Business Cycles

Causes of Business Cycles

The cyclic pattern of changes that occurs in the economy is caused by many factors in combination. There are internal factors within the economy that may be causing these changes. And there are also external factors which may lead to a boom or bust of an economy. Let us take a look at all the causes of business cycles.

Internal Causes of Business Cycles

These endogenous factors can cause changes in the phases of the firm and the economy in general. Let us take a look at the internal causes of business cycles.

Causes of Business Cycles

1] Changes in Demand

Keynes economists believe that a change in demand causes a change in the economic activities. When the demand in an economy increases the firms start producing more goods to meet the demand.

There is more output, more employment, more income, and higher profits. This will lead to a boom in the economy. But excessive demand may also cause inflation.

On the other hand, if the demand falls, so does the economic activity. This may lead to a bust, which if it continues for a longer period of time may even lead to depression in the economy.

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2] Fluctuations in Investments

Just as fluctuations in demand, fluctuations in investment is one of the main causes of business cycles. The investments will fluctuate on the basis of a lot of factors such as the rate of interest in the economy, entrepreneurial interest, profit expectation, etc.

An increase in investment will lead to an increase in economic activities and cause expansion. A decrease in investment will have the opposite effect and may cause a trough or even depression

3] Macroeconomic Policies

The monetary policies and the economic policies of a nation will also result in changes in the phases of a business cycle. So if the monetary policies are looking to expand economic activities by promoting investment, then the economy booms. On the other hand, if there is an increase in taxes or interest rates we will see a slowdown or a recession in the economy.

4] Supply of Money

There is another belief that says that business cycles are purely monetary phenomena. So changes in the money supply will bring about the trade cycles. An increase of money in the market will cause growth and expansion.

But too much money supply may also cause inflation which is adverse. And the decrease in the supply of money will initiate a recession in the economy.

External Causes of Business Cycles

1] Wars

During times of wars and unrest, the economic resources are put to use to make special goods like weapons, arms, and other such war goods. The focus shifts from consumer products and capital goods. This will lead to a fall in income, employment, and economic activity. So the economy will face a downturn during war times.

And later post-war the focus will be on rebuilding. Infrastructure needs to be reconstructed (houses, roads, bridges, etc). This will help the economy pick up again as progress is being made. Economic activity will increase as effective demand will increase.

2] Technology Shocks

Some exciting and new technology is always a boost to the economy. New technology will mean new investment, increased employment, and subsequently higher incomes and profits. For example, the invention of the modern mobile phone was the reason for a huge boost in the telecom industry.

3] Natural Factors

Natural disasters like floods, droughts, hurricanes, etc can cause damage to the crops and huge losses to the agricultural sector. Shortage of food will cause a surge in prices and high inflation. Capital goods may see a reduction in demand as well.

4] Population Expansion

If the population growth is out of control that might be a problem for the economy. Basically of the population growth is higher than the economic growth the total savings of an economy will start dwindling. Then the investments will reduce as well and the economy will face depression or a slow down.

Solved Question on Causes of Business Cycles

Q: A rapid increase in interest rates causes

  1. Expansion
  2. Peak
  3. Contraction
  4. Trough

Ans: The correct answer is C. Recession or Contraction is caused by a sharp increase in interest rates, which will contract the credit and cause companies to slow down on expansion activities.

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