The primary goals of both fiscal policy and monetary policy are “growth” and “price stability.” Although growth in modern economies is understood to be the main concern of the fiscal policy, price stability is considered as the main concern of the monetary policy. Nevertheless, growth is not totally detached from liquidity and money supply management (monetary policy) and likewise price stability is also not free from the impact of management of public revenue and public expenditure (fiscal policy).

Understanding business cycle

Business cycle refers to a cycle or series of cycles of economic expansion and contraction. Growth in any economy depends on savings, capital formation, investment, efficiency etc. Growth has a cyclic behaviour, i.e., it is sometimes slow, sometimes fast and sometimes negative. Very fast growth rate leads to increase in output, employment and income only up to a limit (boom) and after peaking, growth slows down or becomes negative (recession). When economic growth accelerates, it is accompanied by inflation and when growth decelerates it may be accompanied by deflation. The bottom of decelerating growth is reached at a point called “depression”. Growth and price stability once achieved do not always remain at a desirable and pleasant level, these parameters fluctuate overtime. Thus, growth and price stability have alternative phases in an economy and to bring these parameters to normalcy, fiscal and monetary policy are used in combination.

Boom and bust

In economic literature we use another term for business cycle, i.e., boom-and-bust; boom refers to peak of economic activities and bust refers to the bottom of economic activities. Boom is that phase of business cycle in which the economic expansion is rapid and bust refers to phase of severe contraction in growth of an economy.

The business cycle, also known as the economic cycle or trade cycle, is the downward and upward movement of gross domestic product (GDP) around its long-term growth trend. The business cycle describes the rise and fall in production output of goods and services in an economy. Business cycles are generally measured using rise and fall in real – inflation-adjusted – gross domestic product (GDP), which includes output from the household and nonprofit sector and the government sector, as well as business output.

The length of a business cycle is the period of time containing a single boom and contraction in sequence. These fluctuations typically involve shifts over time between periods of relatively rapid economic growth (expansions or booms), and periods of relative stagnation or decline (contractions or recessions). “Inflation” usually occurs on the rising arm of the business cycle (growth phase) while “deflation” occurs on the downward arm of the business cycle (recession phase).

Business cycles are usually measured by considering the growth rate of real gross domestic product. Despite the often-applied term cycles, these fluctuations in economic activity do not exhibit uniform or predictable periodicity.

In economic theory there are different kinds of business cycle. However, modern macro economics does not agree with the fixed periodicity of the business cycles. In 1860 French economist Clement Juglar first identified economic cycles 7 to 11 years long, although he cautiously did not claim any rigid regularity. Joseph Schumpeter (1883–1950) argued that a Juglar cycle consists of four stages: (i) expansion (increase in production and prices, low interest-rates); (ii) crisis (stock exchanges crash and multiple bankruptcies of firms occur); (iii) recession (drops in prices and in output, high interest-rates) and (iv) recovery (stocks recover because of the fall in prices and incomes). Schumpeter’s Juglar model associates recovery and prosperity with increases in productivity, consumer confidence, aggregate demand, and prices. In the 20th century, Schumpeter and others proposed a typology of business cycles according to their periodicity, so that a number of particular cycles were named after their discoverers or proposers:

  1. The Kitchin inventory cycle of 3 to 5 years (after Joseph Kitchin)

  2. The Juglar fixed-investment cycle or business cycle of 7 to 11 years

  3. The Kuznets infrastructural investment cycle of 15 to 25 years (after Simon Kuznets – also called “building cycle”)

  4. The Kondratiev wave or long technological cycle of 45 to 60 years (after the Soviet economist Nikolai Kondratiev).

Inflation

Inflation is the rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of currency is falling. Central banks attempt to limit inflation, and avoid deflation, in order to keep the economy running smoothly.

Inflation measures rise in price level (weighted average price trend of selected and representative commodities – basket of goods and services both) and not single price of a single commodity. When inflation is declining, it means price level is still rising, but with a slower speed; and when inflation is rising, it means price level is rising with a greater speed. When rate of inflation becomes negative, it is called deflation. In other words deflation is the opposite of inflation.

Inflation is the rate of change in prices of all goods and services in an economy over a period of time. Every country has its own set of commodity basket to track inflation. While some countries use Wholesale Price Index (WPI) as their official measure of inflation and some others use the Consumer Price Index (CPI). According to the International Monetary Fund (IMF), while 24 countries use WPI as the official measure to track inflation, 157 countries use CPI. Conceptually these two measures of inflation stress different stages of price realization as well as composition: while WPI measures the change in price level at wholesale market, CPI measures the change in price level at retail level. Wholesale price index may be a proxy for “producers’ price index” whereas consumer price index may be used as a proxy of “cost of living index.”

