Trade cycles, causes of , phases of the trade cycle

1. BUSINESS AND TRADE CYCLES
Prof. Prabha Panth,
Osmania University,
Hyderabad

2. WHAT IS A TRADE CYCLE
• Trade or Business cycles are regular and periodic
changes in the trend of economic activity in capitalist
or market based economies. Features:
– Occur periodically,
– Regular fluctuations in NY and Employment of an economy,
– Period of rising economic activity, followed by periods of
falling economic activity.
– Wave like movement of expansion and contraction
– Trend changes over sufficient period of time – not a
random change
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3. Diagram of Trade Cycle
GDP
YEARS
First Phase: Peak or
Boom – Full
employment
Third Phase:
Depression Fourth Phase –
Trough,
Unemployment
0
Trade Cycle
GDP
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4. Theories of Trade Cycles
1. Schumpeter: Innovations Theory:
Business cycles caused by the “Innovations” activity of
capitalists.
Trade cycle caused due to technical change.
This is a form of economic progress of industrial economies.
Innovations consist of:
a) Changes in combinations of factors of production
b) Changes in business organisation
c) Transport
d) New products
e) New markets
f) New inputs
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5. – Innovation means the application of inventions on
a commercial scale in the economy.
– Inventions go on continuously in the laboratory,
– But applied to the market only periodically – they
are discontinuous, because business not ready to
take risks of new product or process.
– Innovations are lumpy – they can function only on
a large scale.
– Leads to surge in industrial investment.
– The economy moves into the period of ‘boom’
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6. – An innovator is one who is the first to
commercially use a new invention.
– Takes the risk of the new product or process, and
its marketing.
– Profits are payments to innovators or
entrepreneurs.
– others imitate his product or process.
– Investment increases, and the economy surges
upwards.
– This is the First Phase: Prosperity and Boom.
– Investment , income and employment also.
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7. – But with too much competition – price cutting takes
place. Profits start falling.
– New opportunities in this area start decreasing.
– Market is over supplied – not enough demand.
– Investments start falling, also employment and
income.
– This is the Second Phase of the Trade Cycle –
Recession.
– The economy goes into depression – Third Phase,
– At the lowest point, when prices are very low,
businessmen may start the process of innovations
again,
– This leads to the Fourth Phase: Recovery
PRABHA PANTH

8. • Criticism:
– Innovations may not occur so periodically.
– If there are no innovations, will not recovery take
place?
– Monopoly and Patents may prevent use of
innovations by other competitors,
– Innovations may not cause surge and full
employment, but lead to small changes.
– Adjustment of the economy to innovations takes
time.
– Recovery may not be automatic, but requires govt
policy
PRABHA PANTH

9. 2. Samuelson’s Multiplier-Accelerator Theory:
- Interaction between the Multiplier k = 1/mps, and
Accelerator v = I/∆Y results in Trade cycles.
Consumption functionCt = c0 + bYt-1
present consumption is a function of past income (with b as the
marginal propensity to consume)
• Investment is composed of two parts:
It = I0 + v(Ct - Ct-1)
I0 = autonomous investment,
v (Ct - Ct-1) = investment induced by changes in
consumption demand (the "acceleration" principle)
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10. Yt = Ct + It
• But Ct = bYt-1
• I = I0 + v (Ct - Ct-1) or Autonomous investment +
Induced investment
So: Yt = bYt-1 + I0 + v (Ct - Ct-1)
Changes in Y will depend on the values of b and v.
The greater the value of v, the more the fluctuations in
income.
Where: 0 < b < 1 i.e. MPC
And v > 0
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11. Multiplier: When Autonomous Investment increases, Y will
increase.
Accelerator: When Y increases, C increases, and encourages
Induced investment.
Again the Multiplier will start working – and explosive situation
will occur.
The Accelerator and Second order lag are necessary to generate
a trade cycle.
Soon the negative effect [v(Ct − Ct-1)] will reduce Inv.
Investment falls, then the recession will start.
After the trough is reached, the low value of (− Ct-1 ) will increase
Induced Investment once again.
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12. • Criticism:
1) Shows the important role of Autonomous
Investment in the Trade cycle
2) Induced or private investment is affected by the
state of the economy.
But:
1) Does not show the role of fiscal and monetary policy
to control inflation or deflation,
2) The reason for the recovery is not well explained.
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13. 3. Hicks theory of Trade Cycles:
Trade cycles are fluctuations along the growth path of an
economy.
Multiplier and Accelerator interactions are important.
Warranted rate of growth: real I is rising at the same rate as real
S. equilibrium growth path of economy.
The fluctuations of NY take place around the steady warranted
growth rate of the economy
Lagged Consumption function: Ct = fYt-1
Autonomous I not affected by change in Y, exogenous
Induced Investment: is affected by ∆C
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14. HICKS TRADE CYCLE: F = Full capacity growth
path
E = Equilibrium
growth path
L = floor
growth path
A = Autonomous
Investment path
O
u
t
p
u
t
Time
1
2
3
4
5
6
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15. – Increase in Auto I leads to increase in Y and C.
– Increase in C induces an increase in investment due
to the accelerator,
– Autonomous investment continues steadily.
– This goes on till the ceiling is reached at 2.
– Now there is excess production capacity.
– So Investment falls, multiplier works in reverse
direction, and Y and C falls.
– Accelerator cannot work during the down swing.
– Due to Auto Inv, again recovery takes place.
PRABHA PANTH

16. Criticism:
• Hicks showed that trade cycles takes place around the
steady growth of the economy,
But:
• Cannot explain why the actual growth is different from the
steady growth path,
• Cannot show how recovery of the economy takes place.
• Does not show the role of fiscal policy – taxation, or public
expenditure on the economy,
• Does not show the role of monetary policy – changes in rate
of interest, supply of money, credit, etc.
PRABHA PANTH