Business Cycle: Meaning and Phases of a Business Cycle

Q. What is a Business Cycle ? Describe various phases of a Business Cycle. 

Ans. Meaning of Business Cycle: Every country witnesses boom and depression periodically. Depression is characterised by falling production, falling prices, and rise in unemployment. On the other hand, boom is characterised by rising production, rising prices and high employment percentage. These changes of boom and depression are cyclical in form. Hence, these are called Trade or Business Cycles. Rhythmic fluctuations taking place in an economy, at intervals, in the form of boom and depression are called Trade or Business Cycles.

In the words of Lord Keynes, “A business cycle is composed of periods of good trade characterised by rising prices and low unemployment percentage alternating with periods of bad trade characterised by falling prices and high unemployment percentage.”

According to Anatol Murad, “Business Cycles are alternations of prosperity and depression.”

Phases of Business Cycle: According to Prof. Schumpeter a business cycle can have four phases:

(1) Expansion or Boom,

(2) Recession, 

(3) Depression or Trough or Contraction, and

(4) Recovery.

The following figure illustrate all the four phases or stages of business cycles:

● (1) Expansion or Boom: This phase of the business cycle represents the best stage of prosperity. The objective of the national economic policy of each country is to attain this stage. In this phase hectic economic activities go on and factors of production are put to optimum use. The main characteristics of this phase are:

(i) Income or production is maximum. 

(ii) The economy reaches full employment by removing unemployment.

(iii) Prices rise very high.

(iv) Wages, rates of interest, rent and taxes increase. But increase in all these is less than increase in prices. Thus, real wages do not rise much.

(v) Because of relatively more increase in prices than cost of production, profits rise very high.

(vi) Rise in profits and possibility of their remaining high, lead to rise in the prices of shares. As a result, expectations of profits rise further. 

(vii) Under condition of prosperity, today's an entrepreneurs become optimist. All kinds of products and speculative activities grow. As a result, there is more investment.

(viii) Bank banks pursue liberal credit policy leading to more investment in machines, factory buildings, etc. It results in more productivity.

(ix) Under condition of prosperity, producers expand economic activities by stimulating demand for consumption goods and rise in price level. Explain expenditure of the consumers rise and so also demand.

(x) Under condition of prosperity, the process of expansion continues to be cumulative and self-sustained till the economy reaches the highest level of production, called boom. It is the situation of over full employment and inflation.

● (2) Recession: Under the phase of prosperity, the entrepreneurs make investments in certain ventures which do not prove to be profitable. Their optimism gives way to pessimism. Investivment shows signs of decline. Many enterprises are closed down. Unemployment spreads and income of the people falls. As a matter of fact, beyond the stage of full employment, annie increase in investment is followed by increase in interest, wages and other costs. Consequently, prices rise sharply causing fall in demand. Falling demand obliges the firms to sell their stocks at reduced prices. This paves the way for the recession. In this phase there is decline in economic activities. The main to main features of this phase are under.

(i) There is fall in income and output.

(ii) Workers are rendered unemployed.

(iii) Prices begin to fall.

(iv) Wages fall.

(v) Profits fall. There is no new borrowing despite fall in the rate of interest.

(vi) There is contradiction of bank credit.

(vii) Fall in investment sets in motion the reverse action of the multiplier. Consequently, income falls many times more than the decline in investment.

(viii) Demand of the consumers for various goods fall. 

(ix) There is a sharp decline in the stocks of goods. 

(x) There is a feeling of doubt and fear among the people. They turn pessimistic. Share prices fall.

● (3) Depression or Contraction: Once the process of recession starts, it becomes almost difficult to stop the rot. It goes on gathering momentum and ends hopeless depression. Consequently, economic activities are faced with depression or contraction. Level of output and employment is extremely low. There is heavy fall in prices and wages. Prices of goods fall much more than wages and interest, resulting into heavy losses to the entrepreneurs and traders. Workers are the hit adversely because of widespread unemployment. Production and distribution systems of the economy go out of gear. Heavy fall in profits serves as a disincentive to any new investment. Although rate of interest falls, yet no new investment takes place as marginal efficiency of capital falls more than proportionate fall in rate of interest. 

Under depression, prices of raw materials fall more than the prices of finished products. Economic condition of farmers and producers of raw material grows worse than that of the traders and producers of finished goods. Because of the reverse action of the multiplier and the accelerator, there is heavy fall in income. Share prices fall rapidly. Many indian industries are ruined. Eighth every mversously affects the entire economy. Thus, under depression, all economic factors like income, output, employment, prices, profit, interest, wages, demand etc. have a tendency to contract. Salient features of this phase are as follows:

(i) Level of output and income is low.

