MCom I Semester Managerial Economics Trade Cycles or Business Cycles Study Material Notes

MCom I Semester Managerial Economics Trade Cycles or Business Cycles Study Material Notes: Meaning and Definition of Trade Cycle Nature or Characteristics of Trade Cycles Phases of Trade Cycles Classification of Tade Cycles nature or Characteristics of trade Cycles Various Theories of Trade Cycles Non-Monetary Theories Monetary Theories Multiplier and Accelerator Interaction Different Phases of Trade Cycles Control on Trade Cycles Preventive Measures Main  Causes for Giving Brith to Trade Cycles :

MCom I Semester Accounts Holding Companies Study Material Notes

TRADE-CYCLES OR BUSINESS-CYCLES

MEANING AND DEFINITION OF TRADE-CYCLE

Trade-cycle means the cyclical fluctuations which take place frequently and regularly in an economy. In other words, Trade-cycle means the economic incident or incidents which occur regularly at a certain time and causes alternative changes in prices and the situation of employment. The tem *Trade-cycles’ has been defined as under

Keynes, “A Trade-cycle is composed of periods of good trade characterised by rising prices and low unemployment percentages aletering with period of bad trade characterised by falling prices and higher unemployment

Benham, “A Trade-cycle may be defined as a period of prosperity followed by a period of depression. It is not surprising that economic progress should be irregular trade being good at sometime and bad at others.”

Mitchell, “Business-cycles are a series of fluctuations in the conomic activities of organised communities

Haberler, “The Business-cycles in general sense may be defined as an alteration of period of prosperity and depression of good and bad trade.”

Prof. Estay, “Cyclical fluctuations are characterised by alternative waves of expansion and contraction. They do not have a fixed rhythm but they are cyclic in that the phases of contraction and expansion recur frequently, and in fairly similar patterns.”

On the basis of above definitions, it can be concluded that business-cycles are the regular and frequent fluctuations in the economic activities of a country. It may also be defined as a period of prosperity followed by a period of depression

NATURE OR CHARACTERISTICS OF TRADE-CYCLES

Important nature or Characteristics of Trade-cycles are as under

1 Periodicity. An important characteristics of business-cycles in that the sequence of the incidents of business-cycles is definite. On incident is followed by another incident. For example, prosperity is followed by depression

2. Synchronism. Another important characteristic of Trade-cycles is that the incidents of Trade-cycles recur in fairly similar pattern.

CLASSIFICATION OF TRADE-CYCLES

Prof. James Arthur classified business-cycles into three parts as follows:

1 Major and Minor Trade-Cycles. Major Trade-cycles are the Trade-cycles, the period of which is very large. Minor Trade-cycles are the cycles which occur during the period of a major-cycle. Prof. Hanson determined the period of a Major-cycle between 8 years and 33 years. Two or three minor-cycles occur during the period of a major-cycle. Period of a minor-cycle its 40 months.

2. Building-Cycles. Building-Cycles are the Trade-cycles which are related with construction industry. Period of such cycles range from 15 to 20 years.

3. Long Waves. Period of a Long Wave is of 50 years and it was discovered by a Russian Economist Kondratief. One or two major Trade-cycles occur during the period of a long wave.

PHASES OF TRADE-CYCLES

There are four phases of Trade-cycles-(1) Phase of Depression; (2) Phase of Revival or Recovery; (3) Phase of Prosperity or Boom; (4) Phase of Recession or Contraction. Details in this regard are as follows

1 Phase of Depression. Under this phase of Trade-cycles, prices of a product start to decline. Decrease in selling price of a product is more than the decrease in cost of production of the product. As a result, mediators get disappointed and they want to dispose off the stock of product at the earliest. This situation causes further fall in the prices of product. Demand of product also start to decline. As a result, the situation of over production is created. As a result, the workers are retrenched which in turn, worsens the problem of unemployment. Thus, the phase of Depression is characterised by low prices, low demand, over production, idle production capicity and general unemployment. During the phase of depression, agriculture is badly affected, rate of investments and saving decline. Bank deposits also show an declining trend. Rates of wages, salaries, interest, income and profit decline. Thus, this phase causes general disappointment in the economy. This phase of Trade-cycles is very painful for the economy.

2. Phase of Revival Or Recovery. Phase of Depression is followed by the Phase of revival or recovery. After the lowest point of depression, the phase of Recovery starts. Economy starts to give the signs of revival. Business activities start to improve. Industrial production picks up gradually. New investments are made. Government also announces several measures for economic development of the country. An atmosphere of savings and investments is created. All these factors help in increasing the demand of goods and services in the market. As a result, the Volume and amount of sales start to increase and services in the market. As a result, the prices also start to rise steadily. Volume and amount of sales start to increase and possibilities of profit also increase. Wages and salaries start to rise. New in Bes and salaries start to rise. New investments are made in capital goods industries. Banks and financial institutions expand credit to

Sing power of consumers increase. Entrepreneurs emphasise upon the lovation and development of products. Gross National Product (G.N.P.) and National Income show an increasing trend and the atmosphere of pessimism is replaced by the atmosphere of all round hope and expectation.

