In a free market economy, business cycle is self-adjusting. Explain the process of recession when prosperity reaches its peak and the forces of uptrend when depression reaches its bottom.
The correct answer and explanation is:
In a free market economy, the business cycle consists of periods of expansion (prosperity) and contraction (recession). The business cycle is self-adjusting, meaning that economic forces naturally bring the economy back to a state of equilibrium over time.
Recession Process (When Prosperity Reaches its Peak)
During the prosperity phase, economic activity is high, unemployment is low, and businesses experience increased demand. However, as the economy reaches its peak, the risks of overheating become apparent. When demand exceeds supply capacity, inflation begins to rise. This causes the central bank to raise interest rates in an attempt to control inflation. Higher interest rates make borrowing more expensive, which slows down consumer spending and business investment. As a result, businesses begin to reduce production due to lower demand for their goods and services, leading to job losses and rising unemployment. This shift marks the beginning of a recession.
In a recession, the economy contracts, and business activity slows down. Consumers and businesses cut back on spending, which leads to lower production levels. As unemployment rises, consumer confidence falls, further depressing demand. The decline in demand encourages firms to reduce their prices, leading to deflationary pressures. The self-correcting nature of a free market comes into play as these declining conditions eventually force businesses to adjust by cutting costs and improving efficiency.
Uptrend Process (When Depression Reaches its Bottom)
As the economy experiences depression and reaches its bottom, various market forces drive recovery. First, the lower levels of demand reduce inflationary pressures, and businesses begin to adjust by lowering prices and cutting excess inventory. Lower prices encourage consumer spending as goods and services become more affordable. Additionally, reduced production costs make it more attractive for businesses to invest and hire, stimulating job creation and further economic activity.
The central bank may also intervene by lowering interest rates, making borrowing cheaper. This can encourage both consumer spending and business investment. With improved confidence in the economy, consumer spending rises, businesses expand, and the economy enters the recovery phase. Ultimately, the cycle repeats as economic conditions adjust and stabilize, leading to a new period of prosperity.