16.

Trade Cycles-Meaning, Definition and Phases

Objectives:
After studying this lesson, you will be able to understand,

• The meaning of trade cycles.

• The different phases of trade cycles
• The meaning of Boom
• The meaning of Depression
• The meaning of Recovery
• The meaning of Recession

16.1 Introduction

16.2.Definition of Inflation

16.3 Phases of Trade Cycle

16.3.1 Slump or Depression

16.3.2 Recovery

16.3.3 Boom or Prosperity

16.3.4 Recession

16.4 Summary

16.5 Check your progress

16.6 Key concepts

16.7 Self Assessment questions

16.8 Answers to check your progress

16.9 Suggested Readings

16.1 Introduction:

We covered quantity theories of money in earlier lessons. In the present lesson, our
attention will be on Trade cycles or Business cycles and their meaning, Phases and their
importance in an economy. Trade cycles are a prominent feature of the capitalist
economies. Cycles refer to the regular fluctuations in economic activity in the economy
as a whole. The expansions, recessions, contractions and revivals of aggregate economic
activity occur and recur in an unchanged sequence. These business cycles are affected
business firms differently by cyclical fluctuations owing to the differing nature of their
businesses. Moreover, the effects on the business firms during the expansion phase differ
from the effects in the contraction phase. Similarly other phases also will have effect on
business. The measures, which can be employed to solve the problems arising out of
business cycles, are discussed under two. First one is preventive measures are those steps
which are designed to prevent the individual concern from suffering serious losses during
the recession and contraction phases of cycles. Secondly Relief measures are those,
which are designed to quicken the recovery following a period of contraction.

16.2 Meaning of Trade Cycles:

There are different versions given by various groups of economists about the meaning of
trade cycles.

However, Clement Juglar was the first economist who was statistically established the
presence of business cycles in the latter half of the 19 th century. Since then extensive
research has been conducted on the subject and there has been much difference of
opinion among economists in respect of its definition.

According to W C Mitchell and A F Burns “ Business cycles are a type of fluctuation

found in the aggregate economic activity of nations that organize their work mainly in
business enterprises: a cycle consists of expansions occurring at about the same time in
many economic activities followed by similarly general recessions, contractions and
revivals which merge into the expansion phase of next cycle: this sequence of change is
recurrent but not periodic: in duration business cycles vary from more than once year to
ten or twelve years: they are divisible into shorter cycles with amplitudes approximating
their own”.

In Keynes words, “A Business cycles is composed of periods of good trade characterized

by rising prices and low unemployment percentages alternating with periods of bad trade
characterized by falling prices and high unemployment percentages”. Thus, a marked
feature of a business cycle is the boom being followed by a depression, a recovery and
again boom conditions in a free enterprise economy which is highly industrialized.

According to R A Gordon, Business cycles consist of recurring alternations of expansion

and contraction in aggregate economic activity, the alternative movements in each
direction being self-reinforcing and pervading virtually all parts of the economy”. In
other words, business cycles are regular fluctuations in income, output and employment,
which trend to be self-reinforcing or cumulative. Once a change starts, it tends to gather
speed fast.
In A H Hansen’s view, “business cycle is a manifestation of the industrial segment of the
economy from which prosperity or depression is redistributed to other groups in the
highly interrelated modern society”. We can thus say that a trade cycle invariably starts in
the industrial sector and then spreads itself over the other sectors quickly because in
modern economy, the different sectors are interrelated.

John Tin Bergen considered the cyclical fluctuations as the “interplay between erratic
shocks and an economic system’s ability to perform cyclical adjustment movement to
such shocks”

Ragnar Frisch has echoed the same expression in the following words. ”Impulses from
outside operate upon the economy causing it to move in a wave-like manner, just as an
external shock will set a pendulum swinging”.