3. Phase of Prosperity Or Boom. At this phase of business cycles, economy grows at a faster rate and leads to the situation of full employment. There is rapid expansion of business activities. Demand of goods and services touches high marks. Enterpreneurs produce at their maximum production capacity. There is full utilisation of the factors of production. Prices of all the goods and services touch their new heights and as a result, enterpreneurs earn maximum profit through maximum sales. All the job seekers get employment. Number of jobs available in the market is more than the number of job seekers. All the businessmen and industrialists are full of optimism. They make additional investments in different branches of economy. Prices of the factors of production increase because of additional investment by entrepreneurs, even after the stage of full utilisation of factors of production. Banks and financial institutions provide more and more credit facilities. Thus, the phase of prosperity or boom is characterised by high prices, maximum demand of goods and services, production at the highest level of production capacity, high profits, full employment, maximum utilisation of the factors of production, high prices, maximum demand of goods and services, production at the highest level of production capacity, high profits, full employment, maximum utilisation of the factors of production high prices of factors of production and a general feelings of optimism among businessmen and industrialists.

4. Phase of Recession Or Contraction. The phase of prosperity or boom carries with it the seeds of self-destruction. The atmosphere of high optimism converts gradually into the atmosphere of pessimism. The failure of some business and industrial enterprises creates fear and hesitation among entrepreneurs. important causes of such situation are increasing rates of wages, increasing prices of raw materials, higher cost of production, high rate of interest etc. Supply of goods and services is more than their demand. Businessmen are not successful in selling the whole of their product. As a result, they start to withdraw their investments. Banks and financial institutions do not sanction new loans and emphasise upon the recovery of old loans. It further increases the feeling of pessimism among businessmen. All these factors result in the fall in prices, decrease in demand, under-utilisation of productive resources, retrenchment of workers, decline in the level of nroduction and employment etc. It reduces profits and causes a further decline in savings and investments.

It is important to note in this regard that every Trade-cycle is not necessary to pass through all the four stages. It may be possible that there are only two or three phase of Trade-cycle. The phase of recovery may be followed by the phases of recession or contraction without entering into the phase of prosperity.

All the four phases of Trade-cyles can be explained with the help of a diagram which is given on the right side.

 

Conclusion. Trade-cycles or business-cycles are the fluctuations which take place in economic activities regularly and frequently. Trade-cycles may be of three types major and minor Trade-cycles, buildings-cycles, and long waves. There are four phases of Trade-cycles–phase of depression, phase of revival or recovery, phase of prosperity or boom and the phase of recession or contraction. It is not necessary for all the Trade-cycles to pass through all the four phase.

VARIOUS THEORIES OF TRADE-CYCLES

Trade-cycles are a series of fluctuations in economic activities. In other words, trade-cycles are a series of incidents which occur regularly and frequently in the activities of business and industrial enterprises. Many causes and factors are responsible for trade-cycles. Various theories have been propounded by different economists from time to time to explain the causes of business-cycles. These theories can be divided into two parts-(I) Non-monetary Theories. (II) Monetary Theories. Details in this regard are as follows

(1) NON-MONETARY THEORIES

Non-monetory Theories of Trade-cycles are as follows

1 Climate Theory Or Sun-Spot Theory. This theory was propounded by William Stanlay Jevons. Prof. Javons was of the view that trade-cycles are related with the spots which appear at sun in every 10-11 years. These spots affect the density and direction of the heat of sun which, in turn, causes changes in climate. If these changes result in the fall in rainfall, there will be an adverse entect on crops. Adverse effect on crops causes a set back to industries also. Consequently, there is an atmosphere of depression in the economy.

If, on the contrary, changes in climate result favourable effect on agriculture. Farmers get good development of industries also. As a result, the su the economy which gradually converts into the stage changes of climate also are cyclical and cause trade-cycles

Criticisms of Climate Theory. This theory of trade-cycles bitterly criticised on the following grounds

un-spots are the cause of climatic changes, effect on the crops of all the countries of world should be identical but practically it never happen

(1) Climatic changes alone are not sufficient in explaining all the po of trade-cycles.

(iii) If climatic changes are the causes of trade-cycles, there should trade-cycles in industrial countries of the world but the history proves that these cycles occur in industrial countries as well.

(iv) This theory assumes that climatic changes are the only causes of changes in agriculatural production. Thus, this theory ignores the role of improved seeds, fertilizers, chemicals, irrigation facilities and agricultural implements in increasing agricultural production.

2. Psychological Theory. This theory of trade-cycles was propounded by Prof. A.C. Pigou. According to Prof. Pigou. Trade- cycles occur due to the changes in the psychology of enterpreneurs. Prof. Pigou was of the opinion that the fellings of optimism and pessimism develop in the minds and hearts of enterpreneurs and these feelings cause trade-cycles. When big businessmen are optimistic towards their business and look forward the development and bright future, the phase or recovery starts which gradually leads to the phse of prosperity. They make additional investments in their business and take more interest in expending their activities. Many small businessmen follow them.

If, on the contrary, big businessmen are pessimistic towards their business, the phase of recession starts which leads to the phase of depression. Businessmen start to withdraw their investments and do not take much interest in the development and expansion of business activities. As a result, their is a decline in the level of production, income and employment.

These psychological changes are also cyclical and therefore, cause trade-cycles.

Criticisms of Psycholigical Theory. This theory also has been criticised on several gronds. Important criticisms of this theory are as un

(i) This theory does not explain the factors that the psychola businessmen. Thus, this theory is imcomplete.

(ii)This theory of trade-cycles is based upon the assumption 1 feelings of optimism and passimism occur in the minds and men but this theory does not explain why it happens so. In this businessmen but this theory does also, this theory is incomplete.

(iii) This theory does not explain the process of converting one phase of trade-cycles into another phase.

