TRADE CYCLE

Introduction

Many free market economist suggest US and UK and some western European country
have Registered rapid economic grow during the last two centuries. But economic growth
in these countries not followed steady and smooth upward trends. There has been a long
run upward trend in GNP, but periodically there has be short run fluctuations in economic
activity i.e. change in output, income employment and prices along this long term trend.
The period of high output income and employment has been called the period of
expansion or up swing or prosperity and period of low income output and employment
has been described as contraction or recession or down swing or depression. The
economic history of a free market economy has shown that the period of economic
prosperity or expansion alternates the period of contraction or recession. These
alternating periods of expansion or contraction in economic activity has been called
Business or Trade Cycle.

A Trade Cycle is composed of good trade characterised by rising prices and low
unemployment with period of bad trade characterised by falling prices and high
unemployment percentage. -J.M. Keynes

These fluctuations in economic activity are recurrent and have been occurring
periodically in a more or less regular fashion. Though these fluctuations are called
cycles, which means they are periodic and occur regularly however perfect regularity
has not been observed. The duration of Business Cycles varies from a minimum of two
years to a maximum of ten to twelve years. Though in the past it was often assumed that
fluctuation of output and other economic indicators around the trend show repetitive and
regular pattern of alternating periods of expansion and contractions. However there is no
clear evidence of very regular cycles of the same definite durations. Some business cycle
have been very short lasting only two to three years while others have lasted for 7-8 years
with large swings away from the trend.

A significant point about business cycle is that they have been very costly in the
economic sense of the word. During the period of recession or depression many workers
loose there jobs as a result of large scale unemployment, which causes loss of output that
could have been produced with full employment of resources. Besides during depression
many businesses go bankrupt due to massive lose. Thus depression causes a lot of human
suffering and lowers the level of living of the people. Fluctuation in economic activity
creates a lot of uncertainty in the economy which causes anxiety about the future income
and employment opportunities and involves a great risk for long term investment in
projects. Even boom when it is accompanied by inflation has its own social effects.
Inflation reduces the real income of the people and make the life of poor miserable.
Inflation distorts allocation of resources by drawing away scares resources from
productive uses to unproductive ones. Inflation redistributes income in favor of the richer
classes and also when inflation rate is high it impedes economic growth.

Macro Economic Indicators: Trade Cycle, DIMAT Arjun Madan, 2005 1

PHASES OF BUSSINESS CYCLE

Business cycle has shown different phases the study of which is useful to understand their
underline causes. These phases have been called by different names by different
economist. Generally the following phases of business cycle have been distinguished.

1. Expansion (Boom, up swing or prosperity)

2. Peak (upward turning point)
3. Contraction (down swing, recession or depression)
4. Trough (down ward turning point)

The four phases of business cycle are shown in above figure, where we start from Trough
or depression with the level of economic activity i.e. production and employment is at the
lowest level. With the revival of economic activity the economic move into expansion
phase but the expansion can not continue indefinitely and after reaching the peak the
contraction starts. When the contraction gathers momentum we have depression. The
downswing continues till the lowest point which is also called trough is reached. In this
way the cycle is complete. However after remaining at the trough for some time the
economy revives and again the cycle starts.

There are two types of patterns of cyclic change. One pattern is where fluctuation occurs
around a stable equilibrium position as shown by the horizontal line in figure 1. It is a
case of dynamic stability which depicts change but without growth trend. The second
pattern of cyclical fluctuation is where cyclical changes in economic activity take place
around a grow of path (rising trend). H. R. Hicks in his model of business cycle explains
such pattern of fluctuation with long run rising trend in economic activity by imposing
factor such as autonomous investment due to population growth and technological
progress causing economic grow in the otherwise stationary stage.