In brief the above definitions of trade cycles, reveals some important characteristics of
trade cycles, they are: (A) A business cycle is an economy-wide phenomenon. When
depression sets in the industrial sector, it cannot be restricted there. Soon it spreads to
agriculture, trade and transport sectors; so is the case during boom. (B) A business cycle
shows a wave-like variation in economic activity. The expansion or prosperity is
followed by a depression and so on the economy moves from one extreme to another
almost like a pendulum. (C) Business fluctuations tend to recur; they come again and
again after the lapse of some time. The time or periodicity is not always the same. Nor
are the causes always the same. Some trade cycles may last only two or three years while
others may be of six to eight years in duration. (D) Trade cycles are self-reinforcing or
cumulative. Once, the cyclical movement starts in one direction, it tends to feed on itself.
The force of the economic crisis tends to increase. Once the prosperity phase starts, it
tends to run out of control of the policy markers.

16.3 Phases of a Trade Cycle:

A business cycle is a short –term picture of the behavior of real output in a private
enterprise economy. Industrialized economies having free market mechanism have
economic growth over the long period. But the process of economic growth is often
shaken by business cycles, which show up-turn and downturn of income, output and
employment. A business cycle can be shown to be a wave-like path of the economy’s real
output. Economists often describe a business cycle with the help of distinct phases or
stages. The four phases of a business cycle are:
a) Slump
b) Recovery
c) Boom
d) Deflation
These have demarcated in the diagram, now we can describe the four phases of a typical
trade cycle as follows:

16.3.1 Slump or Depression:

This is the most critical and fearful stage of a trade cycle. Haberler has described
depression as “ a state of affairs in which real income consumed or volume of production
per head and the rate of employment are falling and are sub-normal in the sense that there
are idle resources and unused capacity, especially unused labor”. A Slump or depression
shows itself first in a substantial decline in general output and employment. The decline
in economic activity is not, of course, uniform. Contraction in output might be much
more in manufacturing such as machinery and equipment, mining, construction and
transport than in retail trade or agriculture.

While output and employment tend to fall fast during the slump, prices and wages
continue to decline. This is really agonizing experience for both the producers and
workers.

Prices decline because of the expectations of producers in general that these would
continue to fall in spite of all governmental efforts. While the producers try to dispose of
their stocks at the current market prices, the consumers tend to post pone their purchases
in the hope that the prices would fall further and they would be able to benefit from it.
Scared by the general slump in the economy, the financial institutions press the producing
firms to return their advances according to the contract. This forces the producers to meet
their contractual obligations through unintended sales of their inventories in a market
where prices are already declining. This deepens the depression further. Most firms
reduce their output and as such are forced to lay-off workers. As unemployment
increases, the wages tend to fall under its pressure. However, the fall in wages is less than
the fall in prices. This is because workers’ unions strongly oppose wage reductions. The
rate of fall in prices of agricultural raw materials is generally more than that of
manufactured products. This is because the producers are not prepared to lift off the
supplies of the raw materials, which causes a sharper fall in their prices than the prices of
manufactures. The wholesale prices fall faster than the retails prices. These sudden
changes in the relative price structure of the economy cause dislocations in production
and exchange.
Depression or slump leads to redistribution of the national income. Profits and wages fall
faster relatively to rent and other fixed incomes. Incomes of shareholders go down fast.
This reduces the deposits with banks and other financial institutions. They, in turn, follow
the policy of credit contraction. While producers are reluctant to borrow because of dull
trade conditions, the financial institutions are hesitant in lending for fresh investments.
This causes the depression to persist for a longer period than it would have losted on its
own.
16.3.2 Recovery:

Recovery shows the upturn of the output and employment of the economy from the state
of depression. Recovery is most probably the result of the fresh demand for plant and
equipment arising from the consumer goods industries, which has been postponing this
investment during depression. The replacement demand starts the recovery process.
Wages and other incomes show a noticeable rise. Profits also start rising, which spurs the
producers to float fresh investment proposals in the stock market. It must be pointed out
here that a non-intervention policy from the government fails to start the recovery phase.
Recovery is a slow and halting process. The government has to pursue stabilization
policies and show special initiatives in dispelling the pessimistic mood of the investors.
The economic system, left to itself, is likely to stagnate in the state of depression for an
intolerably long period for the working class.