(iv) Feelings of optimism and pessimism can also be an important cause of trade-cycles but they cannot be the only cause of trade cycles. This theory does not explain other causes of trade-cycles. In this respect also this theory is incomplete.

3. Over-Saving Theory. This theory of trade-cycles was propounded by Prof. Hobbson. This theory is known as the theory of under-consumption also. According to the opinion of Prof. Hobson, trade-cycles occur due to improper distribution of national income. Prof. Hobbson was of the opinion that there are wide inequalities in the distribution of income between rich and the poor. Rich persons get a major share of total income which is much more than required by them for their consumption. As a result, they are in a position to save more. They invest these savings in industries. It leads to an increase in the quantity of production on one hand. On the other hand, poor persons get only a small part of total income which is much less than the amount required for their consumption. As a result, they are unable in satisfying all of their needs. As a result, demand of goods and services decreases and a gap is created between demand and supply. The producers and sellers are unable in selling entire stock available with them. It leads to a fall in prices which, in turn, leads to a fall in the sales and profits. It causes frustration and passimism among businessmen and industrialists. It leades to the phase of depression. Thus, according to this theory, the phase of depression occurs due to over savings on one hand and under-consumption on the other.

Criticism of Over-Saving Theory. This theory of trade-cycles has also not been free from criticisms. Important criticisms of this theory are as under

(1) This theory explains the causes of the phase of depression only. It does not explain how do the phases of recovery, prosperity and depression arise.

(ii) This theory does not explain periodicity of trade-cycles.

(iii) This theory does not consider non-monetary factors affecting the prices of goods and services.

(iv) This theory assumes that all the saving are invested but this assumption is not true in practical life.

(v) This theory assumes that the fluctuations of investments depend upon the fluctuation of savings but his assumption also does not hold true in practical life. The practical life experience is that more fluctuations take place in investments in comparision to savings.

4 Over-Production Theory. This theory was propounded by Prof. Sismando. This theory is known as competition theory also. In a capitalist economy, a product is produced by a number of firms. These firms compete with each other. All the firms have to sell their product in the same market. All the firms try to capture maximum part of the market. Result of this situation is that the total production of all the firms exceeds its total market demand. Due to over-production, prices of product profit margin of all the firms start to decline. I frustration among businessmen. They start to withdraw trend is followed by other firms also. All th depression

Criticism of Over production Important criticisms over Production theory of Trade Cycles are as Under-

(i)  This theory explains the phase of depression only. It does not explain the phases of recovery, prosperity and recession.

(ii) This theory does not explain why all the industries are affected by trade-cycles almost in same manner and to the same extent.

(iii) This theory does not explain why does a trade cycle occur after a certain time.

(iv) This theory explains that over-production causes the phase of depression but it does not explain whether it is caused by general over-production or specific over-production.

(v) This theory assumes that over production is a only cause of the phase of depression. It does not consider other causes which are responsible for creating the situation of depression.

5. Cobweb Theory. Cobweb Theory of trade-cycles is based upon the following assumptions

(i) There is perfect competition in the market.

(ii) Market is not affected by production projects.

(iii) Price is perfectly the function of supply of preceding period.

(iv) Related product is perishable.

Cobweb theory of trade-cycles explains the cycles occuring in the quantities of production and prices of agriculatural products. These occur at regular time intervals. Supply of agricultural products is adjusted gradually in accordance with the changes in demand of these products. Therefore, rapid fluctuations take place in the quantities of production and prices of these products. For example, assume that the demand of rice increases for some reasons. The effect of increase in the demand of rice will be an increase in rices of rice in short-run because in short-run, it is not possible to increase the rice. Increase in price will encourage, farmers to produce more quantity of rice. As a result, supply of rice will gradually increase. In supply of rice will exceed its demand. A of rice will exceed its demand. As a result, prices will starts to decline.

 

prices will again discourage farmers to reduce the production of ecline in prices will again discourage farmers to rice. As a result, supply of rice will decrease and gradually the of rice will decrease and gradually the supply of rice than its demand which, in turn, will lead to increase in prices will again be less than its demand which in of demand and supply occur regularly at certain intervals. If These fluctuations of demand and supply are presented in a diagram, we get the shape of Cobweb. these fluctuations are presented in a diagra Due to these reason, this theory is known as Cobwe types of Cobweb

(ii) Continuous Cobweb. In this form of Cobweb, a trade cycle repeats itself around the Cobweb after certain adjustments. Size of these fluctuations neither increase nor decrease. This situation arises due to equal elasticity of demand and supply curves. It can be explained with the help of following diagram

 

In this diagram, quantity of production has been presented on OX axis and the price of product has been presented on ‘OY’ axis. This diagram explains that when the quantity of P: production of product is ‘QQ,, its price will be ‘OP,’. If the demand of the product reduces, the “P. quantity of its production will reduce to ‘0Q2 and due to a decrease in the quantity of S production price will incrase to ‘OP,’. Increase 0

Q2 Q1 in price will again encourage production and as Quantity of Production a result, the quantity of production will increase

Fig. 25.2. to OQ, but due to an increase in quantity of production, price will decline to ‘OP,’. These fluctuation in the price and the quantity of production of the product will continue to occur regularly.

(ii) Convergent Cobweb. This form of Cobweb takes place when the elasticity of supply curve is less than the elasticity of demand curve. In this situation, fluctuations in the quantity of supply are less than they fluctuations in the quantity of demand, as a result of a given change in the price of a product. As a result, both the price and production curves are convergent and every o next Cobwen is smaller than the earlier Quantity of Production Cobweb. It can be explained with the help of diagram, which is given above on the right side.

