If the statistical records of business activities are analysed, it is immediately seen that business conditions rarely stand still. Prosperity may be followed by a panic. National income, employment and production fall.
Prices and profits decline and men are thrown out of employment. Eventually the bottom is reached and revival starts. The recovery may be slow or fast.
It may be complete or it may be incomplete. These fluctuations in economic activities in the capitalist societies are known as Business Cycles or Trade Cycles.
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No two business cycles are quite the same, yet they have much in common. Though not identical twins, they are all members of the same family. No exact formula can be used to predict the timing of future business cycles.
There are three distinct types of business cycles. First, there are long period cycles or longer Kuznets construction cycles.
These are very long period cycles of 50 to 60 years. So far only two such full waves—1789-1814, and 1814-1896—have been identified. According to Schumpeter the upward movement of the first cycle is due to the industrial revolution and that of the second cycle is due to the use of steel and steam.
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Second, there are 8 to 10 years major cycles, also known as Jugler cycles after the name of the man who discovered them. Most of theories of the trade cycles relate to this type of waves. Thirdly, there are shorter, minor waves of 40 months’ duration.
A typical short cycle has four distinct phases—depression, recovery, prosperity and recession, but the two most important ones are called the periods of “expansion” and “contraction or recession.” The expansion phase comes to an end and goes into the recession phase at the upper turning point.
Similarly, the recession phase gives way to that of expansion at the lower turning point. Each phase of the cycle passes into the next.
Each one is characterised by different economic conditions; for example, during expansion we find that employment, production, prices, money, wages, interest rates and profits are usually rising with the reverse true in recession.
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There are a number of theories which seek to explain the origin of a business cycle. Hansen’s emphasis on constructions gives us our first clue to the causation of the business cycle. Certain economic variables always show greater fluctuations than others in the business cycle.
For example, if we plot pig- iron production and cigarette consumptions side by side, there is hardly any business cycle in the latter.
This is due to the fact that cigarettes are non-durable consumer goods and in both good and bad time’s people smoke the same amount while pig iron is one of the basic ingredients of capital goods and is subject to wide fluctuations.
Normally the business cycle theories can be divided into five groups:
(1) Monetary theory. This theory, as developed by Hawtrey and Friedman, attributes the cycle to the expansion and contraction of bank money and credit;
(2) Innovation theory, as developed by Schumpeter and Hansen, attributes the cycle to the clustering of important inventions such as the railroad;
(3) Psychological theory, as advocated by Pigou and Bagehot, treats the cycle as a case of people infecting each other with pessimistic and optimistic expectations;
(4) Under-consumption theory, as developed by Hobson, Sweezy, Foster and Catchings, claims too much income goes to wealthy or thrifty people compared with what can be invested and
(5) Over-investment theory, developed by Hayek, Mises and others claims, that too much rather than too little investment causes recessions. Each theory seems to be quite different, but if we examine them closely we find that they are different aspects of the saving investment process.
These different theories can be basically divided into external and internal theories. The external theories find the root of the business cycle in the fluctuations of something outside the economic system, such as wars, revolutions, rates of growth of population, discovery of new resources and scientific discoveries and innovations.
The internal theories find mechanisms within the economic system itself which will give rise to self-generating business cycles, so that every expansion will breed recession and contraction and every contraction will in turn breed revival and expansion in a repeating chain.
Most economists today believe in a combination of external and internal theories. In explaining the major cycles, they place crucial emphasis on fluctuations in investment or capital goods. Primary causes of these volatile investment fluctuations are found in such external factors as technological innovations and dynamic growth of population and of territory.
With these external factors we must combine the internal factors that cause any initial change in investment to be amplified in a cumulative, multiplied fashion—as people who work in the capital goods industries re-spend part of their new income on consumption goods and, as an air of optimism begins to pervade the business community, causing firms to go to the banks and the securities market for new credit accommodation.
The general business situation definitely reacts in turn on investment. If high consumption sales make businessmen optimistic, they are more likely to embark upon venturesome investment programmes.
Inventions or scientific discoveries may occur independently of the business cycle but their economic introduction will most certainly depend on business conditions. Thus in the short run, investment is in part an effect as well as a cause of income movements.
In the long run, no matter how high a plateau of income is maintained, the stock of capital goods will become adjusted at a higher level and new net investment will drop off to zero unless there is (a) growth of income, (b) a continuing improvement of technology or (c) a never-ending reduction in interest rates.