Economy

Business Cycle: Understanding The Boom & The Bust Phenomena

The free market economies around the globe go through what is termed as a business cycle. In the Indian context, it may be better understood through the period during 4 significant fiscal years i.e. 2004-05 to 2007-08. The fiscal year from 2004-05 to 2006-07 witnessed a stellar performance by the Indian economy, where the average GDP growth rate was 9.47 percent. And then, all of a sudden, the GDP growth rate dipped to 3.90 percent in 2007-08. As per media reports, the fortunes of the economy revived in later years, the prospects of fiscal 2019-20 does not look good. In fact, the episodes of such booms and busts with uncertain periodicity get repeated. If we track India’s GDP growth from fiscal 1980 to 2018 we will be surprised to see that the variance in growth percent varies from 1.1% in 1991 to 10.30% in 2010. The GDP growth rates show peaks and troughs over time.

Effect of socio-political events:

Let us pinpoint some of the major socio-economic and /or political events that have preceded or coincided with most of the troughs. 

  • The negative growth rate of about 0.04% in 1967 was preceded by the war with Pakistan on the western front.
  • The very low growth rate of 1.63% in 1972 was attributed to the war with Pakistan that carved out a new nation – Bangladesh.
  • The biggest trough of fiscal 1980 was due to the Oil shock when the world experienced a shortage of crude oil due to the Iranian revolution and successive price hike OPEC.

Another monumental event that affected the economy was the beginning of economic reforms in India in 1991. The prospects were very bleak for the economy at that time-businesses refrained from major decisions in expectations of a devaluation of the Indian rupee. As expected/feared, the rupee was devalued more than 20% during July 1991. The GDP growth rate came down to barely 1.10% during that year.  And, a decade later, the World Trade Centre bombing in September 2001 jolted the economic world. Air travel and the global trade were substantially reduced in the wake of the event and as a result GDP growth rate in India came down to meager 3.90% in 2002. The last full downturn in India was witnessed in 2008, immediately following the 2007 subprime crisis in the US, which caused a severe downturn and a sharp fall in the US GDP by 2.67%.

Defining Recession

In economics, the downturn of an economy— expressed by a negative GDP growth rate—is known as a recession. A textbook definition defines a recession as a phenomenon where the GDP falls at least for two (2) consecutive quarters. Now, India has not experienced a negative GDP since 1979, but, significant dips in GDP can also be defined as a recession. A negative GDP growth rate or a sharp fall in the GDP growth rate also indicates a lowered output of goods and services. One of the reasons behind the reduced output is caution exercised by firms due to the accumulation of inventories. Inventories pile up when the sufficient demand is not coming through for the goods and services. Thus, a lack of sufficient demand for goods and services is the main reason for a recession set in.

The Unemployment rate

Why do we worry so much about the boom and the bust phases? Well, during the boom period when the GDP growth rate runs with an upward trend, demand for the good & services also grows. This is good news for the economy as a higher GDP & higher outputs mean that there is will be more employment in the economy. Should the target of the government or industry then be zero unemployment rate? Before we address this, we need to understand unemployment better and with the right perspective. A person is considered involuntarily unemployed if he/she is looking for work at the going wage but does not find one. The workforce of a country consists of those who are employed and those who are involuntarily unemployed. The unemployment rate is defined as a percentage of the workforce that is involuntarily unemployed. So, going back to the first question regarding attaining zero unemployment rates, theoretically, it may be possible but practically difficult to achieve. There may be a case where a person is unemployed because he is not finding the job of his choice. This kind of unemployment is called ‘Frictional unemployment’.

Factoring all these points, a thumb rule has been devised in the western world where 4-5% unemployment is considered natural and consistent with the full-employment of resources. During the upswing of the business cycle, the unemployment rate may temporarily go below the natural rate. This may also happen that during the downswing of business cycle-the bust phenomena, the demand for the goods & services falls causing the unemployment rate to increase far beyond the natural rate of unemployment.

Fiscal policy adjustments:

Till now, we tried to understand that a recession that occurs due to a fall in the demand for goods & services is characterized by the fall in the GDP of a sharp fall in GDP growth rate and high unemployment. In such a situation, the government follows what is called an expansionary fiscal policy. This may be better understood with the following example;

In 2007-08, the fiscal deficit for the central government was 2.5% and the GDP growth rate was 9.82%. However, during the next year, due to the subprime crisis in the US, the GDP growth rate fell substantially to 4.93%. This adverse development forced the government to go for fiscal adjustment by way of reducing the excise duties from 14% to 8% and service tax from 12% to 10%. This was done in addition to increase fiscal spending on MGNREGS, highway projects and 6th Pay commission payouts.

As a result of this expansionary fiscal policy, fiscal deficit increased from 2.5% to 6.30% in the ensuing years 2008-09 & 2009-10. But, it has a salutary effect on growth: the GDP growth rate bounced back, averaging about 9% during the fiscal year 2010 & 2011. 

Monetary Policy related adjustments by RBI:

Over the decades, the government has given the responsible and independent role to the central bank i.e. RBI. RBI follows an independent monetary policy to control inflation and to boost demand during recessionary periods. During the boom phase, RBI uses contractionary monetary policy to control the demand-pull inflations. On the other hand, if the economy is in recession due to a deficient demand for goods & services, RBI may engage in expansionary monetary policy. We know that a high recession is linked to a high unemployment rate. Therefore, to increase employment, RBI induces companies/firms to start new projects and this may happen only if the cost of capital for the firm comes down and for effecting this, the interest rates in the economy must come down. We also know that for increased availability of loans in the market, the availability of funds with the banking system must improve.

RBI can decrease CRR and SLR so that the banks are left with more cash on hand per deposit received. This would enable banks to initiate multiple deposit/credit creations. With the increased availability of loans in the market, downward pressure on interest rates is created.

Conclusion:

Till now various facets of the business cycle are explained with various remedies to dampen it. For example, owing to some negative socio-economic and political factors, business pessimism sets in and a deficient demand leads to recession. This results in a fall in GDP or in GDP growth rate and higher unemployment. A price rise is not a concern in a recession which is caused by deficient demand. In fact, prices may go down. In such a situation, expansionary fiscal and monetary policies are adopted to revive the economy. On another hand, if the economy is in a boom phase, there is a high growth rate in GDP, a low unemployment rate and high inflation, the contractionary fiscal and monetary policy will be followed. 

Promoting GDP and reducing inflation is always difficult. The customized fiscal and monetary policies offer a trade-off between the two. Either they extinguish inflation at the cost of growth or have growth at the cost of inflation. Therefore, it is of paramount importance that the fiscal and monetary policies have to be completed by some tailor-made policies in the right perspective.

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VIKAS ANAND
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