In above diagram, quantity of production has been presented on ‘OX’ axis and the price of product has been presented of ‘OY’ axis. Above diagram explains that when the quantity of production of a product is ‘OQ,’, its price is ‘QP,’. Due to low price of the product quantityof production will decrease to ‘OQz’. As a result of decrease in the quantity of supply, price will increase to *Q2Pz’. This increase in price will encourage producers to increase the quantity of production and when the quantity of production increases to ‘OQ3’, the price will decrease to “Q3P;!. Decrease in price will again result in a decrease in the quantity of production and when the quantity of production decreases to ‘OQ.’. the price will again increases to ‘Q.P4. These fluctuations in the quantity of production and price of product will continue for ever.

(iii) Divergent Cobweb. Divergent Cobweb is just opposite to convergent Cobweb. Thus, divergent Cobweb take place when the elasticity of supply of a product is more than the elasticity of its demand. In this situation, every Cobweb is larger than its earlier Cobweb. It can be explained with the help of following diagram

In this diagram, quantity of production has been presented on ‘OX’ axis and the price of product has been presented on ‘OY’ axis. When the quantity of production of a product is “OQ,’, its price is ‘Q,P,’. Due to low price of product, the quantity of production of the product will decrease to ‘OQ,’. As a result of a decrease in the quantity of production, the price will decrease to ‘Q P’. Increase in price will encourage producers to produce more and when the quantity of production increases to

 

Quantity of Production ‘OQ’, the price will increase to ‘Q,P,’. This increase in price will again decrease the quantity of production to ‘Q:P4’ and this will again increase the price to ‘Q.P.. This process of fluctuations will continue for ever at regular intervals.

Criticisms of Cobweb Theory. Important criticisms of Cobweb theory are as under

(i) Cobweb theory of trade-cycles depends upon certain assumptions but almost all the assumptions of this theory are unreal.

(ii) This theory of trade-cycles applies only on agricultural products. Therefore, it cannot be regarded as the theory of trade-cycles in its real sense.

(iii) The situation of continuous Cobweb theory cannot continue for indefinite period.

(iv) This theory does not explain the periodicity of trade-cycles.

(v) This theory does not explain all the phases of trade-cycles.

(II) MONETARY THEORIES

Important Monetary Theories are as follows

1 Pure Monetary Theory of Prof. Haw tray. Prof. Hawtray was of the opinion that trade-cycles are purily a monetary problem. He was of the view that the situations of money inflation and money deflation cuase the fluctuations in business activities.

Prof. Hawtray propounded that a change in the quantity of money cases trade-cycles. When quantity of money increases (either due to the issue of fresh currency or due to the increase in supply of money by bank credit or due to the increase in v elocity of money), phase of prosperity starts because due to an increase in the quantity of money, consumers get more money to spend. Their purchasing power incrases and as a result, prices of goods and services start to increase. It encourages businessmen & industrialists to increase their investment in their enterprises. They avail the benefit of liberal credit policy of banks and other financial institutions. They take more loans and invest in their enterprises to increase their production capacity. It increases the quantity of production on one hand and the cost of production on other hand (because the prices of factors of production increase because of their higher demand) purchasing power of the factors of production increases and as a result, the demand of goods and services increases further. It again encourages an increase in production capacity. Thus, it may be concluded that increase in the quantity of money leads to increase in the purchasing power of consumers which encourages an increase in the quantity of production and all these factors together help in creating the atmosphere of prosperity.

On the other hand, decrease in the quantity of money causes the phase of recession and depression. Decrease in the quantity of money (either due to the withdrawl of currency from circulation or due to the contraction of credit or due to a fall in the velocity of money) means a decrease in the purchasing power of consumers, as a result the demand of goods and services decreases and the prices start to decline. It compells the businessmen and industrialists to decrease the quantity of production and to withdraw their investments. Banks do not sanction new loans and advances and start to withdraw the present loans and advances also. They increase the rate of interest on their loans and advances. It causes the feeling of passimism and frustration among businessmen and industrialists. They reduce the quantity of production and start to withdraw their investments. They try to sell the entire stock of their product at the earliest. As a result, the prices of goods and services further decline. All these factors together create the phase of depression.

Criticism of Pure Monetary Theory. Some of the important criticisms of this theory are as under

(i) This theory considers only the monetary factors while the fact is that both the monetary and non-monetary factors are responsible for trade-cycles.

(ii) This theory assumes that the investment decisions are affected by credit facilities and rate of interest only but the fact is that the expectation of changes of price in future also affect investment decisions to a great extent.

(iii) This theory ignores the productivity of capital.

(iv) Porf. Hawtray has not analysed the changes of the flow of trade-cycles.

2. Over-Investment Theory. This theory has propounded by Prof. Havek. Prof. Hayek was of the opinion that trade-cycles occur due to difference between natural rate of interest and actual rate of interest. Difference between these two rates of interest causes significant increase or decrease in the prices of goods and services. This theory is based upon the assumption that savings and investments are always equal. It can be possible only when the capital is created and generated through savings only. In practical life, banks also create credit. Main aim of banks is to earn maximum Profit To Achieve this object, they reduce the rate of interest so that the nessmen and industrialists may be encouraged to take more and more loans for their business and industrial enterprises. As a result, the investment in Business and industrial enterprises starts to increase which in turn, increases the level of production, employment, wages and salaries etc. Due to an increase m the prices of factors of production, their purchasing power increases and they demand more goods and services than before. It leads to an increase in the prices of goods and services. All these factors together create the atmosphere of prosperity.

