UNIT V

NATIONAL INCOME

Concepts & Meaning of National Income
National Income is the sum of factor income earned by the normal residents of a country in the
form of wages/income, rent, interest and profit in an accounting year.
It is the total amount of income earned by the citizens of a nation.

Concepts of National Income
There are different concepts of National Income, namely; GNP, GDP, NNP, Personal Income
and Disposable Income.

1. Gross National Product (GNP) :- It is sum total of all the goods and services
produced in a country during a year and net income from abroad. GNP is the sum of
Gross Domestic Product at Market Price and Net Factor Income from abroad.



+ =
(3)
GNP at
market price
(1)+(2)
(2)


The total value of the level of aggregate output is called Gross National Product (G.N.P.)

Basically, GNP measures the value of goods and services that the country's citizens
produced regardless of their location. GNP is one measure of the economic condition of a
country, under the assumption that a higher GNP leads to a higher quality of living, all
other things being equal.


(1)
Gross domestic
product at
market price
Net factor
income from
abroad
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2. Gross domestic product (GDP) :- It is the total market value at current prices of
all final goods and services produced within a year by the factors of production located
within a country. GDP per capita is often considered an indicator of a country's standard
of living.

3. Net National Product ( N N P ) :- The investment expenditure of the firms is
made up of 2 parts. One part - is to buy new capital goods & machinery for production.
It is called net investment because the production capacity of the firms can be expanded.
Another part - consumption allowance or depreciation - is spent on replacing the used-up
capital goods or the maintenance of existing capital goods because capital goods will wear
and tear out over time..

(Depreciation refers to all those expenses to replace physical capital due to wear and tear,
obsolescence, destruction and accidental loss etc.)
The sum of these 2 amounts is called Gross Investment in economics.

Gross Investment = Net Investment + Depreciation

Net investment will increase the production capacity and output of a nation, but not by
depreciation expenditure. So we have,
N N P = G N P - Depreciation

4. Net Domestic Product at Factor Cost (NDP at FC):-
Net Domestic product of factor cost or domestic income is the income earned by all the
factors of production within the domestic territory of a country during a year in the form of
wages, interest, profit and rent etc. Thus NDP at FC is a territorial concept. In other words
NDP at factor cost is equal to NNP at FC less net factor income from abroad.
[NDP at FC =NNP at FC - Net factor income from abroad]


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5. Net National Product at Factor Cost (NNP at FC)
Net national product at factor cost is the aggregate payments made to the factors of
production. NNP at FC is the total incomes earned by all the factors of production in the form
of wages, profits, rent, interest etc. plus net factor income from abroad. NNP at FC is the
NDP at FC plus net factor income from abroad. NNP at FC can also be derived by excluding
depreciation from GNP at FC.
[NNP at FC =NDP at FC +Net Factor Income from abroad]

6. Gross Domestic Product at Factor Cost (GDP at FC):
Gross Domestic Product at factor cost refers to the value of all the final goods and services
produced within the domestic territory of a country. If depreciation or consumption of fixed
capital is added to the net domestic product at factor cost, it is called Gross domestic Product
at Factor cost.
[GDP at FC =NDP at FC - Depreciation]

7. Gross National Product at Factor Cost (GNP at FC):-
Gross national product at factor cost is obtained by deducting the indirect tax and adding
subsidies to GNP at market price or Gross national Product at factor cost is obtained by
adding net factor incomes from abroad to the GDP at factor cost.
[GNP at FC =GNP at MP - Indirect tax +Subsidies] or, [GNP at FC =GDP at FC +Net
Factor Income from abroad]

8. Private Income:-
Private income means the income earned by private individuals from any source whether
productive or unproductive. It can be arrived at from NNP at factor cost by making certain
additions and deduction. The additions include (a) transfer earnings from Govt, (b) interest on
national debt (c) current transfers from rest of the world. The deductions include (a) Income
from property and entrepreneurship (b) savings of the non- departmental undertakings (e)
social security contributions. In order to arrive at private income the above additions and
subtraction are to be made to and from NNP at factor Cost.
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[Private Income =NNP at FC +transfer payments +Interest on public debt - social securities
- profits and surpluses of public undertakings]