Expansion and Prosperity

In its expansion phase both output and employment increase till we have full employment
of resources and the production is at the highest possible level with the given productive
resources. There is no involuntary unemployment and whatever unemployment prevails it
is only of frictional and structural types. When expansion gathers momentum and we
have prosperity the gape between potential GNP and actual GNP is zero. A good amount
of good investment is occurring and demand for durable consumer goods is also rising.
Prices also rise during the expansion phase but due to high level of economic activity
people enjoy a high standard of living.

Then something may occur whether banks start reducing credit or profit expectation
change adversely and businessmen become pessimistic about the future state of the
economy that brings and end to the expansion phase. Economist defer regarding the
possible causes of the end of expansion and start of contraction in economic activity.
Monetarists have argued that contraction in bank credit may cause the down swing.
Keynes on the other hand holds that sudden collapse of the expected rate of profit caused

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by adverse changes in expectations of the entrepreneurs lowers investment in the
economy causing down swing in economic activity.

Contraction and depression

During contraction there is fall in GNP but also level of employment is reduced. As a
result involuntary unemployment appears on a large scale. Investment also decreases
causing further fall in the consumption of goods and services. At times of contraction
prices also fall due to fall in aggregate demand. A significant of the depression phase is
the fall in rate of interest. With lower rate of interest peoples demand of money holding
increases, thus, lot of access capacity due to the lack of demand. Capital goods and
consumer durable goods industry are specially hit hard. Depression occurs when there is
serious contraction or recession of economic activity, as in the case of The Great
Depression of 1929-1933.

Trough and revival

There is limit to which level of economic activity can fall lowest level of economic
activity is generally called as Trough lasting for some time. Capital stock is allowed to
depreciate without replacement. The progress in technology makes the existing capital
stock obsolete. The banking system start expanding credit or there is a spurt in investment
activity due to the emergence of the scarcity of capital goods as a result of non
replacement of depreciated capital and also because of new technology requiring new
type of machine and other capital goods. The stimulation of investment brings about the
revival or recovery of the economy. Recovering is the turning point from the depression
into expansion. As investment rises this causes an induced increase in consumption. As a
result industry start producing more and excess capacity is now put into full use. Rate of
employment increases and with this the cycle is complete.

Futures of business cycle

1. Business cycle occurs periodically. Though they do not show same regularity they
have some distinct phases such as expansion, contraction and trough. Further the
duration of cycle vary a good deal from a minimum of two years to maximum of
10-12 years.
2. Business cycle are synchronic i.e. they do not cause changes in any single
industry or sector but are of all embracing. Recession or contraction occurs
simultaneously in all industries or sectors of economy. Recession passes from one
industry to another and the chain reaction continues till the whole economy is in
the grip of recession. Similar process is at ward in the expansion phase where
prosperity spreads through linkage of input output relations between various
industries or sectors.
3. It has been observed that fluctuation occurs not only in level of production but
also simultaneously in other variables such as employment, investment,
consumption, rate of interest, price level etc.

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4. Another important feature of business cycle is that investment or consumption of
durable consumer goods is affected most by the cyclical fluctuations. Investment
is greatly volatile and unstable as it depends on profit expectation of profit
enterprise. Since the consumption of durable goods can be deferred it also
fluctuations during the course of business cycle.
5. An important feature of business cycle is that consumption of non durable goods
and services do not vary much during different phases of business cycle. Past data
reveals that house holds maintain a great stability in consumption of non durable
goods.
6. The immediate effect or impact of depression or expansion on the inventories of
goods. When depression sets in the inventories starts accumulating beyond the
desired levels. This leads to a cut in the production of goods. On the contrary
when recovery starts the inventories go below the desired level. This encourages
industry to produce more goods which stimulates investment in capital goods.
7. Yet another important feature of business cycle is that profit fluctuates more than
any other type of income the occurrence of trade cycle causes a lot of uncertainty
for business and makes it difficult to forecast economic conditions. During
depression profit may even become negative causing industrial bankruptcies.
8. Business cycles are international in character i.e. once started in a country they
spread to other country through trade relations between or among them.

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