After a certain point, banks abandon the policy of expansion of credit. They increase the rate of interest. It compells, businessmen and industrialists to withdraw their investments. Banks do not sanctiobn fresh loans and advances. As a result, the quantity of production decreases, the prices of factors production also decrease which restricts their purchasing power. It leads to a decrease in the prices of goods and services. All these factors together create the atmosphere of depression. Thus, it may be concluded that the expansion and contraction of credit facilities cause unequalities between saving and investments and these inequalities cases trade-cycles.

Criticism of Over-Investment Theory. Some of the important criticisms of this theory are as under

(i) This theory assumes that when there is a situation of equilibrium in an economy, all the factors of production get full employment but this assumption is not real

(ii) Prof. Hayek was of the opinion that the equilibrium between savings and investments is established by the rate of interest but this assumption is also not correct because the equilibrium between savings and investments is established by the level of income and not by the rate of interest.

(iii) Prof. Hayek has over emphasised the importance of changes in the rate of interest.

(iv) This theory does not explain how the investments are related with demand.

(v) This theory does not explain all the phases of trade cycles.

(vi) This theory does not consider the periodicity of trade-cycles.

3. Innovation Theory. This theory of trade-cycles was propounded by Prof. Schumpetor. He was of the opinion that innovations are the regular feature of capitalist countries. These innovations change the present technologies of production by which whole of the economy is affected. Therefore, innovations should be regarded as an important cause of trade-cycles. Prof. Schumpetor includes following in innovations-Production of a New Product Developmdent of a New Technology of Production, Mechanical Develoopments, Development of New Markets Development of a New Forms of Business Organization Prof. Schumpeter propounded that whenever there is an innovation, the situation of imbalance arises in the present economic system. This situation of imbalance continues till the economic forces do not get adjusted in new situations. This theory is based upon the assumption that there is full employment in the economy. Suppose a new product is to be produced or the quantity of production of an existing product is to be increased, higher remuneration will have to be paid to the factors of production so that they may be attracted. As a result, the prices of factors of production will increase, even in existing industries. It will increase the cost of production in all the industries. In such situation, bank credit will be expanded to finance new industries. It will further increase the prices of factors of production. Increase in the price of factors of production will increase their purchasing power. As a result, the demand of goods and services will increase which will lead to the increase in their prices. It will create money inflation in the country and all these factors together will create atmosphere of prosperity.

Gradually the demand of new products will increase and that of existing products will decrease. Therefore, the sales and profits of the firms producing new products will start to increase. These firms will be in a position to repay bank loans. It will lead to a decrease in the amount of bank credit. On the other hand, the firms engaged in the production of old products will have to reduce the quantity of their production. A number of workers will be retrenched and the demand of factors of production will decrease. As a result, purchasing power of these factors will decrease which will lead to a decrease in the demand of goods and services which, in turn, will decrease their prices. All these factors together will create the atmosphere of depression.

Criticisms of Innovation Theory. Some of the important criticisms of this theory are as under

(i) This theory assumes that the innovations are the only cause of trade-cycles but this assumption is not correct. The fact is that it is one of the several factors causing trade-cycles but it is not the only factor.

(ii) Bank credit alone cannot finance innovations as assumed in their theory. The fact is that the innovations are financed through the issue of shares, debentures and public deposits also

(iii) Prof. Schumpeter could not explain the phase of recovery clearly.

(iv) This theory also does not consider the periodicity of trade-cycles.

4. Saving and Investment Theory. This theory was propounded by Prof. Keynes. Prof. Keynes did not elaborate a separate theory of business-cycles. He has given an explanation of business-cycles in his general theory. According to Prof. Keynes, important cause of trade-cycles are the cyclical changes in the quantity of investment which arise due to the fluctuations in Marginal Efficiency of Capital (MEC). Amount of investment is affected by following two factors-(i) Rate of Interest. (ii) Marginal Efficiency of Capital. Out of these two factors also, Marginal Efficiency of Capital is the most important determinant of the amount of investments because the rate of interest stabilizes after a certain point.

When Marginal Efficiency of Capital (MEC) improves or increases the amount of investments also starts to increase. As a result, the level of production, employment and income also start to increase. Entrepreneurs try to increase their production capacity to the maximum level. It increases the demand of goods and services in the country which leads to an increase in their prices. All these factors together create the atmosphere of prosperity.

On the contrary, if Marginal Efficiency of Capital (MEC) decreases, the amount of investment also decreases. As a result, there is a general fall in the level of production, employment and income. Entrepreneurs start to withdraw their investments. Quantity of production decreases. Prices of factors of production also decrease which reduce their purchasing power. Due to it, the prices of goods and services also decrease. All these factors together create an atmosphere of depression.

Criticisms of Savings and Investment Theory. Some of the important criticisms of theory are as under

(i) According to Prof. Keynes, Marginal Efficiency of Capital (MEC) is the only factor affecting the amount of investments. Thus, he has ignored several other factors affecting the amount of investments.

(ii) According to Prof. Keynes, remedy to overcome the situation of economic crises is cheap money policy but it is not necessary that this policy will always help in overcoming the situation of economic crises and in increasing the amount of investments,

(iii) Complete theory of Prof. Keynes depends upon Marginal Efficiency of Capital but he has not defined and explained the Concept of MEC.