(ii) Unemployment increases.

(iii) Wages, interest and other costs decline.

(iv) Price level falls.

(v) Volume of the profits falls sharply. Hence, despite fall in the rate of interest, inducement to invest very low.

(vi) Cash reserves with the bank pile up and demand for credit falls. 

(vii) Old and worn-out machines are not replaced. Hence, demand for capital gods falls.

(viii) Demand for consumer goods falls.

(ix) There is an all-round decline in investment , causing reverse action of multipliers and accelerator.

(x) People grow pessimist. It affects economy adversely. 

● (4) Recovery: It is worth noting that depression phase cannot last for ever. During the phase of depression the entrepreneurs do not even replace machines and other capital goods. Production falls considerably. Stocks of goods are at their lowest. Even during the phase of depression a situation does arise wherein shortage of goods is experienced. Need for replacement of machines become so imperative that the entrepreneurs are obliged to buy new machines to replace old and worn out ones. It results into more demand for capital goods. Investment in capital goods industries increased. As a result of it, interaction of multiplier and the accelerator comes into play and there is increase in income. Demand for goods rises. There is increase in output and employment. Thus, the economy gradually moves from depression to recovery. The wave of recovery once initiated begins to feed up itself. The main features of this phase are as follows:

(i) Replacement investment results into increase and income output. 

(ii) Employment increases.

(iii) Demand for consumption and production good rises.

(iv) Prices begin to look up.

(v) There are more profits.

(vi) Costs increase relatively less.

(vii) Investment increases.

(viii) Demand for bank loans and advances increases.

(ix) Pessimism gives place to optimism.

Table. Features of Different Phases of Business Cycles 

 

Feature	Expansion or Boom	Recession	Depression	Recovery
1.  Employment	Increases	Suddenly falls	Very Low	Slowly rises
2. Output	Increases	Falls	Falls very low	Slowly rises
3. Wages	Rise	Fall	Fall very low	Begin to rise
4. Prices	Rise	Fall sharply	Fall very low	Begin to rise
5. Interest	High	Begins to fall	Very low	Begins to rise
6. Bank Credit	Expands	Suddenly falls	Falls low	Begins to expand
7. Cost of Production	Rises	Falls	Falls very low	Begins to rise
8. Stocks	Large	Fall	Fall very low	Begins to rise
9. Feeling	Optimism	Doubt and Fear	Pessimism	Optimism

Phases of Business Cycle 

Inflation definition and causes

Q. What is inflation. Describe the main causes of inflation. 

Ans. Meaning of Inflation: The dictionary meaning of the word inflation is expansion or an act of inflating. In the context of prices, inflation means persistent rise in general price level.

In the words of Peterson, “The word inflation in the broadest possible sense refers to any increase in the general price level which is sustained and non-seasonal in character.”

In the words of Samuelson, “By inflation we mean a time of generally rising prices.”

In the words of Shapiro, “Inflation is simply a persistent and appreciable rise in general price level.”

In short, Inflation is the process of persistent increase in the price level. 

Causes of Inflation: Inflation is the outcome of an imbalance in demand for and supply of goods. When demand exceeds supply or cost rises then inflation takes place. Thus, causes of inflation relate to:

(1) Demand Side, and (2) Supply Side.

● (1) Demand Side: Demand refers to demand for money to buy goods. Demand for money increases mainly due to the following reasons:

(i) Increase in Public Expenditure: Increase in public expenditure in a country leads to an increase in the purchasing power which in turn leads to more demand for goods and services. But after full employment there is no increase in production of goods. As a consequence, prices begin to rise causing inflation. The situation can arise even after full employment if certain bottlenecks slow down the pace of production.

(ii) Deficit Financing: When government covers its deficit by printing more notes it leads to increase in the monetary income of the people. However, production does not increase to the extent demand for goods increases. This causes price to rise. 

(iii) Cheap Monetary Policy: Cheap money policy also causes excessive increase in supply of money and thereby increase in the demand for goods and services. It results into rise in prices.

(iv) Increase in Disposable Income: Another cause of inflation is increase in the income of consumers. Demand for goods increases due to increase in consumers’ income. When some people by consuming more goods and services make relative improvement in their standard of living, it has a demonstration effect on others. They also imitate their consumption pattern, even if their present income is low. There is thus, an increase in pressure on demand resulting into high prices.