9. Personal Income:-
Personal Income is the total income received by the individuals of country from all sources
before direct taxes. Personal income is not the same as National Income, because personal
income includes the transfer payments where as they are not included in national income.
Personal income includes the wages, salaries, interest and rent received by the individuals.
Personal income is derived by excluding undistributed corporate profit taxes etc. from National
Income.
[Personal Income =Private Income - Saving of Private enterprise - Corporate tax]

10. Disposable Income:-
Disposable income means the actual income which can be spent on consumption by individuals
and families. It refers to the purchasing power of the house hold. The whole of disposable
income is not spent on consumptions; a part of it is paid in the form of direct tax. Thus
disposable income is that part of income, which is left after the exclusion of direct tax.
[Disposable Income =Personal Income - Direct tax]












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MEASUREMENT OF NATIONAL INCOME

There are mainly 3 approaches to measure National Income.
The relationship of the 3 approaches is shown by the diagram below.

The Circular Flow of Economic Activities


Land , labour , capital and organisation



Rent , wage , interest and profit

Firms



Real goods and services


Payment of good and services


The circular flow has two aspects. They are as follows:
Real Flow: It represents movement of factor services from the household to the firm and
movement of goods and services from the firms to the households.
Money Flow: Representing the money value of the physical exchange involved. Money moves
from households to firms when the payment is made for goods and services and from the firms
to the households when the payment for the factor services are made. We conclude:-

National Product = National Dividend = National Expenditure






Households
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METHODS OF COMPUTING/MEASURING NATIONAL INCOME:

There are three methods of measuring national income of a country. They yield the same
result. These methods are:
(1) The Product Method.
(2) The Income Method.
(3) The Expenditure Method.

(1) Product Method or Value Added Method:
Goods and services are counted in gross domestic product (GDP) at their market values. The
product approach defines a nation's gross product as that market value of goods and services
currently produced within a nation during a one year period of time.

The product approach measuring national income involves adding up the value of all the final
goods and services produced in the country during the year. The main sectors whose production
value is added up are:
(i) agriculture (ii) manufacturing (iii) construction (iv) transport and communication (v) banking
(vi) administration and defense and (vii) distribution of income.

Precautions For Product Method or Value Added Method:
There are certain precautions which are to be taken to avoid miscalculation of national income
using this method. These in brief are:

(i) Problem of double counting: When we add up the value of output of various sectors, we
should be careful to avoid double counting.
(ii) Value addition in particular year: The values which had previously been added to the
stocks of raw material and goods have to be ignored. GDP thus includes only those goods, and
services that are newly produced within the current period.
(iii) Stock appreciation: Stock appreciation, if any, must be deducted from value added. This is
necessary as there is no real increase in output.

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(iv) Production for self consumption: The production of goods for self consumption should be
counted while measuring national income. In this method, the production of goods for self
consumption should be valued at the prevailing market prices.

(2) Expenditure Method:
The expenditure approach measures national income as total spending on final goods and
services produced within nation during an year. The expenditure approach to measuring national
income is to add up all expenditures made for final goods and services at current market prices
by households, firms and government during a year. Total aggregate final expenditure on final
output thus is the sum of four broad categories of expenditures:
(i) consumption (ii) investment (iii) government and (iv) Net export.

(i) Consumption expenditure (C): Consumption expenditure is the largest component of
national income. It includes expenditure on all goods and services produced and sold to the final
consumer during the year.

(ii) Investment expenditure (I): Investment is the use of today's resources to expand
tomorrow's production or consumption. Investment expenditure is expenditure incurred on by
business firms on (a) new plants, (b) adding to the stock of inventories and (c) on newly
constructed houses.

(iii) Government expenditure (G): It is the second largest component of national income. It
includes all government expenditure on currently produced goods and services but excludes
transfer payments while computing national income.

(iv) Net exports (X - M): Net exports are defined as total exports minus total imports.
National income calculated from the expenditure side is the sum of final consumption
expenditure, expenditure by business on plants, government spending and net exports.