(iv) This theory does not explain the causes why trade-cycles occur at regular intervals’.

(v) Prof. Keynes has supported Government Regulated Investment Policy’ to overcome the problem of economic crises but Prof. Keynes did not predict that this policy means gradual Government control over the whole economy

5. Samuelson’s Model of Trade-Cycles. Samuelson’s model of trade-cycles is a complete, logical and scientific explanation of the nature of trade-cycles. According to Prof. Samuelson, cyclical fluctuations of an economy occur due to interaction of accelator and multiplier. Most important theme of this theory is that some value of accelator takes the form of a particular type of trade-cycle with some value of multiplier. As the value of Accelator goes on increasing, the form of trade cycle also goes on changing. Prof Samuelson has developed the model on the basis of one period lag and marginal propensity to consume (MPC = a) and accelerator (B) which are

Diagram ‘A’ represents the path without circle because it is based upon the fact of multiplier only and there is no role of accelator in it. Diagram ‘B’ represents slow fluctuations. Diagram ‘C’ represents comparatively more fluctuations. Diagram ‘D’ represents very high fluctuations and diagram ‘E’ represents the explosive stage of fluctuations.

Critical Appraisal to the Model of Prof. Samuelson. Model developed by Prof. Samulson is a logical and scientific explanation of the causes of trade cycles. This model explains the causes and proces of Trade-cycles very clearly because it it based upon the interaction od multiplier and accelator. This model guides the whole economy also.

In the words of Prof. Kuhihara, “Law of accelator assisted with the analysis of multiplier is an useful tool of the analysis of trade-cycles because it is based upon the assumption of marginal propsnsity to consume being less than one. It is an important guide of Trade-cycle policy also. In the word of Prof. Aiste, “Such combination of multiplier and accelator seems to have capacity to produce cyclical fluctuations.”

Criticism of the Model of Prof. Samuelson. Though the model of Prof. Samuelson occupies an important place, yet it is not free from citicisms. Important criticisms of this model are as under :

(i) This model is of technical nature. Therefore, it is difficult to follow and understand

(ii) This model considers only the technical causes of Trade-cycles. It ignors noo-technical causes of Trade-cycles.

(iii) This model assumes marginal propensity to consume (MPC) and accelator to be stable but this assumption is not real in practical life.

(iv) this model ignors monetary forces affecting Trade-cycles

(v) The consumption function and investments function used in this model are incomplete,

(vi) This model does not explain the span of different Phases of Trade-cycles.

6. Prof. Hicks Theory of Trade-Cycles Or Modern Theory of Trade-Cycles. Prof. Hicks propounded a new theory of Trade-cycles. This theory is known as modern theory also. This theory is also based upon multiplier and accelator. According to Prof. Hicks. “Main cause of cyclical fluctuations is the combined result of multiplier process and aceelator effect. He further said, Multiplier and accelator theories are the two arms of fluctuations theory.”

Prof Hicks Has divided total investments into two parts-H1) Autonomous Investments, and (11) Induced Investments. Autonomous

Investments are the Investments which are not affected by the changes of name or demand. These Investments continue to grow on their own. On the anteary Induced Investments are the investments which are affected by the changes of income or demand or production etc.

This theory of trade-cycles explains the mutual relationship between income and investments. It explains those changes of production and consumption also that take place due to the changes in income and investment. It explains the effect of investments on the multiplier of consumption and the effect of changes in the accelator of consumption on investments. Mutual effects of these factors causes fluctuations in the economy.

Suppose that there is a situation of equilibrium between production and investments. Now a new autonomous investment is made. As a result, the multiplier will increase the quantity of income many times is comparison to investment. Increase in income means an increase in consumption which increases induced investments also. Thus, induced investments increase production and the increase in production further increases induced investments. As a result, the economy rises above the point of equilibrium but it cannot rise beyond a certain level. At this level, trend of expansion is checked and at the last starts to go down to the operation of multiplier and accelator in opposite direction. Importance cause of such decline is that the induced investments are insufficient to maintain the level of production. Soon the trend of decline starts, sale of production becomes a difficult problem. Industrial enterprises are unable in recovering even their fixed costs, as a result, some firms start to fail. It increases the liquidity preference of public which, in turn, worsens credit creation. As a result, there is a steep fall in business activities. All these factors together create the atmosphere of depression.

Following table makes is clear how to do the multiplier and accelator affect economic fluctuations

Multiplier and Accelerator-Interaction

Above table has been prepared on the following two assumptions(i) Marginal Propensity to Consume (MPC) is 1/2 or 0.5. (ii) Accelator is 2. Above table presents the results as follows

(i) During the first period, multiplier and accelator do not operate. Therefore, total income and marginal investment are equal (Rs. 200/Crores).

(ii) During second period, consumption is Rs. 100 crores because MPC = 0.5. Investments increase by Rs. 200 crores because accelator is 2. Therefore, total increase in income during second period is Rs. 500 crores.

(11) During third period, expenditure on consumption will be Rs. 250 crores (500 x 1/2). Thus, total expenditure on consumption will increase by Rs. 150 crores. Induced investments will be Rs. 300 crores and total income will increase by Rs. 750 crores.

(iv) During fourth period, total income will be Rs. 825 crores due to interaction of multiplier and accelator.