(v) Black Money: Unaccounted money is called black money. It is the outcome of tax evasion. Holders of black money squander (waste, उड़ाना, गंवाना) it on luxuries and conspicuous (attracting attention) consumption. (Conspicuous consumption means purchasing of goods and services to display wealth, status or social power rather than to satisfy practical needs.) They do not care for prices. Consequently, demand increases and price rise. 

(vi) Increase in Investment: Increase in investment also accounts for inflation. When prospects (expectations, chances) of profits are quite bright (high), firms increases their investment. There is more capital formation. Prices of goods increase under the pressure of increased demand. Prices of other goods begin to rise in sympathy (in response to, because of a similar effect). 

(vii) Reduction in Taxes: When government reduces taxes, people’s real and monetary income increase causing increase in their effective demand. This additional purchasing power in the hands of the people stimulates (increases) their demand for goods making price-rise inevitable.

(viii) Less Public Borrowing: In case of reduced public borrowing or when old debts are repaid, people have more purchasing power exerting (applying,  creating) pressure on available goods and services resulting in inflation.

(ix) Increase in Population: If the growth rate of population is higher than the growth rate of output in the country, demand for goods and services outstrips (exceeds, is more than) their supply causing rise in prices. 

(x) Increase in Exports: Rising exports push up prices on two counts: (a) More exports mean more income and hence more demand for goods and services by the exporters leading to rise in the prices. (b) More exports of consumer goods mean less supply for domestic consumption and so rise in their prices. 

● (2) Supply Side: Supply refers to the quantity of available goods or output on which people spend their income. In case of inflation supply of goods and services does not increase proportionate in the demand. As a result, there is disequilibrium in the economy. It is this disequilibrium that causes rise in prices. Following factors may be noted in this regard.

(i) Less Production: Fall in production is one of the principal causes of rise in prices. Fall in agricultural or industrial production in relation to demand leads to rise in prices. Production may fall due to diverse reasons such as, disputes between employers and employees, natural calamities, under-utilisation of production capacity or non availability of the strategic (important/crucial) inputs. 

(ii) Artificial Scarcity: Hoarders and Profiteers create artificial scarcity of goods by way of hoarding.

(iii) Taxation Policy of the Government: High rates of sales tax, excise duty, corporation tax, expenditure tax, etc., discourage production. Under the situation even when demand for goods remain constant there will be rise in their prices. Thus, fall in production give rise to inflation.

(iv) Shortage of food grains: In the event of short fall of the production of foodgrains, pulses, edible oils, etc., their prices shoot up. This shortage may be due to failure of monsoon or more production of cash crops than food crops.

(v) Industrial Disputes: Sometimes industrial disputes may culminate (result) into strike or lockout. It causes fall in supply or production and hence rise in prices.

(vi) Technical Changes: New inventions ever take place in this dynamic age of science. Switching over to new techniques takes time, with the result production process is slowed down. However, technicians and specialists are paid their remuneration as usual. This increases cost of production only to accelerate the inflationary pressure.

(vii) Lack of Raw Materials: Lack of raw materials within the country and little hope of its availability from abroad reduces production and pushes up prices.

(viii) Natural calamities: Agricultural production is occasionally (कभी-कभार) exposed (open, not protected) to such natural calamities as floods and droughts, prices of the agricultural products therefore rise.

(ix) Productive Set up: Sometimes production pattern in the country undergoes such a change that producers begin to produce more and more luxury goods or basic and heavy goods. It is so because production of these goods is more profitable that mass consumer goods. Consequently, income of the labourers increases and so also their demand for wage goods. This causes the prices of such goods to rise very much.

(x) War: Production of consumer goods falls heavily during war time, because productive resources are diverted to the production of war-goods. It raises the prices of production goods.

(xi) International Causes: In modern times different countries have trade relations with one another. Price rise in one of the trading countries has its effect on other countries as well. Inflation in one country spreads through other countries through trade. For example, one of the reasons for global inflation in modern times is the price-hike of petrol and petroleum products.

(xii) Industrial Policy of Government: If industrial policy of the government is restrictive, it would adversely affect supply. If the setting up of a new industry is strictly controlled, then production would fail to cope with demand and so prices will rise.

(xiii) Bottlenecks in Production: When the supply of electricity, coal, means of transport, etc., becomes erratic, production slows down. As a consequence, supply falls and prices rise.

Monetary policy: Meaning and instruments.