Types of Inflation

Classification of Inflation on the basis of speed

  1. Creeping inflation — Inflation below 5%

  2. Walking inflation—- Inflation above 5% and less than 10%

  3. Galloping inflation— Double digit Inflation, i.e 10% up to 99%

  4. Hyper inflation—- 100% or more

The above classification was given by prof Samuelson; however, the numbers were associated with the concepts for the convenience and objectivity in understanding later on.

Classification of Inflation based on causation

  1. Demand Pull Inflation: Inflation that is caused by excess of demand of a commodity over its supply. The excess demand may be caused by rising disposable income, lower direct taxes or even falling prices. It may also be caused by behavioural and taste changes among consumers. Inflation follows when too much money is chasing too few goods. In other words when growth is slow, but money supply increases or purchasing capacity of people increases inflation takes place.

  2. Cost push inflation— This type of inflation is caused by supply side changes such as rising wages, increasing cost of raw materials and inputs like fuel, higher indirect taxes and inefficiency in production etc.

Classification based on Measurement

Headline Inflation— Headline inflation is a measure of the total inflation within an economy, including commodities such as food and energy prices (e.g., oil and gas), which tend to be much more volatile and prone to inflationary spikes.

Core Inflation— “core inflation” (also non-food-manufacturing or underlying inflation) is calculated from a price index minus the volatile food and energy components. In other words, core inflation is equal to headline inflation minus inflation in primary articles.

The European Central Bank and the Bank of England have mandates that spell out their inflation goals in terms of headline inflation. India also focuses on headline inflation. Headline inflation may not present an accurate picture of an economy’s inflationary trend since sector-specific inflationary spikes are unlikely to persist.

In the United States, however, the Federal Open Market Committee (FOMC) focuses on core inflation—namely the “personal consumption expenditures price index”. However, President of the Federal Reserve Bank of St. Louis James B. Bullard explained that the FOMC still takes headline PCE into account, and that since 2008 (in the wake of the financial crisis) the FOMC has included forecasts for both types of inflation in its semiannual “Monetary Policy Report” for the United States Congress. He emphasized that “the Fed’s main concern is long-run headline inflation and the prices people actually pay.

Measurement of Inflation in India

Headline inflation, wholesale inflation, year-on-year inflation or point to point inflation

In India, headline inflation is measured through the WPI (the latest base year 2011-12) – which consists of 697 commodities (services are not included in WPI in India). It is measured on year-on-year basis i.e., rate of change in price level in a given month vis a vis corresponding month of last year. This is also known as point to point inflation.

In India, there are three main components in WPI – Primary Articles (weight: 22.62%), Fuel & Power (weight: 13.15%) and Manufactured Products (weight: 64.23). Within WPI, Food Inflation is also calculated on year-on-year basis.

Consumer price Index

Another measure of inflation in India is Consumer Price Index (CPI). CPI is computed to capture inflation in India in the retail sector, which in fact shows the price level in retail sector or on consumers’ end. In particular, four categories of CPI are computed – for Industrial Workers (CPI-IW), Urban Non-Manual Employees (CPI-UNME), Agricultural Labourers (CPI-AL) and Rural Labourers (CPI-RL).

CPIN, CPIR and CPIU

Past India used WPI to measure headline inflation due to its wider coverage. WPI, however, did not reflect the price changes in the services sector. Therefore, India started using CPI to measure headline inflation. The Central Statistical Organization (on 18th February 2011) has introduced a new series of CPI (with 2010=100 as the base year), which would be calculated for all-India as well as States/UTs – with separate categorization for rural, urban and combined (rural + urban). So we have now CPI- rural (CPIR) and CPI- urban (CPIU). CPIN (CPI national) is average of CPIR and CPIU.

Based on Urjit Patel Committee recommendations, India uses CPIN equivalent of 4%+/- 2% for inflation targeting.

Inflation an interpretation

Inflationary and deflationary gaps

According to J.M. Keynes inflation occurs only after an economy achieves “full employment (of factors of production)”. Keynes gave the concept of “inflationary gap”. An inflationary gap, in economics, is the amount by which the actual gross domestic product exceeds potential full-employment GDP.

Inflationary gap is the amount by which the actual aggregate demand exceeds ‘aggregate supply at level of full employment’. For instance, in Fig. 8.16, BE is shown as inflationary gap. It is a measure of the excess of aggregate demand over level of output at full employment. Inflationary gap causes a rise in price level which is called inflation.

