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Business cycle is also called Trade Cycle. The business is never steady.
There are always ups and downs in economic activity. This cyclical
movement both upwards and downwards is commonly called Trade Cycle.
This is a wave like movement in regular manner in business cycle. In
business, there are flourishing activities, which take economy to prosperity
and growth whereas there are periods when there is recession, which leads
to decline in the employment, income and output. When the economy goes
into downswing then there is a stage of recovery to reach a new boom.
Example:
Business Cycle (or Trade Cycle) is divided into the following four phases :-
The four phases of business cycles are shown in the following diagram :-
Level of output
Time
The business cycle starts from a trough (lower point) and passes through a
recovery phase followed by a period of expansion (upper turning point) and
prosperity. After the peak point is reached there is a declining phase of
recession followed by a depression. Again the business cycle continues
similarly with ups and downs.
1. Prosperity Phase
When there is an expansion of output, income, employment, prices and
profits, there is also a rise in the standard of living. This period is termed as
Prosperity phase.
2. Recession Phase
3. Depression Phase
4. Recovery Phase
Innovation means the introduction of (1) new product, (2) new process, (3)
new market, (4) new sources of raw material and (5) changes in the
operation of business.
Every innovation increases the demand for capital and other resources.
Bank credits expand and prices rise. The process is accelerated if the
innovation is successful and a large number of new concerns are started.
This is the period of prosperity. But the forces which innovations set in
motion carry with them the seeds of their own destruction.
Innovation engenders booms but booms are the cause of depression which
continues until readjustment required by innovation is carried through.
Schumpeter connects long waves with major innovations and short waves
with minor innovations.
The innovation disturbs this equilibrium. The innovator with bigger prospect
of his business turns towards banks for more funds and thus profit rates
rise.
Forces of recession set in. The economic system finds its way back to a
new equilibrium through a period of adaptation by most of the old firms
through rationalisation and reconstruction.
In this way during this period of upswing, output increases faster than the
equilibrium rate. Investment also increases faster than the normal rate.
The expansion of income and output will continue till the economy reaches
the upper limit or ceiling determined by full employment.
After this ceiling, it starts declining. The rate of expansion in output and
income is slowed down to the natural rate.
A fall in investment reduces income at a faster rate and the reduced income
again reduce the level of investment and so on.
Now the level of output and income will not only reduce to the equilibrium
level but rather below it.
The reason is obvious as the multiplier and the accelerator work just in the
opposite directions. This will go on declining till it reaches the minimum
(lower) turning point.
Thus, the cycle is complete the main limitation of this theory lies in the use
of acceleration principle which the modern economists consider as a crude
tool.