BECC 109 Intermediate Macroeconomics-II Solved Question Paper June 2026 for IGNOU BA (Honours) Economics (BAECH)

The business cycle: meaning, phases and features

Question 1: Explain the term "business cycle". What are the different phases of a business cycle? Explain its features. (20)

Meaning. A business cycle is the recurring rise and fall of aggregate economic activity, measured through real GDP, employment, income and investment, around the economy's long-run growth trend. Arthur Burns and Wesley Mitchell of the NBER, in Measuring Business Cycles (1946), described it as expansions that spread across many activities at about the same time, followed by equally general contractions, with a full cycle lasting from just over a year to about ten or twelve years.

The word "cycle" can mislead. Fluctuations repeat, but they are not periodic like a pendulum: each cycle has its own length and depth. That is why modern macroeconomics treats them as deviations of actual output from trend output rather than as waves of fixed length.

Phases of a business cycle

1. Expansion (recovery and boom). After the trough, output starts rising. Idle capacity is put back to work, employment and incomes rise and consumer spending picks up. As confidence improves, firms raise investment, banks expand credit and inventories are rebuilt. In the later boom stage capacity becomes tight, wages and prices rise faster and interest rates climb.
2. Peak. The upper turning point. Output is at its highest relative to trend, unemployment is at its lowest and inflationary pressure is strongest. Costs begin to overtake expected returns, so profit margins narrow and new investment plans are scaled back.
3. Contraction (recession). Output, employment and investment fall across many sectors together. Firms cut orders, run down unplanned inventories and postpone projects. When the fall is long and deep, the contraction is called a depression, as in the Great Depression of the 1930s.
4. Trough. The lower turning point. Unemployment and excess capacity are at their highest, but low interest rates, cheaper inputs and the need to replace worn-out machines prepare the ground for the next recovery.

Features of business cycles

1. Recurrent but not periodic. Cycles keep coming back, yet no two have the same duration or amplitude, which makes exact forecasting impossible.
2. Co-movement. Output, employment, consumption, investment, profits and credit move together across industries and regions. This economy-wide spread is what separates a business cycle from a shock that hits only one sector.
3. Unequal volatility. Investment, especially in inventories and durable goods, swings far more than consumption of non-durables and services, because households try to smooth consumption over time.
4. Procyclical and countercyclical variables. Employment, labour productivity and inflation generally rise in booms and fall in slumps, so they are procyclical. Unemployment moves the other way and is countercyclical.
5. Cumulative and self-reinforcing. Once a movement begins it feeds on itself through the multiplier, the accelerator and changing expectations, until some ceiling or floor produces a turning point.
6. Asymmetry. Contractions are usually shorter and sharper than expansions, which tend to be long and gradual.
7. International transmission. Through trade, capital flows and financial links, booms and slumps spread across countries, as the global financial crisis of 2008 showed.
8. Readable through indicators. Leading indicators such as new orders, building permits and share prices turn before the economy. Coincident indicators such as GDP, industrial production and employment move with it. Lagging indicators such as the unemployment rate and the inventory-sales ratio follow it.

Conclusion. Knowing the phases and features is the basis for stabilisation policy. Fiscal and monetary authorities try to shorten contractions and cool an overheated boom without choking long-run growth, which is exactly where Block 3 of the course picks up.

The Harrod-Domar model and knife-edge equilibrium

Question 2: Explain the Harrod-Domar model in detail. Why is the equilibrium condition in the Harrod-Domar model called the "knife-edge" equilibrium? (20)

Introduction. The Harrod-Domar model, developed separately by Roy Harrod (1939) and Evsey Domar (1946), extends Keynesian short-run analysis to the long run. It asks how fast an economy must grow so that the saving it generates is fully absorbed by investment, while the new capital that investment creates is also fully used.

Assumptions. A single good is produced. The saving ratio s is constant. The capital-output ratio v (= K/Y) is fixed because capital and labour are combined in fixed proportions. The labour force grows at a constant exogenous rate n. There is no technical progress, no government or foreign sector, and depreciation is ignored.

Domar's version: the dual character of investment

On the demand side, extra investment raises income through the multiplier:

ΔY = ΔI × (1/s)

On the supply side, investment adds to productive capacity:

ΔY_p = σI,   where σ = 1/v

For new capacity to be fully used, the rise in demand must equal the rise in capacity: ΔI/s = σI, which gives ΔI/I = sσ. Investment, and with it income, must grow at the rate sσ every period. If s = 0.2 and σ = 0.25, investment must grow at 5 per cent a year just to keep capacity employed.

Harrod's version: three growth rates

• The actual growth rate is G = s/C, where C is the actual ratio of new capital to new output (ΔK/ΔY).
• The warranted growth rate G_w = s/v is the rate at which planned investment exactly equals saving, so producers are satisfied with what they have done.
• The natural growth rate G_n = n (plus labour-augmenting technical progress) is the highest rate the labour force allows.

Equilibrium condition. Steady growth with full use of both capital and labour needs G = G_w = G_n, that is, s/v = n. With s = 0.24 and v = 4, the warranted rate is 6 per cent. If the labour force grows at only 2 per cent, the warranted path cannot be sustained.

Why it is called the knife-edge equilibrium

1. Equality is a coincidence. The saving ratio depends on household behaviour, the capital-output ratio on technology and the growth of labour on demography. Nothing in the model brings these three independently given numbers into line, so balanced growth would happen only by accident.
2. The warranted path is unstable. Suppose actual growth G rises above G_w. Then the actual C falls below the desired v: firms find their capital stock too small for the demand they face, so they invest more. Through the multiplier this lifts demand again and pushes G even further above G_w. The reverse also holds. If G falls below G_w, firms are left with idle capacity, cut investment, demand falls further and the economy slides into a cumulative contraction. A small departure is magnified rather than corrected, like a ball balanced on a knife's edge that falls to one side at the slightest push.
3. The gap between G_w and G_n. If G_w > G_n, the labour force cannot support the warranted rate, actual growth keeps falling short and the economy tends towards chronic stagnation. If G_w < G_n, labour grows faster than capital, so unemployment keeps rising alongside demand pressure.

Conclusion. The knife-edge result comes from rigid assumptions, above all the fixed capital-output ratio. Robert Solow (1956) showed that once capital and labour can be substituted, v adjusts and the economy can settle on a stable path, which is why the Solow model follows Harrod-Domar in Block 1.