(v) During fifth period, the downward trend starts and total income comes to Rs. 6.8 crores only

DIFFERENT PHASES OF TRADE-CYCLES

Suppose that an incident increases investments. Due to the operation of multiplier, the increase in total income as a result of additional investments, will be much more than the increase in investments. Actual amount of increase in total income will depend upon the marginal propensity to consume. Increase in income will increase the demand for consumption. It will increase production. It will increase the demand of capital goods and the factors of production. As a result, the prices of factors of production will also increase which, in turn, will increase the demand of goods and services in the country. All these factors together will create an atmosphere of propensity. These determinants will operate as follows

(i) As and when there is an increase in income, marginal propensity to consume decreases. In other words, expenditure on consumption does not increase in the ratio of increase in income.

(ii) As a result of increase in prices, profits increase at a faster rate than wages. It implies that the distribution of additional income goes in favour of entrepreneurs whose propensity to consume is relatively low.

(iii) When increase in prices is under control for some time, capital output ratio starts to increase. As a result, investments seem to be less profitable.

(iv) When the rate of increase in the expenditure on consumption goes down and the amount of investments starts to decrease due to accelator, the situation of depression arises.

(v) When the situation of depression persists for a certain time, above forces start to operate in opposite direction. As a result, Marginal Propensity to Consume (MPC) increases and the distributon of additional income goes in the favour of workers. Gradually, the demand of goods and services increases, level of consumption, production, employment and income also increases. All these factors together create the situation of prosperity.

Explanation with the Help of a Diagram. This theory can be explained with the help of following diagram also—

 

In this diagram, ‘AA’ line represents autonomous investments. Since it is a straight line, it represents that the investments of this nature increase at a certain rate. ‘FE’ line represents increase in total income generated by the interaction of multiplier and accelator. ‘FF’ is the highest level of employment and total national product cannot increase beyond this limit. ‘LL is the line below which national income cannot go. Suppose that ‘Po’ is the situation of equilibrium in above diagram and due to a research or innovation, the investment increases to ‘Pi’. As a result of this, total income also increases. This increase further encourages A investments due to the operation of accelerator. As this stage, multiplier starts to operate which o increases income many times. As a result of Time interaction of multiplier and accelerator, total income goes on increasing on Poll to ‘Pi’ path but it can never cross ‘Pi’ because it is the maximum limit of production and employment. After this point, the rate of increase in national income comes down, as a result of which, trade-cycle curve slopes downwards. Therefore, total national income moves to ‘EE from the point “P2’. Investments go on declining and the economy touches the point ‘Q. National income cannot be less than this level. Therefore, trade-cycle curve will not slope downward further. Economy will slope from ‘Qi’ to ‘Q2’. At this point, investments start to increase slightly

Assumption of the Theory of Prof. Hicks. This theory of trade-cycles based upon the following assumptions

(i) Present consumption is the function of previous income.

(ii) The multiplier of savings and investments is in the form that the economy can move in a circular form.

(iii) Values of multiplier and accelerator are constant.

(iv) Economy is developing in which autonomous investments increase at a constant rate and as a result, the economy remains in the situation of dynamic equilibrium.

(v) Economy cannot be expanded beyond the level of full employment.

(vi) The operation of accelerator during the period of contraction is different from its operation during the period of expansion and this difference is important for the fluctuations of economic activities.

(vii) Average capital production ratio is more than unit. (viii) Production and income are always measured in their real senses.

Critical Evaluation. Modern theory of trade-cycles as propounded by Prof. Hicks is a logical and scientific analysis of different phases of trade-cycles. Even it is not free from criticisms. Important criticisms of this theory are as under

(i) This theory is based upon certain assumptions out of which some assumptions are not real. These assumptions are as under:

(a) This value of multiplier and accelator remains constant during different phases of trade-cycles.

(b) Ratio between accelator and capital output is constant.

(c) Autonomous investments are made regularly during different phases of Trade-cycles

(ii) This theory defines the level of full employment as independent from the path of production but in practical life, it cannot be so.

(iii)This theory assumes that the problem of Trade-cycles is purely a problem of technical or machenical nature but in practical life, the changes in economic activities are not so technical and machanical.

(iv) This theory makes significant difference between autonomous investments and induced investments. In practical life, it is not possible to draw such a line of distinction between the two.

(v) This theory does not emphasise upon the role of monetary forces.

(vi) This theory is unable in explaining the process of change from the phase of prosperity to the phase of depression.

(vii) This theory assumes that during depression, autonomous investments will increase but the critics are of the view that it does not happen so.

(viii) This theory assumes that the duration of the phase of contraction is longer than that of the phase expansion. Practical experience, particularly after wars, has proved tht the duration of the period of expansion is much longer than the duration of contraction.

Conclusion. Various theories have been propounded to explain the process and causes of Trade-cycles. These theories can broadly be divided into two parts-monetary theories and non-monetary theories. All the theories concentrate upon the some particular factor or factors but no theory is free from criticisms. All the theories have been criticised for one reason or other. However, the theory of Prof. Hicks can be regarded as a complete, logical and most scientific theory of Trade-cycles.

MAIN CAUSES FOR GIVING BIRTH TO TRADE-CYCLES

Important causes giving birth to Trade-cycles may be explained as follows

1 Expansion of Loans and Contraction of Loans by Banks. A change in the credit policy of banks is an important cause of Trade-cycles. When banks adopt the policy of credit expansion, it leads to the phase of prosperity. On the other hand, when banks adopt the policy of credit contraction, it leads to the phase of depression.

