Phases of the Business Cycle

Written By Fathimath Sama on Saturday, 22 June 2013 | 23:10

1. Recovery: 

We start from a situation when depression has lasted for some time and revival phase or the lower-turning points starts. The ‘originating force’ or ‘starters’ may be exogenous or endogenous forces. Suppose the semi-durable goods wear out which necessitates their replacement in the economy, it leads to increased demand investment and employment increase. Industry begins to revive. Revival also starts in related capital goods industries. Once begum, the process of revival becomes cumulative. As a result, the levels of employment, income and output rise steadily in the economy. In the early stages of the revival phase, there is considerable excess or idle capacity in the economy so that output increases without a proportionate increase in total costs. But as time goes on, output becomes less elastic, bottlenecks appear with rising costs, deliveries are more difficult and plants may have to be expanded. Under these conditions prices rise. Profit increases, business expectations improve, optimism prevails. Investment is encouraged which tends to raise the demand for bank loans. It leads to credit expansion. Thus the cumulative process of increase investment, employment, output, income and prices will feed upon itself and becomes self-reinforcing. Ultimately revival enters the prosperity phase. 

2. Prosperity: 

In the prosperity phase, demand, output, employment, and income are at a high level. They tend to raise prices. But wages, salaries, interest-rates, rentals and taxes do not rise in the same proportion to the rise in prices. The gap between prices and costs increases the margin of profit. The increase of profit and the prospect of its continuance commonly cause a rapid rise in stock market values.” All securities including bonds rise under the influence of improving expectations. The outstanding change is in stocks that, reflecting the capitalized values of prospective earnings, register in an exaggerated form the rising profits of enterprise”.  The economy is engulfed in waves of optimism. Larger profit expectations further increase investments which is helped by liberal bank credit. Such investments are mostly in fixed capital, plant, equipment and machinery.  They lead to considerable expansion in economic activity by increasing the demand for consumer goods and further raising the price-level. This encourages retailers, wholesalers and manufacturers to add to inventories. In this way, the expansionary process becomes cumulative and self-reinforcing until the economy reaches a very high level of production, known as the peak or boom. 

The peak or prosperity may lead the economy to over-full employment and to inflationary rise in prices. It is a symptom of the end of the prosperity phase and the beginning of the recession. The seeds of recession are contained in the boom in the form of strains in the economic structure which act as brakes to the expansionary path. They are: 
  1. Scarcities of labour, raw-materials etc leading to rise in costs relative to prices. 
  2. Rise in the rate of interest due to scarcity of capital and 
  3. Failures of consumption to rise due to rising prices and stable propensity to consume, when incomes increase.  
The first factor brings a decline in profit margins. The second makes investment costly and along with the first lowers business expectations. The third factor leads to the piling of inventories indicating that sales or consumption lags behind production. These forces become cumulative and self-reinforcing. Entrepreneurs, businessmen and traders become over cautious and over optimism give way to pessimism. 

3. Recession: 

Recession starts when there is a downward descend from the ‘peak’ which is of a short duration.” It marks the turning point during which the forces that make for contraction finally win over the forces of expansion. Its outward signs are liquidation of bank loans, and the beginning of the decline of prices.” As a result, profit-margins decline further because costs start overtaking prices. Some firms close down. Others reduce production and try to sell out the accumulated stocks. Investment, employment, incomes and demand decline. This process becomes cumulative. 

4. Depression: 

Recession merges into depression when there is a general decline in economic activity. There is considerable reduction in the production of goods and services, employment, income, demand and prices. The general decline in economic activity leads to a fall in bank deposits. Credit expansion stops because the business community is not willing to borrow. Bank rate falls considerably. According to prof. Esley; “This fall in active purchasing power is the fundamental background of the fall in prices. That, despite the general reduction of output, characterizes the depression”. Thus depression is characterized by mass unemployment, general fall in prices, profits, wages, interest rate, consumption expenditure, investment, bank deposits and loans. Factories close down and construction of all types of capital goods, buildings etc. comes to a standstill. These forces are cumulative and self reinforcing. 

Depression may be short lived or it may continue at the lowest point for considerable time. But sooner or later limiting forces are set in motion which ultimately tends to bring the contraction phase to end and pave the way for the revival. A cycle is thus complete.

Related Article: Four Phases of Business Cycle


Notes provided by Prof. Sujatha Devi B (St. Philomina's College)
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