to pull back aggregate demand by using the above measures and to control recessionary trend, the money supply is increased to stimulate aggregate demand. The monetary measures are explained as below.

1- Increase in bank rate

Bank rate is the rate at which the central bank provides loans to commercial banks. When the central bank increases its bank rate, commercial banks also push up interest rates. As a result, investors do not take more loans while depositors deposit more in banks. It causes a fall in money supply. Consequently, there is a fall in aggregate demand and also fall in inflation. Thus the expansionary trend comes under control. If there is a recessionary trend in the economy, the central bank plays just the reverse role as mentioned above.

2-Increase in cash reserve ratio

By law, the commercial banks must keep a certain portion of deposit-collection in the central bank as cash reserve. If the ratio of this cash reserve (CRR) is increased by the central bank, more cash, out of deposit, is to be kept in the central bank as cash reserve by commercial banks and the lending capacity of commercial banks fall. As a result, money supply falls and inflation comes under control. In recessionary trends, just the opposite role is played by the central bank to boost up the economy.

3-Open market operation

Under this method, the central bank sells government securities to the public. They withdraw their bank deposits and purchase government bonds and securities. This process reduces lending capacity of commercial banks and also flows, the cash with people, to the central bank. As a result, money supply falls and aggregate demand also falls. Consequently expansionary trends are checked.

4-Increase in margin requirements

Increase in margin requirement is also one of the methods to control inflation. The commercial banks provide loans against some security. While lending loans it provides fewer amounts than the current market value of the security. The difference between the market value of security and loan provided against it is the margin requirement. If the central bank fixes high margin requirements to control bank credit, money supply falls and inflation drops down along with the fall in AD.

5- Selective instruments

By quantitative measures, the monetary authorities influence the flow of credit but it may not be equally desirable in all situations. If the quantitative measures are not desirable, policy makers may adopt selective measures. The selective instruments are credit rationing, margin requirements, moral suasion and direct action.

5.1-  Credit rationing

Credit rationing refers to that policy measure in which the central bank fixes credit quotas for different business activities. In this situation, the central bank cannot grant loans to the business firm beyond the limit. Thus, the unnecessary flow of credit breaks and inflationary pressure get paused. If there is a recessionary trend, credit quota is increased and with this the flow of credit overshoots in the economy.

5.2-  Moral suasion

Sometimes, the central bank persuades or pressurizes commercial banks to flow its directions on account of credit flow. The commercial banks generally follow the directions of the central bank. So, at the time of inflationary pressure, the central bank gives direction to cut in credit flow and at recession, it directs the commercial banks to flow more credit. This is how the economy is handled by using moral suasion policy.

5.3-      Direct action

In case, the commercial banks do not follow the directions of the central bank regarding credit flow, it takes direct action against the commercial banks. It may refuse to provide loans, discounting facilities, also may penalize some extra amount. Thus, with direct action, the central bank regulates the economy.

Monetary and fiscal policies are equally important to control economic fluctuations. It is, however, always desirable to adopt a proper mix of monetary and fiscal policies to check the business cycle.