Business Cycle

6 June 2017

Four Phases of Business Cycle Business Cycle (or Trade Cycle) is divided into the following four phases :- 1. Prosperity Phase : Expansion or Boom or Upswing of economy. 2. Recession Phase : from prosperity to recession (upper turning point). 3. Depression Phase : Contraction or Downswing of economy. 4. Recovery Phase : from depression to prosperity (lower turning Point). The four phases of business cycles are shown in the following diagram The business cycle starts from a trough (lower point) and passes through a recovery phase followed by a period of expansion (upper turning point) and prosperity.

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After the peak point is reached there is a declining phase of recession followed by a depression. Again the business cycle continues similarly with ups and downs. Explanation of Four Phases of Business Cycle The four phases of a business cycle are briefly explained as follows :- 1 . Prosperity Phase 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 Prosperity phase. The features of prosperity are 1. High level of output and trade. 2. High level of effective demand. 3. High level of income and employment. Rising interest rates. 5. Inflation. 6. Large expansion of bank credit. 7. Overall business optimism. 8. A high level of MEC (Marginal efficiency of capital) and Investment. Due to full employment of resources, the level of production Is Maximum and there Is a rise In GNP (Gross National Product). Due toa high level of economic activity, It causes a rise In prices and profits. There Is an upswing In the economic activity and economy reaches its Peak. This is also called as a Boom Period. 2. Recession Phase The turning point from prosperity to depression is termed as 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 the 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 cancelled 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. 3. Depression Phase 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 1. Fall in volume of output and trade. 2. Fall in income and rise in unemployment. 3. Decline in consumption and demand. 4. Fall in interest rate. 5. Deflation. 6. Contraction of bank credit. 7. Overall business pessimism. 8. Fall in MEC (Marginal efficiency of capital) and investment. In depression, there is under-utilization of resources and fall in GNP (Gross National Product).

The aggregate conomic activity is at the lowest, causing a decline in prices and profits until the economy reaches its Trough (low point). 4. Recovery Phase The turning point from depression to expansion is termed as Recovery or Revival Phase. During the period of revival or recovery, there are expansions and rise 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 evival 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. Thus we see that, during the expansionary or prosperity phase, there is inflation and during the contraction or depression phase, there is a deflation. Knife Edge Instability Roy Harrod is credited with getting twentieth-century economists thinking about economic growth.

Harrod built on Keynes’s theory of income determination. The Harrod-Domar model (named for Harrod and Evsey Domar, who worked on the concept independently) is explained in Towards a Dynamic Economics, though Harrod’s first version of the idea was published in “An Essay in Dynamic Theory. ” Harrod introduced the concepts of warranted growth, natural growth, and actual growth. The warranted growth rate is the growth rate at which all saving is absorbed into investment. If, for example, people save 10 percent of their income, and the economy’s ratio of capital to output is four, the economy’s warranted growth rate is . percent (ten divided by four). This is the growth rate at which the ratio of capital to output would stay constant at four. The natural growth rate is the rate required to maintain full employment. If the labor force grows at 2 percent per year, then to maintain full employment, the economy’s annual growth rate must be 2 percent (assuming no growth in productivity). Harrod’s model identified two kinds of problems that could arise with growth rates. The first was that actual growth was determined by the rate of saving and that natural growth was determined by the growth of the labor force.

There was no necessary reason for actual growth to equal natural growth, and therefore the economy had no inherent tendency to reach full employment. This problem resulted from Harrod’s assumptions that the wage rate is fixed and that the economy must use labor and capital in the same proportions. But although they disagree about how quickly. And virtually all mainstream economists agree that the ratio of labor and capital that businesses want to use depends on wage rates and on the price of capital. Therefore, one of the main problems implied by Harrod’s model does not appear to be much of a problem after all.

The second problem implied by Harrod’s model was unstable growth. If companies adjusted investment according to what they expected about future demand, and the anticipated demand was forthcoming, warranted growth would equal actual growth. But if actual demand exceeded anticipated demand, they would have underinvested and would respond by investing further. This investment, however, would itself cause growth to rise, requiring even further investment. Result: explosive growth. The same story can be told in reverse if actual demand should fall short of anticipated demand.

The result then would be a deceleration of growth. This property of Harrod’s growth model became known as Harrod’s knife-edge. Here again, though, this uncomfortable conclusion was the result of two unrealistic assumptions made by Harrod: (1) companies naively base their investment plans only on anticipated output, and (2) investment is instantaneous. In spite of these limitations, Harrod did get economists to start thinking about the causes of growth as carefully as they had thought about other issues, and that is his greatest contribution to the field.

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