2. Mala-Adjustment between Demand and Investment. If there is Mala-Adjustment between Savings and Investment, it causes Trade-cycles. When there is over-investment, it leads to the phase of prosperity and when He is under-investment, it leads to the phase of depression.

3. Lack of Adjustment between Demand and Supply. Demand and supply of goods and services play an important role in giving birth to Trade-cycles. If the demand of goods and services is more than their supply, it causes prosperity. If, on the other hand, supply of goods and services is more than their demand, it causes depression.

4. Lack of Adjustment between Income and Expenses of Consumers. If the income of consumers is more than their regular expenses, the phase of prosperity is caused. If, on the other hand, income of consumers is less than their regular expenses, it leads to the phase of depression.

5. Feeling of Entrepreneurs. An important cause of Trade-cycles is the feelings of entrepreneurs. If the entrepreneurs are optimistic and hopeful, it will lead to the phase of prosperity. If, on the other hand, entrepreneurs are pessimistic and frustrated, it will lead to the phase of depression.

6. Development of New Technologies of Production. Development of New Technological of Production affects the level of production, employment and income. If new technologies of production, develop, it leads to the phase of prosperity and if there is a lack of development of new technologies, it may lead to the phase of depression.

7. Lack of Favourable Ratio. Development of new technologies of production disturb the existing ratio of factor of production. Sometimes the ratio becomes more favourable and sometimes it becomes unfavourable. When this ratio is favourable, it leads to the phase of prosperity and when this ratio is not favourable, it leads to the phase of depression.

8. Psychology of Consumers. Psychology of consumers also cause Trade-cycles. If the consumers are hopeful and optimistic, it will lead to the phase of prosperity and if the consumers are passimistic and not hopeful, it may lead to the phase of depression.

9. Seasonal Fluctuations. Seasonal Fluctuations affect agricultural production to a large extent, which, in turn, causes Trade-cycles.

CONTROL ON TRADE-CYCLES

Measures to control Trade-cycles can broadly be divided into two parts-(I) Preventive Measures, (II) Formal Measures. Detail in this regard are as follows

(I) PREVENTIVE MEASURES

Preventive measures are not the measures to control Trade-cycles. These are the measures which are adopted to minimise the possibility of occurance of Trade-cycles. Important preventive measures are as follows

(1) Agricultural should not upon rain-fall. Adequate irrigation facilities should be developed in the country.

(2) Inequalities in the distribution of income and wealth should be reduced to minimum.

(3) Speculative trend should be checked.

(4) Wherever necessary, industries should be nationalised.

(5) All the effects should be made to maintain proper balance between demand and supply.

(6) Monetary and fiscal policies should be well regulated and controlled.

(7) All the business and industrial activities should be strictly controlled.

(II) FORMAL MEASURES

Formal Measures are the measures which cannot help in removing the fundamental causes of Trade-cycles, however, can minimize them. Important formal measures are as under

1 Monitory Policy. Monetary Policy includes all the measures through which central bank of the country regulates, the supply of money and credit in the country. To overcome the situation of depression, the policy of credit expansion is followed so that the entrepreneurs may be encouraged to take more loans and to increase their investment so that the level of production, employment and income may be increased. On the contrary to overcome situation of money inflation, the policy of credit contraction is adopted so that entrepreneurs may be compelled to withdraw their investment.

2. Fiscal Policy. There are four important components of fiscal policy-Budget Policy, Taxation Policy, Public Expenditure and Public Debt. Fiscal policy plays an important role in controlling trade-cycles. During the period of depression, important object of fiscal policy should be two increase effective demand. During the period of money inflation, main aim of fiscal policy should be to reduce public expenditure. Following are the measures which can be adopted through fiscal policy

(1) During the period of depression, deficit financing should be adopted.

(ii) During the period of inflation, budget deficit be within limits.

(iii) During the period of depression, there should be maximum burden of taxation on consumers. In addition to this, tax concessions should be announced. Taxation policy should be used for re-distribution of national income. During this period, the distribution of income should be in the favour of poor persons.

(iv) During the period of money inflation, new taxes should be imposed and the existing tax concessions should be withdrawn.

(v) During the period of depression, public expenditure should be increased so that effective demand may increase. Public investments should be made on large scale so that the deficit of private investment may be compensated. Government should spend heavy amount on public works during this period so that the level of employment may be increased.

(vi) During the period of money inflation, public expenditure should be curtailed and public investments should be minimimum. Government should not start new projects.

(vii) During the period of money inflation, the Government should collect maximum money as public debt. During the period of depression, public debts should be repaid.

An important point to note in this regard is that both monetary and fiscal policies have their own limitations. Therefore, the Governement should use these policies very carefully to have a check and control over trade-cycles. Government should use these policies so that and effective co-ordination may be established between these policies.

3.Physical Controls. Physical Controls include price support policy, price control and rationing etc. During the period of depression, Government should fixed minimum prices so that the rise in price may be controlled. In addition to this, Government should purchase various products at a pre-determined price. During the period of money inflation, Government should adopt the policy of rationing so that the goods may be provided to consumers at reasonable prices.

4. Other Measures. Other Measures to control trade-cycles are as follows

(i) International assistance should be obtained of fight against the problems of depression and unemployment.

(ii) Technical unemployment should be removed by removing market imperfections.

Conclusion. Above discussion makes it clear that there are several causes of trade-cycles. Though these causes cannot be fully checked and controlled, yet they can be minimised if proper and adequate measures are adopted by Government. Full co-operation of Government machinery should co-operate in this direction and the business society should make their best efforts.