Contrary to it Deflationary gap is the amount by which actual aggregate demand falls short of aggregate supply at level of full employment’.

Deflationary gap is the amount by which actual aggregate demand falls short of aggregate supply at level of full employment’. For instance, in Fig. 8.17, EB is shown as deflationary gap. It is a measure of amount of deficiency of aggregate demand. Deflationary gap causes a decline in output, income and employment along with persistent fall in prices.

Equilibrium level of national income is determined by the equality between aggregate demand and aggregate supply (or between savings and investment). An ideal situation for an economy is full employment equilibrium, i.e., when its aggregate demand and aggregate supply are in equilibrium at such a point where all the resources of the economy are fully employed. Every economy aspires for it. But in real world situation, aggregate demand either exceeds or falls short of the level of full employment supply. Excess demand results in inflation without an increase in output and employment whereas deficient demand leads to unemployment and fall in output, income and prices.

Effects of Inflation

Inflation adversely affects the fixed income groups who depend on wages and remuneration, lenders and investors. In the short run it may benefit the business- wholesellers and retailers and borrowers. In the long run inflation does not benefit anybody, if it is high and rapid.

  1. There is an inverse relationship between inflation and value of money/ purchasing power of money.

Vm 1/ P, Where, Vm is value of money and P is price level

This means that when inflation increases, the purchasing capacity or value of a currency is decreased. In such a case, there is a depreciation in the exchange rate of a currency against other currencies.

  1. Fisher, a renowned economist pointed out that there is a direct and proportional relation between money supply and price level. According to Fisher’s equation

MV PT

Where, M is money Supply, V is velocity of money, P is price level and T is Transaction value (or value of goods and services in exchange).

Fisher assumes that in the short run Velocity of money (how many times a monetary unit changes hands or enters into transaction or exchange) and goods and services in exchange remain constant. He concludes, therefore, that price level is directly proportional to supply of money. This means that if M becomes 2M, then P becomes 2P. Today all the economists agree that money supply determines the price level, yet they do not agree with proportionality rule.

  1. When there is high inflation, the real rate of interest decreases. Real rate of interest is equal to nominal rate of interest minus inflation.

  2. Little bit of inflation or tolerable level of inflation reflects positive expectations in an economy. Deflation reflects negative expectations. For every economy, the tolerable level of inflation may be different. For emerging economies it may be slightly higher than developed economies, say for example, 5% and 3% respectively.

Recession

Recession is a period of temporary economic decline during which trade and industrial activity are reduced, generally identified by a fall in GDP in two successive quarters. In economics, a recession is a business cycle contraction which results in a general slowdown in economic activity. Macroeconomic indicators such as GDP (gross domestic product), investment spending, capacity utilization, household income, business profits, and inflation fall, while bankruptcies and the unemployment rate rise. In the United Kingdom, it is defined as a negative economic growth for two consecutive quarters.

Recessions generally occur when there is a widespread drop in spending (an adverse demand shock). This may be triggered by various events, such as a financial crisis, an external trade shock, an adverse supply shock or the bursting of an economic bubble. Governments usually respond to recessions by adopting expansionary macroeconomic policies, such as increasing money supply, increasing government spending and decreasing taxation.

Deflation

Deflation implies reduction of the general level of prices in an economy. In economics, deflation is a decrease in the general price level of goods and services. Deflation occurs when the inflation rate falls below 0% (a negative inflation rate). Inflation reduces the value of currency over time, but deflation increases it. This allows one to buy more goods and services than before with the same amount of currency. Deflation is distinct from disinflation, a slow-down in the inflation rate, i.e. when inflation declines to a lower rate but is still positive. Economists generally believe that deflation is a problem in a modern economy because it increases the real value of debt, especially if the deflation is unexpected. Deflation may also aggravate recessions and lead to a deflationary spiral.

Deflation usually happens when supply is high (when excess production occurs), when demand is low (when consumption decreases), or when the money supply decreases (sometimes in response to a contraction created from careless investment or a credit crunch). It can also happen as a result of too much competition and too little market concentration.

Phillips Curve

The Phillips curve is a single-equation empirical model, named after William Phillips, describing a historical inverse relationship between rates of unemployment and corresponding rates of rises in wages that result within an economy. Stated simply, decreased unemployment, (i.e., increased levels of employment) in an economy will correlate with higher rates of wage rises. Phillips did not himself state there was any relationship between employment and inflation, although this notion was subsequently made popular by Milton Friedman from 1967.