NI = C + I +G + (X - M) Precautions

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Precautions For Expenditure Method:
While estimating national income through expenditure method, the following precautions should
be taken:
(i) The expenditure on second hand goods should not be included as they do not contribute to
the current year's production of goods.
(ii) Similarly, expenditure on purchase of old shares and bonds is not included as these also do
not represent expenditure on currently produced goods and services.
(iii) Expenditure on transfer payments by government such as unemployment benefit, old age
pensions, interest on public debt should also not be included because no productive service is
rendered in exchange by recipients of these payments.

(3) Income Approach:

Income approach is another alternative way of computing national income, This method seeks
to measure national income at the phase of distribution. In the production process of an
economy, the factors of production are engaged by the enterprises. They are paid money
incomes for their participation in the production. The payments received by the factors and paid
by the enterprises are wages, rent, interest and profit. National income thus may be defined as
the sum of wages, rent, interest and profit received or occurred to the factors of production in
lieu of their services in the production of goods. Briefly, national income is the sum of all income,
wages, rents, interest and profit paid to the four factors of production. The four categories of
payments are briefly described below:

(i) Wages: It is the largest component of national income. It consists of wages and salaries
along with fringe benefits and unemployment insurance.
(ii) Rents: Rents are the income from properly received by households.
(iii) Interest: Interest is the income private businesses pay to households who have lent the
business money.

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(iv) Profits: Profits are normally divided into two categories (a) profits of incorporated
businesses and (b) profits of unincorporated businesses (sold proprietorship, partnerships and
producers cooperatives).

Precautions For Income Approach:
While estimating national income through income method, the following precautions should be
undertaken.
(i) Transfer payments such as gifts, donations, scholarships, indirect taxes should not be
included in the estimation of national income.
(ii) Illegal money earned through smuggling and gambling should not be included.
{iii) Windfall gains such as prizes won, lotteries etc. is not be included in the estimation of
national income.
(iv) Receipts from the sale of financial assets such as shares, bonds should not be included in
measuring national income as they are not related to generation of income in the current year
production of goods.

DETERMINANTS OF NATIONAL INCOME OR FACTORS AFFECTING THE
NATIONAL INCOME:

(i) The stock of factors of production: One of the very important factors which influences the
size of the national income is the quality and quantity of the country's stock of factors of
production. The factors of production are land, labor, capital and organization. Land supplies
man with gifts of nature. It provides him with agricultural goods and. raw material for production.
The production of land depends upon fertility of the soil, latitude, climate and irrigation system in
the country. If the land is fertile and is not handicapped in any way say by salinity, water logging,
shortage of rainfall and adverse climate, the size of the national income will be quite large, if the
quality of land is poor, the size of the national income will be small.

(ii) Labor: The second factor of production, i.e., labor is by no means less important. This can
be judged from it that if land is not aided by human labor, it cannot produce anything except the
wild vegetation. The size of the national income greatly depends upon the quality and quantity of
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labor in the country. If the labor is efficient and its size is consistent with the means of
subsistence, the size of the national income will be large and if the labor is underfed, under
clothed and under-housed unskilled, and has no ambition to rise, the size of the national income
will be small.

(iii) Capital: The volume of production is also very much influenced by the! quality and quantity
of capital available in the country. Capital now-a-days is considered to be the lifeblood of the
modern industry. If the capital consists of primitive tools, the size of the national income cannot
be large. But if modern types of plants are used for production, then they can enhance the
productive capacity of a country.

(iv) Enterprise: The size of the national income also greatly depends upon! the number and skill
of the entrepreneurs. If the captains of the industries! are efficient, they will combine; the various
factors of production to the! optimum proportion and so the volume of total production will be
quite large, if managerial skill is lacking in the country, the size of the national income will be
small.

(v) State of technical knowledge: State of technical knowledge is also one of the very
important factors which influences the size of the national income. The methods of production
now-a-days have become so much roundabout that unless advance technical knowledge is
available in the! country, they cannot be adopted. The roundabout methods of production have
considerably increased the production capacity of the country. If the state of technical knowledge
is poor in the country, the size of the national income will be small, but if advance technical
knowledge is available, then the size of the national income will be large.

(vi) Political Stability: Political instability greatly hampers economic progress. If there is political
stability in the country, the production can be maintained at the highest level. The size of the
national income will be large. In case of political instability, the production will be adversely
affected and so the size of the national income will be small.
Besides, durable goods provide welfare to us over a period of time ( usually more than 1 year ).
This cannot be shown by GNP figures within a year.
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INFLATION
Inflation is a state of generally rising price and falling value of money. Crowther
By inflation we mean a time of generally rising prices. Samuelson.

