The following is the most comprehensive ever explanation to the

most mysterious phenomenon of Capitalism – the Business Cycles.

In order to ensure that the article can be read by any well

educated reader, I have minimized the economics jargon and have

added a short and simple introduction to the structure of the

economy. Each and every one of us would be interested to know

as to why we cannot have a paradise on earth. Why is it that we

are often besieged by such painful downslides of economic

activity such as Great Depression or the nerve wracking periods

such as Stagflations? Why can’t we all be always happy with

hundred percent employment all the time, with each and every

one of us employed? The following article provides simple and

complete Business Cycle explanations to Depressions before

1930s, Recessions after 1940s, Stagflations of 70s and

Continuous Booms of 80s and 90s.

The income that we earn is normally divided into two portions,

Consumption and Savings. We normally consume a large portion of

the income we earn for our day to day necessities as well as

irregular buys. Regular necessities include food, clothing,

toothpastes, soaps and other daily necessities. Irregular buys

include bikes, cars, books, movies, music and so on. After we

spend most of our incomes on Consumption, we save a small

portion of our income and invest it in shares, bonds, fixed

deposits and other long term investments.

In direct relation to our above mentioned activity, our economy

is divided into two sectors – Consumption sector and Investment

sector. If we exclude the government spending, Consumption

sector constitutes roughly around 80% of the size of economy.

It includes everything that we buy – food, clothing, cars,

bikes, TVs and other durable goods, books – every thing. And

around 20 percent of the size our economy is constituted by the

Investment sector. Investment sector mainly includes activities

such as installing new plants and capacities, and housing. A

three sector model would also include government spending as

well. However free markets have more to do with these sectors

and less to do with Government Spending, so let us exclude

governemnt spending. The figures given above are only

approximate and can vary sizeably from economy to economy.

So how are profits made by the Consumption sector

manufacturers? In any economy, Consumption sector always

produces in excess of its requirements – it produces surplus.

Consumption sector capitalists as well as households also save

a certain portion of their income. Investors invest these

Savings in the Investment sector. So these Savings turn into

the earnings of the Investment sector capitalists and workers.

The workers and capitalists of the Investment sector then spend

their earnings on the consumption goods. So basically the

surplus production of the Consumption sector is consumed by the

workers and capitalists of the Investment sector. Therefore in a

circular flow monetary economy, the income of the Investment

sector becomes the profit or surplus of the Consumption sector

firms. There is a small assumption that is made here on which I

shall allude to at the end of the article.

So there are two things that we have to note here. First the

size of the investment sector decides on the size of the

profits of the Consumption sector. If there are huge

Investments made, the Consumption sector capitalists make huge

surpluses or profits and if the size of the Investment sector

is on the lower side, the Consumption sector capitalists would

make lower surpluses or profits. Also all of the Savings made

should always be invested. If Savings are made but are not

invested, then it would lead to a lower size of Investments and

lower profits. Insufficient profits would force the producers to

cut down on their production levels and this would directly lead

to rising unemployment and recession! It is a long recognized

economic thought that Savings made should be compulsorily

invested fully so that the economy can be in equilibrium. If

the Savings made are not invested fully, it can lead to

disequilibrium between Supply and Demand and can lead to piling

up of unsold stocks of inventories and a subsequent recession.

With the above short introduction to the structure of our

economy, we are ready for a small journey into the fascinating

world of Business Cycles.

Our economies are rarely ever static. They keep growing in size

every year. Now in a growing economy Consumption also grows.

Year on year more cars are purchased, more televisions are

bought, more computers are installed and so on. It is natural

that when Consumption grows by say 6%, the suppliers would

expect their surplus also to grow by 6% because surplus, which

is called profit in the business parlance, is obviously

measured in percentage terms. However the surplus production

has to be consumed by the workers of the Investment sector

which obviously means that even Investment would have to grow

by 6%. However this would mean that Savings, which is the fund

for Investment, would also have to grow by 6%. What would

happen if Consumption grows by 6% but Investment or Savings do

not grow by an equivalent percentage? To the extent of the

inequality, producers’ surplus would remain unsold and the

economy would be in disequilibrium. So the equilibrium

condition of the economy would be –

Periodic Growth percentage of Consumption = Periodic growth

percentage of Investment = Periodic growth percentage of

Savings.

