Various Phases of Trade Cycle

08/02/2020 0 By indiafreenotes

Four phases of a trade cycle are: 1. Prosperity, 2. Recession, 3. Depression, 4. Recovery Phase!

  1. Prosperity phase: Expansion or the upswing.
  2. Recessionary phase: A turn from prosperity to depression (or upper turning point).
  3. Depressionary phase: Contraction or downswing.
  4. Revival or recovery phase: The turn from depression to prosperity (or lower turning point).

The above four phases of a trade cycle are shown in Fig. 1. These phases are recurrent and follow a regular sequence.

The Phases of a Trade Cycle

This means that when prosperity ends, recession starts; depression follows recession; recovery follows depression; prosperity comes after recovery and in turn gives way to recession. Thus, each phase always appears when the immediately preceding phase has run its course. It should be remembered that no phase has any definite periodicity or time interval.

  1. Prosperity

Haberler defines prosperity as “a state of affairs in which the real income consumed, real income produced and level of employment are high or rising and there are no idle resources or unemployed workers or very few of either.”

As Haberler points out, the characteristic features of prosperity are (i) a high level of output and trade, (ii) a high level of effective demand; (iii) a high level of employment and income; (iv) a high marginal efficiency of capital; (v) a price inflation; (vi) a rising structure of interest rate; (vii) a large expansion of bank credit; (viii) overall business optimism, and (ix) tendency of the economy to operate at almost full capacity along its production possibility frontier.

The prosperity phase comes to an end when the forces favouring expansion become progressively weak. Bottlenecks begin to appear at the peak of prosperity. In fact, the profit-inflation and over-optimism which increase the tempo carry with them the seeds of self- destruction.

In view of high profits and business optimism, entrepreneurs invest more and expand further. But scarcity of resources, particularly, the shortage of raw materials and labour causes bottlenecks and business calculations go wrong. Hence entrepreneurs become over-cautious and the peak of prosperity and their over-optimism pave the way to over-pessimism. Thus, prosperity digs its own grave.

  1. Recession

When prosperity ends, recession begins. Recession relates to a turning point rather than a phase. It lasts relatively for a shorter period of time. It marks the point at which the forces that make for contraction finally win over the forces of expansion. Liquidation in the stock market, repayment of bank loans and the decline of prices are its outward symptoms.

The stock market is the first to experience the downfall as there will be sudden and violent changes in the prevailing atmosphere. During a recession, businessmen lose confidence. Everyone feels pessimistic about the future profitability of investment. Hence, investment will be drastically curtailed and production of capital goods industries will fall.

During the recessionary phase, the banking system and the people in general try to attain greater liquidity. Therefore, credit sharply contracts. Business expansion stops, orders are cancelled and workers are laid off. There is a general drive to contract the scale of operations, leading to increase in unemployment; thus, income throughout the economy falls. Reduced income causes a decrease in aggregate expenditure and thus, the general demand falls, in turn, prices, profit and business decline.

  1. Depression

During a depression, the most deplorable conditions prevail in the economy. Real income consumed, real income produced and the rate of employment fall or reach subnormal levels due to idle resources and capacity.

As Haberler points out, the characteristic features of a depression are the reverse of prosperity:

(i) Shrinkage in the volume of output, trade and transactions;

(ii) Rise in the level of unemployment;

(iii) Price deflation;

(iv) Fall in the aggregate income of the community (especially wages and profits);

(v) Fall in the structure of interest rates;

(vi) Curtailment in consumption expenditure and reduction in the level of effective demand;

(vii) Collapse of the marginal efficiency of capital and decline in the investment demand function;

(viii) Contraction of bank credit, etc.

In short, a depressionary period is characterised by an overall curtailment of aggregate economic activity and its bottom. Thus, depression and prosperity differ in degree rather than in kind. In the former economic activity is at its trough, while in the latter, economic activity is at its peak.

However, a depression cannot be regarded as a permanent feature of an economy. In fact, the very forces which cause the depression are themselves self- defeating. For, during a depression, businessmen postpone replacement of their plant and machinery and consumers postpone the purchase of durable goods. Hence the need for replacement and the purchase of durable goods gradually accumulate.

Hence, after a period of time, there will be a moderate increase in the purchase of durable goods on the consumer’s part and replacement of plant and machinery on the part of producers. This will call for an increase in production, in turn leading to an increase in employment, income and aggregate effective demand. Banks will be anxious to expand credit by reducing the rate of interest. Gradually, pessimism vanishes and optimism develops and economic activity once again gathers momentum. Thus, a stage of recovery sets in.

  1. Recovery Phase

The revival or recovery phase refers to the lower turning point at which an economy undergoes change from depression to prosperity. With an improvement in demand for capital goods, recovery sets in. When the demand for consumption goods rises or when the capital stock increases, the demand for capital goods will rise and new investment will be induced.

Such induced investment will cause a rise in employment and income. The increased income in turn will lead to a rise in consumption which will push up the demand further which in turn leads to a rise in prices, profits, further investment, employment and income.

The increased income in turns will lead to a rise in consumption which will push up the demand further which in turns leads to a rise in prices, profits, further investment, employment and income. Once the expansionary movement starts, this is how it gathers momentum. During the revival period, level of employment output and income slowly and steadily improve. Stock markets become more sensitive during this period.

A bullish atmosphere will prevail on the stock exchanges. An increase in stock prices favours expansion and hasten revival. The expectations of the entrepreneurs improve and business optimism leads to the stimulation of development investment.

The wave of recovery, once initiated, begins to feed upon itself. Thus, during a recessionary period, the expansionary process will be self-reinforcing and if it is continued for some time, the economy will find itself in a position of rising level of income, output and employment. When this happens, revival slowly emerges into prosperity and the cycle repeats itself.

A business cycle is a complex phenomenon which embraces the entire economic system. It can scarcely be traced to any single cause. Normally a business cycle is caused and conditioned by a number of factors, both exogenous and endogenous.

Various theories have been expounded by different economists to explain the cause of a trade cycle, the symptoms of which are alternating periods of prosperity and depression. Different explanations stressing one or a few factors at a time have been advanced by economists. A brief review of important trade cycle theories has been attempted in the following sections.