16.3.3 Boom or Prosperity:

During the recovery phase, rise in output and incomes of the people induce substantial
increase in aggregate spending. This has a multiplier effect. This cumulative process of
rising investment and employment forges ahead. As investors become more confident,
expanding productive activity takes the economy to a boom or prosperity phase. It means
that there is a state of enthusiasm in the business community. Industrial and commercial
activity, both speculative and non-speculative, shows remarkable expansion.
Construction activity gets a bog boost. Share markets reflect the general state of
exuberation of the investors. Financial institutions tend to expand credit as the interest
rates and discount rates go up. Thus, everyone seems to be happy during the state of
prosperity, which ultimately, of course, proves to be short-lived.

16.3.4 Recession:

The end to prosperity phase comes because of certain tendencies in the private-enterprise
economy prevalent during the boom conditions. They are: a) as prices rise, wages tend to
lag behind. As a result, purchasing power of workers, who form a majority of the people,
tends to lag behind the supply of consumer goods. b) Expansion of production is
hampered by shortages of some inputs and bottlenecks in production. c) Excessive
demand for labor and materials pushes up both the factor and the product prices but in a
disproportionate fashion. d) The non-availability of credit beyond a particular rate of
expansion might also act as a serious break on prosperity. Financial institutions including
banks cannot expand credit beyond a limit put by their reserve requirements. As this limit
is reached, they start recovering their loans. Shortages of finance crop up. Firms are
forced to liquidate their stocks when most firm try to sell there output at the same time,
the price level starts falling. When some firms get involved in losses in this way, a wave
of pessimism runs through the share markets. Production schedules by firms are
curtailed; workers are laid off and outstanding orders for raw materials are cancelled. In
this way the wave of pessimism gets transmitted to other sectors of the economy. The
whole economic system thereby runs into a crisis. Thus the next stage of the trade cycle,
called recession of deflation starts.

When sure signs of recession appear on the stock and financial markets, over-pessimism,
nervousness and fear born out of uncertainty overtake the businessmen. In this
atmosphere, new projects are shelved. Even the projects in hand may be abandoned.
Some firms go sick. Others simply go bankrupt. All this hastens the process of economic
contraction. The fall in the purchasing power of the general public reduces demand for
consumer goods, which aggravates the slackening demand for machines and equipment.
The business would goes panicky. What was recession or deflation fore some time now
converts itself into depression.

16.4 Summary

Trade cycles are a prominent feature of the capitalist economies. Cycles refer to the
regular fluctuations in economic activity in the economy as a whole. The expansions,
recessions, contractions and revivals of aggregate economic activity occur and recur in an
unchanged sequence. A business cycle can be shown to be a wave-like path of the
economy’s real output. Economists often describe a business cycle with the help of
distinct phases or stages. They are, Slump or Depression, Recovery, Boom or Prosperity
and Deflation. A Slump or depression shows itself first in a substantial decline in general
output and employment. The decline in economic activity is not, of course, uniform.
Recovery shows the upturn of the output and employment of the economy from the state
of depression. During the recovery phase, rise in output and incomes of the people induce
substantial increase in aggregate spending. This has a multiplier effect. As investors
become more confident, expanding productive activity takes the economy to a boom or
prosperity phase. In the pessimistic atmosphere, new projects are shelved. Even the
projects in hand may be abandoned. Some firms go sick. Others simply go bankrupt. All
this hastens the process of economic contraction. This is the stage of recession. These
various types of business cycle are affected business firms differently by cyclical
fluctuations owing to the differing nature of their businesses. Moreover, the effects on the
business firms during the different phases are certainly having different effects. Therefore
governments have to take required actions to come out of them and should see that the
economy run smoothly.
16.5 Check your progress
State whether the following statements are True or False
1. Business cycles are affected business firms
2. Business cycle shows a wave-like variation in economic activity.
3. Slump or depression shows a substantial rise in general output and employment.
4. Recovery shows the upturn of the output and employment of the economy from the
State of boom
16.6 Key concepts
Business cycles
Boom
Recovery
Depression
Deflation
Stabilization policies

16.7 Self Assessment questions

1. Define the business cycles

2. Explain the different phases of Trade Cycles
3. What are the effects of Trade cycles

16.8 Answers to check your progress

1. True 2. True 3. False 4. False

16.9 Suggested Readings

Ackley Gardner: Macro economic theory
Ward R A: Monetary theory and policy
Rana & Verma: Macro economic analysis
Hajela TN: Monetary economics
Ghatak: Monetary economics in developing economies