TYPE OF INFLATION
1. Open Inflation and Suppressed Inflation :-
Open Inflation : When government does not attempt to restrict inflation, it is known as Open
Inflation. In a free market economy, where prices are allowed to take its own course, open
inflation occurs.
Suppressed Inflation : When government prevents price rise through price controls, rationing,
etc., it is known as Suppressed Inflation. It is also referred as Repressed Inflation. However,
when government controls are removed, Suppressed inflation becomes Open Inflation.
Suppressed Inflation leads to corruption, black marketing, artificial scarcity, etc.

2. Creeping Inflation , Walking Inflation , Running Inflation and Hyperinflation :
Creeping Inflation :- When prices are gently rising, it is referred as Creeping Inflation. It is the
mildest form of inflation ,when prices rise by not more than upto 3% per annum (year), it is called
Creeping Inflation.

Walking Inflation :- When the rate of rising prices is more than the Creeping Inflation, it is
known as Walking Inflation. When prices rise by more than 3% but less than 10% per annum (i.e
between 3% and 10% per annum), it is called as Walking Inflation.
It must be taken seriously as it gives a cautionary signal for the occurrence of Running inflation.
Furthermore, if walking inflation is not checked in due time it can eventually result in Galloping
inflation or hyperinflation.

Running Inflation: - A rapid acceleration in the rate of rising prices is referred as Running
Inflation. When prices rise by more than 10% per annum, running inflation occurs. Though
economists have not suggested a fixed range for measuring running inflation, we may consider
price rise between 10% to 20% per annum (double digit inflation rate) as a running inflation.

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Hyperinflation :- Hyperinflation refers to a situation where the prices rise at an alarming high
rate. The prices rise so fast that it becomes very difficult to measure its magnitude. However, in
quantitative terms, when prices rise above 100% to 1000% per annum (quadruple or four digit
inflation rate), it is termed as Hyperinflation.
Two worst examples of hyperinflation recorded in world history are of those experienced by
Hungary in year 1946 and Zimbabwe during 2004-2009 under Robert Mugabe's regime.

3. Demand-Pull Inflation :
Inflation which arises due to various factors like rising income, exploding population, etc., leads
to aggregate demand and exceeds aggregate supply, and tends to raise prices of goods and
services. This is known as Demand-Pull or Excess Demand Inflation.

4. Cost-Push Inflation :
When prices rise due to growing cost of production of goods and services, it is known as Cost-
Push (Supply-side) Inflation. For e.g. If wages of workers are raised then the unit cost of
production also increases. As a result, the prices of end-products or end-services being
produced and supplied are consequently hiked.

CAUSES OF INFLATION
Inflation is caused when the aggregate demand exceeds the aggregate supply of goods and
services. The factors which lead to increase in demand and the shortage of supply.

(I) Factors Affecting Demand :-

Both Keynesians and monetarists believe that inflation is caused by increase in the
aggregate demand. They point towards the following factors which raise it.