 Q. What is meant by Monetary Policy? Explain the main instruments of monetary policy. 

Ans. Meaning of Monetary Policy: Monetary policy refers to that policy through which central bank of the country (Reserve Bank in India) controls (i) the supply of money, (ii) availability of money, and (iii) the cost of money in order to attain a set of objectives focusing on growth and stability of the economy.

It is an economic policy that manages the size and growth rate of the money supply in the economy. It is primarily concerned with the management of interest rate and the total supply in money in circulation and is generally carried out by central bank.

In the words of G.K. Shaw, “By monetary policy, we mean any conscious action undertaken by the monetary authorities to change the quantity, availability or cost (rate of interest) of money.”

Main instruments of Monetary Policy: 

Monetary policy instruments to credit control is often categorised as Quantitative and Qualitative. Quantitative instruments are applied as non-discriminatory credit policy of the central bank: all sectors of economy are uniformly treated while monetary policy is being pursued. Qualitative instruments are applied as discriminatory credit policy of the government: different sections are treated differently depending on the prevailing situation in the country. Qualitative credit control is also called selective credit control.

I. Quantitative Instruments: Following are the instruments for quantitative credit control:

(1) Bank Rate: Bank rate is an important instrument of credit control. Bank rate is that minimum rate of interest at which central bank of a country is willing to discount the first grade securities of other banks or lends on approved securities. Rise in Bank rate raises the rate of interest and fall in bank rate lowers rate of interest. When bank rate is raised, there is contraction of credit, fall in aggregate demand and hence fall in prices. On the contrary, to check deflation in the country, bank rate is lowered.

(2) Open Market Operations: When the central bank of a country buys or sells securities in the open market is called Open Market Operations. If the credit is to be contracted, the central bank begins to sell securities in the open market. On the contrary, if the central bank wants to expand credit, it begins to buy securities in the open market. In the event of inflation, central bank sells securities in the open market. As a result of it, credit is contracted, aggregate demand goes down and prices tend to fall. On the contrary during depression, the central bank buys securities as a result of which credit expands, aggregate demand increases and prices tend to rise.

(3) Change in Minimum Reserve Ratio: Commercial banks are required to keep a given percentage of their total deposits as cash reserve with the central bank. If the central bank wants to contract credit, it raises the cash reserve ratio. As a result, banks have to keep a larger percentage of their deposits in terms of cash with the central bank. It reduces their cash reserves. Lower cash reserves reduces credit creation capacity of the commercial banks. On the other hand, when the central bank wants to expand credit, it lowers the cash reserve ratio. This leaves the banks with larger cash reserves to create credit.

(4) Change in Liquidity Ratio: Every bank is required to keep a given proportion of its total assets in the form of liquid (or near liquid) assets. It is called liquidity ratio. When the central bank is to contract credit, it raises liquidity ratio. On the contrary, when the central bank is to expand credit, it lowers the liquidity ratio.

II. Qualitative (or Selective) Policy Instruments:

(1) Change in Margin Requirements of Loans: When the central bank feels that the traders are stock piling (collects/hoards) certain commodities as a result of which their prices are rising, then it controls the availability of credit for these goods by changing margin requirement. It means that the margin between the value of the goods pledged as security and the amount of loan is increased. Supposing a person pledges goods worth ₹100 as security with a bank and gets a loan amounting to ₹80. In this example, margin requirement is ₹20, or say 20 per cent. If the margin requirement is raised, then the borrower will have to pledge goods of greater in order to secure loan of a given amount. This way credit is contracted. Supposing, margin requirement is raised to ₹60 only against the security of goods worth ₹100 only. Obviously, if the margin requirement is lowered, there will be expansion of credit. 

(2) Rationing (allocating, distributing) of credit: Central bank is the lender to the last resort to commercial banks. Hence, if it so chooses, it can introduce rationing of credit in order to control credit. Rationing of credit may have any of the four variants:

(i) The central bank can decline loan to a specified category of commercial banks.

(ii) The central bank can reduce the quantum of loans for all the banks.

(iii) Central bank can fix credit quota for different banks.

(iv) Central bank can determine the limit of credit granted to industry and trade. As a result of credit rationing banks become cautious in advancing loans; accordingly flow of credit is restricted.

(3) Direct Action: Sometimes, the central bank may initiate direct action against the commercial banks defying its directives. The central bank may impose strict restrictions on the functioning of defaulting banks including denial of loans.

Quantitative and Qualitative credit control are not ‘either-or’ forms of credit control. These are complementary to each other. Both quantitative as well as quantitative policy instruments may be simultaneously pursued with a view to achieving the objectives of monetary policy.

