Four Phases of Business Cycle

Business Cycle (or Trade Cycle) is divided into the following four phases;

1. Prosperity Phase: Expansion or Boom or Upswing of economy.
2. Recession Phase: from prosperity to recession.
3. Depression Phase: Contraction or Downswing of economy.
4. Recovery Phase: from depression to prosperity.

Supply Side Economics

The problem of stagflation encountered by USA and UK during the seventies and early eighties when both high inflation and high unemployment prevailed simultaneously did not admit for easy solution through the Keynesian demand management policies, it only worsened the situation. 

Against this backdrop, the alternative school of thought, about macroeconomics laid stress on Supply Side of macroeconomic equilibrium, that is, it focused on shift in the aggregate supply curve to the right rather than causing the shift in the aggregate demand curve. Thus Supply side economics prefers to solve the problem of stagflation through the management of aggregate Supply rather than the management of aggregate demand. Further Supply Sides economics stresses the determinants of long run growth instead of causes of short run cyclical movement in the economy. Supply Side economists laid emphasis on the factors that determine the incentives to work, save and invest, which ultimately determine the aggregate supply of the output of the economy.

Rational Expectation Theory (RATEX)

Meaning:

New classical economics based on rational expectation hypothesis was put forward by Robert Lucas of the University of Chicago. Rational Expectation theory which is the corner stone of recently developed macro-economic theory, popularly called new classical macroeconomics. Friedman’s adaptive expectation theory assumes nominal wages lag behind changes in the price level. This lag in the adjustment of nominal wages to the price-level brings about rising business profits which induces the firms to expand output and employment in the short run, and leads to the reduction in unemployment rate. But according to the Ratex theory, there is no lag in the adjustment of nominal wages consequent to rise in price level. The advocates of this theory further argue that nominal wages are quickly adjusted to any expected changes in the price level. According to the Ratex theory, as a result of increasing aggregate demand, there is no reduction in unemployment rate, the rate of inflation resulting from increasing aggregate demand is fully and correctly anticipated by workers and business firms and get completely and quickly incorporated into the wage agreement resulting in higher prices of products. 

Inflationary Gap

In his pamphlet,’ how to pay for the war ‘published in 1940, Keynes explained the concept of ‘inflationary gap’. It differs from his views on inflation given in the general theory. In the general theory, he started with underemployment equilibrium, but in how to pay for the war, he began with a situation of full employment in the economy. He defined an inflationary gap as an excess of planned expenditure over the available output at pre-inflation or base prices. According to Lipsey,’ the inflationary gap is the amount by which aggregate expenditure would exceed aggregate output at the full employment level of income’. The classical economists explained inflation as mainly due to increase in the quantity of money, given the level of full employment. Keynes, on the other hand, ascribed it to the excess of expenditure over income at the full employment level. The larger the aggregate expenditure, the larger the gap and the more rapid the inflation will increase. Given a constant average propensity to save, rising money incomes at full employment level would lead to an excess of demand over supply and to a consequent inflationary gap. Thus Keynes used the concept of the inflationary gap to show the main determinants that cause an inflationary rise in prices.