1. Increase in Money Supply:- Inflation is caused by an increase in the supply of money
which leads to increase in aggregate demand. The higher the growth rate of the nominal money
supply, the higher is the rate of inflation. Modern quantity theorists do not believe that true
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inflation starts after the full employment level. This view is realistic because all advanced
countries are faced with high levels of unemployment and high rates of inflation.
2. Increase in Disposable Income:- When the disposable income of the people increases, it
raises their demand for goods and services. Disposable income may increase with the rise in
national income or reduction in taxes or reduction in the saving of the people.
3. Increase in Public Expenditure:- Government activities have been expanding much with the
result that government expenditure has also been increasing at a phenomenal rate, thereby
raising aggregate demand for goods and services. Governments of both developed and
developing countries are providing more facilities under public utilities and social services, and
also nationalizing industries and starting public enterprises with the result that they help in
increasing aggregate demand.
4. Increase in Consumer Spending:- The demand for goods and services increases when
consumer expenditure increases. Consumers may spend more due to conspicuous consumption
or demonstration effect. They may also spend more when they are given credit facilities to buy
goods on hire-purchase and installment basis.
5. Cheap Monetary Policy:- Cheap monetary policy or the policy of credit expansion also
leads to increase in the money supply which raises the demand for goods and services in the
economy. When credit expands, it raises the money income of the borrowers which, in turn,
raises aggregate demand relative to supply, thereby leading to inflation. This is also known as
credit-induced inflation.
6. Deficit Financing:- In order to meet its mounting expenses, the government resorts to
deficit financing by borrowing from the public and even by printing more notes. This raises
aggregate demand in relation to aggregate supply, thereby leading to inflationary rise in prices.
This is also known asdeficit- induced inflation.
7. Expansion of the Private Sector:- The expansion of the private sector also tends to raise
the aggregate demand. For huge investments increase employment arid income, there creating
more demand far goods and services. But it takes time for the output to enter the market.
8. Black Money:- The existence of black money in all countries due to corruption, tax
evasion etc. increases the aggregate demand. People spend such unearned money
extravagantly, thereby creating unnecessary demand for commodities. This tends to raise the
price level further.
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9. Repayment of Public Debt:- Whenever the government repays its past internal debt to
the public, it leads to increase in the money supply with the public. This tends to raise the
aggregate demand for goods and services.
10. Increase in Exports:- When the demand for domestically produced goods increases in
foreign countries, this raises the earnings of industries producing export commodities. These, in
turn, create more demand for goods and services within the economy.

(II) Factors Affecting Supply

1. Shortage of Factors of Production:- One of the important causes affecting the
supplies of goods is the shortage of such factors as labour, raw materials, power supply, capital
etc. They lead to excess capacity and reduction in industrial production.
2. Industrial Dispute:- In countries where trade unions are powerful, they also help in
curtailing production. Trade unions resort to strikes and if they happen to be unreasonable from
the employers' viewpoint and are prolonged, they force the employers to declare lock-outs. In
both cases, industrial production falls, thereby reducing supplies of goods. If the unions succeed
in raising money wages of their members to a very high level than the productivity of labour, this
also tends to reduce production and supplies of goods.
3. Natural Calamities :- Drought or floods is a factor which adversely affects the
supplies of agricultural products. The latter, in turn, create shortages of food products and raw
materials, thereby helping inflationary pressures.
4. Artificial Scarcities :- Artificial scarcities are created by hoarders and speculators
who indulge in black marketing. Thus they are instrumental in reducing supplies of goods and
raising their prices.
5. Increase in Exports :- When the country produces more goods for export than for
domestic consumption, this creates shortages of goods in the domestic market. This leads to
inflation in the economy.
6. Lop-sided Production :- If the stress is on the production of comfort, luxuries, or
basic products to the neglect of essential consumer goods in the country, this creates shortages
of consumer goods. This again causes inflation.
7. Law of Diminishing Returns :- If industries in the country are using old machines
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and outmoded methods of production, the law of diminishing returns operates. This raises cost
per unit of production, thereby raising the prices of products.

MEASURES TO CONTROL INFLATION

There are broadly two ways of controlling inflation in an economy:

1). Monetary measures and

2). Fiscal measures

1. Monetary Measures
The monetary measures to control inflation generally aims at reducing money incomes. These
are:
(a) Credit Control: The central bank could adopt a number of methods to control the quantity
and quality of credit to reduce the supply of money. For this purpose, it raises the bank rates,
sells securities in the open market, raises reserve ratio, and adopts a number of selective credit
control measures, such as raising margin requirements and regulating consumer credit.
(b) Demonetisation of Currency: Another monetary measure is to demonetise currency of
higher denominations. Such a measure is usually adopted when there is abundance of black
money in the country.
(c) Issue of New Currency: The most extreme monetary measure is the issue of new currency
in place of the old currency. Under this system, one new note is exchanged for a number of the
old currency. Such a measure is adopted when there is an excessive issue of notes and there is
hyperinflation in the economy.