Macroeconomics: Meaning, scope, limitations

 Q. Define macroeconomics. Explain the scope and limitations of macroeconomics.

Ans. MEANING OF MACROECONOMICS: The term ‘Macro’ is derived from the Greek Word ‘Makros’ which means large. Thus, macroeconomics means economics of large dimension, referring to the economy as a whole.

Macroeconomics is defined as that branch of economics which studies economic activities including economic issues and economic problems at the level of economy as a whole. It focuses on macroeconomic variables like aggregate demand, aggregate supply, general price level, national income and output etc.

DEFINITION OF MICROECONOMICS:
In the words of Boulding, “Macroeconomics theory is that part of Economics which studies the over all averages and aggregates of the system.”

According to Shapiro, “Macroeconomics deals with the functioning of the economy as a whole.”

SCOPE OF MACROECONOMICS: It refers to the issues, problems and parameters of Economics that are included in macroeconomics. Following are the broad areas of study of macroeconomics and subject matter of macroeconomics.

i) Theory of National Income: Macroeconomics studies the concept of national income, its different elements, methods of measurement and social accounting.

ii) Theory of Employment: Macroeconomics also studies problems relating to employment and unemployment. It studies different factors determining the level of employment, viz. effective demand, aggregate supply aggregate consumption, aggregate investment, aggregate saving, etc.

iii) Theory of Money: Changes in demand for and supply of money have considerable
bearing on the level of employment. Macroeconomics studies functions of money and theories relating to it. The system of barking and other financial institutions is also studied in this context.

iv) Theory of General Price Level: Determination of changes in general price-level are the core issues of macroeconotnics. Problems concerning inflation and deflation are the principal issues involved in this context.

v) Economic Growth and Development: Study of problems relating to economic growth or increase in per capita real income forms a part of macroeconomics. Specifically, it studies the growth problem of underdeveloped economies.

vi) Business Cycles: Economic activity always shows ups and downs, it never shows a steady pattern of change for all time to come. This cyclical movement of the economy is better known as business cycle. It is a major macroeconomic issue and an important area of macroeconomics study.

vii) Theory of International Trade: Macroeconomics also studies trade among different countries. Theory of international trade, tariff protection, etc., are subjects of great significance in macroeconomics.

viii) Budgetary Deficit and Fiscal Policy: In the wake of privatisation and globalisation of the world economies, budgetary deficit and the related fiscal policy has emerged as a issue of macroeconomics.

ix) Interest Rates and Monetary Policy: Monetary policy involves monetary measures by the government in terms of changing interest rate with a view to stimulating economic growth and stability.

LIMITATIONS OF MACROECONOMICS: Main limitations of macroeconomics are as under:

i) Dependence on individual units: Several conclusions of macroeconomics are based on the sum total of individual units. In fact, it is not correct, because what is true for individuals may not necessarily be true for the whole economy. For instance, an individual may save in terms of money but if everybody starts saving, the aggregate demand will fall causing reduction in national income.

ii) Heterogeneous Units: Under macroeconomics, hetergeneous units are studied. These units are measured in different ways. It is not possible to express these units in uniform numbers or homogeneous measure.

iii) The composition (ingredients) of structure (manner) of the Aggregate is more important than the Aggregate itself: Macroeconomics studies aggregate but as a matter of fact, it is the composition of the structure of the aggregates which influences an economy more than the aggregate itself. Supposing, price level in 2012 and 2013 remains constant but it does not imply thar no change prices took place in 2013. It is possible that prices of food grains might have fallen in 2013 and that of industrial goods might have risen correspondingly, keeping the general price level constant. Thus, for a proper study of an economy, knowledge of the composition of structure of the aggregate is much essential as the aggregate itself.

iv) Different effects of Aggregates: Another difficulty in the study of macroeconomics is that it does not study the different effects of an aggregate on different sectors of an economy. Macroeconomic tendency (particular way of behaving) has not uniform effect on all sectors of an economy. For example, rise in price level benefits the traders and the industrialists but the wage-earners are the losers.

v) Limited Application: Another limitation of macroeconomics is that most of the models relating to it have only theoretical significance. They have very little use in practical life. Moreover, it is very difficult to measure various aggregates of macroeconomics.

vi) It ignores the contribution of Individual units: Macroeconomics analysis throws light only on the functioning of the aggregates. However, in real life, the economic activities and decisions taken by individual units on private level have their effects on the economy as a whole. Such effects are not known by the study of macroeconomics alone.