While there is a short run tradeoff between unemployment and inflation, it has not been observed in the long run. In 1968, Milton Friedman asserted that the Phillips curve was only applicable in the short-run and that in the long-run, inflationary policies will not decrease unemployment. Friedman then correctly predicted that in the 1973–75 recession, both inflation and unemployment would increase. The long-run Phillips curve is now seen as a vertical line at the natural rate of unemployment, where the rate of inflation has no effect on unemployment. In recent years the slope of the Phillips curve appears to have declined and there has been significant questioning of the usefulness of the Phillips curve in predicting inflation. Nonetheless, the Phillips curve remains the primary framework for understanding and forecasting inflation used in central banks.

NAIRU

NAIRU is an acronym for non-accelerating inflation rate of unemployment, and refers to a level of unemployment below which inflation rises. It was first introduced as NIRU(non-inflationary rate of unemployment) by Franco Modigliani and Lucas Papademos in 1975, as an improvement over the “natural rate of unemployment” concept, which was proposed earlier by Milton Friedman.

Monetary policy conducted under the assumption of a NAIRU involves allowing just enough unemployment in the economy to prevent inflation rising above a given target figure. Prices are allowed to increase gradually and some unemployment is tolerated.

Misery Index

The misery index is an economic indicator, created by economist Arthur Okun. The index helps determine how the average citizen is doing economically and it is calculated by adding the seasonally adjusted unemployment rate to the annual inflation rate. It is assumed that both a higher rate of unemployment and a worsening of inflation create economic and social costs for a country.

Misery index= Rate of Inflation + rate of Unemployment

Barro Misery Index

Harvard Economist Robert Barro created what he dubbed the “Barro Misery Index” (BMI), in 1999. The BMI takes the sum of the inflation and unemployment rates, and adds to that the interest rate, plus (minus) the shortfall (surplus) between the actual and trend rate of GDP growth. In the late 2000s, Johns Hopkins economist Steve Hanke built upon Barro’s misery index and began applying it to countries beyond the United States. His modified misery index is the sum of the interest, inflation, and unemployment rates, minus the year-over-year percent change in per-capita GDP growth.

Recent trends of Inflation in India

Consumer Price Index

Indian consumer prices rose 4.28 percent year-on-year in March of 2018, following a 4.44 percent increase in February and compared with market expectations of 4.2 percent. It is the lowest inflation rate in five months amid a slowdown in food cost. Inflation Rate in India averaged 6.62 percent from 2012 until 2018, reaching an all time high of 12.17 percent in November of 2013 and a record low of 1.54 percent in June of 2017.

Indian consumer prices rose 4.28 percent year-on-year in March of 2018, following a 4.44 percent increase in February and compared with market expectations of 4.2 percent. It is the lowest inflation rate in five months amid a slowdown in food cost. Cost went up at a slower pace for food and beverages (3.01 percent from 3.38 percent in February). The food index alone rose 2.81 percent, below 3.26 percent in the previous month. Inflation eased for vegetables (11.7 percent from 17.57 percent) but went up for fruits (5.78 percent from 4.8 percent) and prices of pulses fell slightly less (-13.41 percent from -17.35 percent). Inflation was also lower for fuel and light (5.73 percent from 6.8 percent) and clothing and footwear (4.91 percent from 5 percent) but was slightly higher for housing (8.31 percent from 8.28 percent).

The corresponding provisional inflation rates for rural and urban areas are 4.44 percent and 4.12 percent (4.45 percent and 4.52 percent respectively in February).

Wholesale price Index in India

According to a Ministry of Commerce and Industry release, wholesale prices in India hit an eight-month low in March 2018, as prices for food articles continued to decline. Inflation measured by the Wholesale Price Index stood at 2.47 percent last month, compared with 2.48 percent in February. This is the lowest wholesale price-based inflation since July 2017, when it stood at 1.88 percent. Meanwhile, the wholesale inflation was revised to 3.02 percent in January from 2.84 percent earlier.

The index for food articles fell 0.4 percent led by five percent fall in egg prices, and three percent fall in the prices of tea, coffee, poultry and spices. The Reserve Bank of India’s monetary policy committee, in its bi-monthly meeting in April 2018 noted that a sharp moderation in food prices over the last two months will keep inflation lower-than-expected during the April-September period this year.

Key Highlights:

  • Prices of primary articles fell 0.5 percent.

  • Prices of food articles fell 0.4 percent.

  • Prices of fuel and power fell 0.1 percent.

  • Prices of manufactured products rose 0.4 percent.

The post Business Cycle, boom, bust, inflation and recession appeared first on Civil Services Strategist.

Powered by WPeMatico