2. Fiscal Measures
Monetary policy alone cannot control inflation. Therefore, it should be supplemented by fiscal
measures. The principal fiscal measures are discussed below.
(a) Reduction in Unnecessary Expenditure: The government should reduce unnecessary
expenditure on non-development activities in order to curb inflation.
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(b) Increase in Taxes: To cut personal consumption expenditure, the rates of personal,
corporate and commodity taxes should be raised and even new taxes should be levied, but the
rates of taxes should not be too high as to discourage saving, investment and production.
(c) Increase in Savings: Another measure is to increase savings on the part of the people so
that their disposable income and purchasing power would be reduced. For this the government
should encourage savings by giving various incentives.
(d) Surplus Budgets: An important measure is to adopt anti-inflationary budgetary policy. For
this purpose, the government should give up deficit financing and instead have surplus budgets.
It means collecting more in revenues and spending less.
(e) Public Debt: In addition, the government should stop repayment of public debt and postpone
it to some future date till inflationary pressures are controlled. Instead, the government should
borrow more to reduce money supply with the public.

3. Other (Direct) Measures
Other measures to control inflation generally aims at increasing aggregate supply and reducing
aggregate demand directly. These are :-
(a) To Increase Production. The following measures should be adopted to increase production:
(i) The government should encourage the production of essential consumer goods like
food, clothing, kerosene oil, sugar, vegetable oils, etc.
(ii) All possible help in the form of latest technology, raw materials, financial help,
subsidies, etc. should be provided to different consumer goods sectors to increase
production.

(b) Rational Wage Policy: Another important measure is to adopt a rational wage policy. The
best course for this is to link increase in wages to increase in productivity. This will have a dual
effect. It will control wage and at the same time increase production of goods in the economy.

(c) Price Control: Price control and rationing is another measure of direct control to check
inflation. Price control means fixing an upper limit for the prices of essential consumer goods.

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(d) Rationing: Rationing aims at distributing consumption of scarce goods so as to make them
available to a large number of consumers. It is applied to essential consumer goods such as
wheat, rice, sugar, kerosene oil, etc. It is meant to stabilize the prices of necessaries and assure
distributive justice.

EFFECTS OF INFLATION
Inflation affects different people differently. When price rises or the value of money falls, some
groups of the society gain, some lose and some stand in between. Let us discuss the effects of
inflation on distribution of income and wealth, production, and on the society as a whole.

1. Effects of Inflation on Business Community: Inflation is welcomed by entrepreneurs
and businessmen because they stand to profit by rising prices. They find that the value of
their inventories and stock of goods is rising in money terms. They also find that prices
are rising faster than the costs of production, so that their profit is greatly enhanced.

2. Fixed Income Groups: Inflation hits wage-earners and salaried people very hard.
Although wage- earners, by the grace of trade unions, can chase galloping prices, they
seldom win the race. Since wages do not rise at the same rate and at the same time as
the general price level, the cost of living index rises, and the real income of the wage
earner decreases.

3. Farmers: Farmers usually gain during inflation, because they can get better prices for
their harvest during inflation

4. Investors: Those who invest in debentures and fixed-interest bearing securities, bonds,
etc, lose during inflation. However, investors in equities benefit because more dividend is
yielded on account of high profit made by joint-stock companies during inflation.

5. Inflation will lead to deterioration of gross domestic savings and less capital formation in
the economy and less long term economic growth rate of the economy.

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STAGFLATION
A condition of slow economic growth and relatively high unemployment - a time of stagnation -
accompanied by a rise in prices, or inflation.
Stagflation occurs when the economy isn't growing but prices are rising which is not a good
situation for a country to be in. This happened to a great extent during the 1970s, when world oil
prices rose dramatically, fueling sharp inflation in developed countries. For these countries,
including the U.S., stagnation increased the inflationary effects.

DEFLATION
A general decline in prices, often caused by a reduction in the supply of money or credit.
Deflation can be caused also by a decrease in government, personal or investment spending.
The opposite of inflation, deflation has the side effect of increased unemployment since there is
a lower level of demand in the economy, which can lead to an economic depression. Central
banks attempt to stop severe deflation, along with severe inflation, in an attempt to keep the
excessive drop in prices to a minimum.
The decline in prices of assets, is often known as Asset Deflation
Deflationary periods can be both short and long, relatively speaking. J apan, for example, had a
period of deflation lasting decades starting in the early 1990's. The J apanese government
lowered interest rates to try and stimulate inflation, to no avail. Zero interest rate policy was
ended in J uly of 2006.
A decline in general price levels, often caused by a reduction in the supply of money or credit.
Deflation can also be brought about by direct contractions in spending, either in the form of a
reduction in government spending, personal spending or investment spending. Deflation has
often had the side effect of increasing unemployment in an economy, since the process often
leads to a lower level of demand in the economy. opposite of inflation.






