Phases of Business Cycle in Business and Financial Market

After understanding what are business cycle and their characteristics, we will take each phase of business cycle in detail.

Prosperity or Expansion:

This phase of business cycle is called the upswing. This phase is in the upper half of the cycle. To start with, we will try to see how this phase begins. It starts from equilibrium position. When the demand increases, the demand of raw material also increases and so the employment which again leads to increase in employment in other industry. As the consumption increases, general employment also increases. The wages, salaries, interest rates, taxes and the cost do not increase in the same proportion and consequently profit margins go up. There is a general feeling of optimism, and the production capacity of the economy is fully utilized. The rise in general price is marked in this phase.

In this phase, investment activity increases due to increase in demand for consumption goods. This optimistic sentiment can be seen in real estate and share market boom. Manufacturers pile up stock with improved prospects of increase in demand. This activity of producers’ increase in production is faster than consumption. But this process cannot be indefinitely continued. This phase ends and turns into phase of recession. The factors for recession to start are, when the gap between cost and price starts rising and the profit margin declines. This happens because of scarcity felt in different factor market and therefore the price of factors of production rises.

Recession:

This is a turning period, which is relatively shorter. But in this phase the production of consumer goods do not decline immediately. The demand for consumer goods fall with lag but the fall in demand for capital goods falls drastically. Producers cancel their future investment programmers so the demand for machinery decreases and therefore the capital goods manufacturing sectors respond more quickly. In this period over optimism gives way to over pessimism. All the investment seems unprofitable and so there is collapse in Marginal Efficiency of Capital. The employment situation gets bad as investment activity declines. This is referred as mild recession but when recession is severe it is called crisis.

Depression or Contraction:

This phase is a phase of low economic activity. There is a fall in production and employment throughout the economy. But it is not uniform in all sectors. The fall in demand for consumer goods is less than the fall in demand for machines and equipment. During depression, the expenditure on durable goods fall more than consumer goods. Therefore, the production and employment is affected in the sectors producing durable goods. Agriculture sectors are not much affected, as it is necessary for subsistence. The producers and wholesalers start liquidating their inventories piling up during prosperity phase. This phase shows low economic activity with fall in production, fall in employment and fall in general price level and the profit margins also. Producers are not interested to venture fresh investment as the MEC totally collapses.

The price structure is distorted as for some goods, price falls a little; whereas for some goods, the price vertically collapses making the income distribution worst and this prolongs the phase of depression. On the other hand, not all the costs fall at an equal rate; as wages and salaries tend to be sticky during this period due to trade unions about labour laws. Rents, interest rates and taxes come down slowly, while price falls down continuously and cost rigidity washes away the profit margins for producer. Turning point of depression is ‘trough,’ which is a very short period but sometimes it is for 3-5 years. For e.g. the Great depression of 1930s. After this, the recovery phase starts.

Recovery:

This phase is gradual. It starts when the price stops falling. This is said to start when the piled up stock is exhausted. Now, the producers start planning for production. This generates employment and income, which again leads to demand for consumer goods. The MEC starts improving. This leads to correction of price and so also to the relationship between cost and price. The profit starts replacing looses and recovery gathers momentum. Rising price encourages companies towards new investment and projects. This phase of recovery takes the economy to the phase of prosperity. Thus, the cycle is again ready to repeat itself.

Now we know what a business cycle and the phases of business cycle. In the next section, we will try to understand the theories of business cycle. They will explain you the causes of business cycle.