Suppose during a particular period, there was a perfect

equilibrium in which Consumption was C, Investment was I and

Savings was S. Suppose during the next financial period C grows

by a certain X percentage points. Then S and I would also have

to grow by the same X percentage points. Suppose either I or S

does not grow by X percentage points, the economy would be in

disequilibrium even if Investment is equal to Savings!

Here in lies a blue print for different types of Business

Cycles.

A normal characteristic of any recession is the presence of

huge un-invested Savings. Investors hoard money without

investing it because of lack of investor confidence. At the

trough or the lowest point in a business cycle, Consumption is

relatively low and Savings are relatively high, especially

un-invested Savings. Then as economic activity picks up, all of

the Savings are invested and the producers of the Consumption

sector would be able to realize their expected surpluses. The

size of Investment sector is equal to the surplus of the

Consumption sector. Since Savings are high and are fully

invested, the producers of the Consumption sector would be able

to realize huge surpluses. Economic activity picks up a roaring

speed.

As economic activity picks up, there starts a battle amongst

the producers for market shares. For example, each car

manufacturer wants to sell as many cars as possible. He would

not think – let me produce less cars now, let me save and

invest more for later. So as the battle for market share picks

up, Consumption accelerates at the expense of Savings i.e.

Consumption grows at a faster rate than Savings. Our above

mentioned condition tells us that for equilibrium to exist,

Consumption and Savings have to grow at an equal pace. So if

Consumption grows at a faster pace than Savings, would this

lead to disequilibrium immediately? This may not immediately

lead to disequilibrium because producers would obviously not

keep expecting to earn abnormally high profits the way they

earned in the initial stages of the boom. Their expectations

are also geared towards comparatively lower profits or what is

called as normal profits as the boom progresses and therefore

lower growth rate in Savings vis-à-vis Consumption would not

immediately damage their expectations of surplus. This way the

boom progresses from the trough to the peak for a few years.

After a few years of growth of Consumption at a faster rate

than Savings, the percentage of Savings in the income would

drop so low that Savings are not sufficient to meet the

expectations of surplus of the producers of the Consumption

sector. Even if Savings are fully invested, this does not

generate the surplus as expected by the Consumption sector

because of the lower size of investment and would lead to

disequilibrium. Producers see their unsold inventory stock

piles rise and their profits dwindle. The situation needs

correction. Consumption needs to be cut and Savings need to be

raised. As they are not able to sell their goods, the producers

of Consumption sector would be more than willing to do so. They

cut their production and increase their Savings.

However the required correction might not materialize! The very

objective of capitalist economies is Consumption. If Consumption

is on the decline, we cannot expect Investment to increase. We

cannot have fewer bikes sold as compared to previous year and

at the same time have much higher Investment in the bike sector

as compared to the previous year. A cut in Consumption might

increase Savings but would not raise Investment. Investment

follows the path of Consumption and it itself starts in the

downward trend. As a result the increased Savings are not

invested and the disequilibrium takes on a relatively permanent

position and we have a recession! There are no automatic forces

to ensure immediate correction. What started with a cut in

Consumption to increase Savings leads to a fall in Investment.

This drop in Investment leads to a further depletion of

aggregate demand which then prompts the producers to cut their

production levels even further. Consumption declines even

further and the spiral continues until the economy settles at a

low output with a lot of unemployment. This sort of downward

spirals were recognized by the eminent British economist John

Maynard Keynes. Eventually, after a few years of low output,

some invention or some enthusiastic entrepreneurs who are

attracted by prevalent low interest rates might trigger

Investment to reverse its downward path and start the process

of expansion all over again. I believe that most recessions in

US and Europe after 1940s occurred in this way. I would call

these cycles – the Consumption led Business Cycles.

© 2005 Thotakura R,US registration:TXU 1-256-191