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BUSINESS CYCLE
The recurring and fluctuating levels of economic activity that an economy experiences over a
long period of time. The five stages of the business cycle are growth (expansion), peak,
recession (contraction), trough and recovery. At one time, business cycles were thought to be
extremely regular, with predictable durations, but today they are widely believed to be irregular,
varying in frequency, magnitude and duration.

Explanation of Four Phases of Business Cycle
The recurring and fluctuating levels of economic activity that an economy experiences over a
long period of time. The five stages of the business cycle are growth (expansion), peak,
recession (contraction), trough and recovery.

Peak Peak

Prosperity Recession Prosperity Recession
% rise in price Full employment line

Depression Recovery

Tough
Time (years)

The Five phases of a business cycle are briefly explained as follows :-

1. Prosperity Phase or Expansion:

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.
The features of prosperity are :-
1. High level of output and trade.
2. High level of effective demand.
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3. High level of income and employment.
4. Rising interest rates.
5. Inflation.
6. Large expansion of bank credit.
7. Overall business optimism.
8. A high level of MEC (Marginal efficiency of capital) and investment.
Due to full employment of resources, the level of production is Maximum and there is a rise in
GNP (Gross National Product). Due to a high level of economic activity, it causes a rise in prices
and profits. There is an upswing in the economic activity and economy reaches its Peak. This is
also called as a Boom Period.

2. Boom/ Peak.
An expansion, like a contraction, eventually comes to an end. The end of an expansion, and
the onset of a contraction is a peak.
While a peak, the highest level of the business cycle, might seem like a good thing, it really has
a down side. A peak means that the expansion has ended and that a contraction is about to
begin.

3. Recession Phase

The turning point from prosperity to depression is termed as Recession Phase.
During a recession period, the economic activities slow down. When demand starts falling, the
overproduction and future investment plans are also given up. There is a steady decline in the
output, income, employment, prices and profits. The businessmen lose confidence and become
pessimistic (Negative). It reduces investment. The banks and the people try to get greater
liquidity, so credit also contracts. Expansion of business stops, stock market falls. Orders are
cancelled and people start losing their jobs. The increase in unemployment causes a sharp
decline in income and aggregate demand. Generally, recession lasts for a short period.



Sabita singh (Lecturer MBA Department)
4. Depression Phase
When there is a continuous decrease of output, income, employment, prices and profits, there is
a fall in the standard of living and depression sets in.
The features of depression are :-
1. Fall in volume of output and trade.
2. Fall in income and rise in unemployment.
3. Decline in consumption and demand.
4. Fall in interest rate.
5. Deflation.
6. Contraction of bank credit.
7. Overall business pessimism.
8. Fall in MEC (Marginal efficiency of capital) and investment.
In depression, there is under-utilization of resources and fall in GNP (Gross National Product).
The aggregate economic activity is at the lowest, causing a decline in prices and profits until the
economy reaches its Trough (low point).

5. Recovery Phase
The turning point from depression to expansion is termed as Recovery or Revival Phase.
During the period of revival or recovery, there are expansions and rise in economic activities.
When demand starts rising, production increases and this causes an increase in investment.
There is a steady rise in output, income, employment, prices and profits. The businessmen gain
confidence and become optimistic (Positive). This increases investments. The stimulation of
investment brings about the revival or recovery of the economy. The banks expand credit,
business expansion takes place and stock markets are activated. There is an increase in
employment, production, income and aggregate demand, prices and profits start rising, and
business expands. Revival slowly emerges into prosperity, and the business cycle is repeated.
Thus we see that, during the expansionary or prosperity phase, there is inflation and during the
contraction or depression phase, there is a deflation.

Causes of business cycle and Measures to control business cycle (Read from Book given
to you in TBL .)
Sabita singh (Lecturer MBA Department)