Causes of Business Cycles

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What is Business Cycle? 

A business cycle is the on-going downward and upward movement of GDP, Gross Domestic Product. Broadly, it can be defined as the series of cycles of economic expansion as well as economic contraction. The other names for a business cycle are as follows.

  • Economic Cycle 

  • Trade cycle 

Many factors affect the business cycle. Both internal and external causes of the business cycle play a vital role in this. Here we shall learn in detail about the causes and effects of the business cycle.

Internal Causes of Business Cycles

The factors or causes that are built within the economic system are known as internal causes of the business cycle in economics. Let us learn in detail about the major causes of the business cycle. 

1. Change in Demand

In the terms of economics, change in demand causes a change in the economy. When the demand increases, a firm will naturally purchase more goods and services to meet the increased demands of the economy. This thereby increases employment opportunities and the output produced. As a result, the company experiences great profits. However, one must also know that excessive demand can also lead to inflation in the economy. 

Talking about the conditions of fall in demand in an economy, the decreased demand results in lower output, employment, and income. It eventually leads to a trough in the economy. If the same situation prevails for a longer period, it can also cause depression in the economy. 

2. Investment Fluctuations

It is a concept quite similar to the increase or decrease in demand in an economy. The major factors that cause fluctuations in demand are as follows.

  1. Expectation of profits

  2. The current rate of interest 

  3. Entrepreneurial interest 

  4. Income generation 

It is naturally understood that if the investments in the economy are increased, it experiences an expansion in the economy. Whereas, if the investments in the economy are decreased, it can result in depression or trough in the economy. 

3. Macroeconomic Policies

The economic policies, also known as monetary policies of a nation set up by the government, play a vital role in affecting the business cycle. If the economic policies are set up or planned in a manner that benefits humans, such as providing subsidies and taking other relevant measures, it can result in the boom in an economy. Whereas, if the government increases the tax rate, interest rates, or remove the existing subsidies, it can result in uneasy financial conditions among people. Hence, in such cases, you can experience a recession, also known as a slowdown in the economy.

4. Supply of Money

Money plays a vital role in shaping the graph of the business cycle. The relevant changes in the money cycle change the trade cycles of the economy. It is so obvious that if people have a considerable amount of money, they will spend more to consume goods and services. Therefore, more supply of money leads to growth or expansion of the economy. Whereas, on the other hand, less money supply may lead to a recession in the economy. 

It is necessary to note that excessive money supply can even lead to inflation in the economy, whereas an extremely low money supply can result in depression in the economy.

External Causes of Business Cycles

The external factors that cause changes in the business cycle are known as external causes of the business cycle. These changes do not happen within the economy, but other factors or things happening in the outside world also affect the business cycle. These are also known as exogenous causes of the business cycle. Some important external factors are discussed below in brief.

1. Wars

Wars and fights at any place cause a situation of unrest for human lives. Also, it severely affects the economic conditions of the place. During wars, large economic resources and monetary resources are used in the production of weapons for the war, including arms, guns, and other such things. It automatically shifts the focus of government and people of the country from education, employment, and other beneficial factors of the economy to the production of capital goods. The importance and need for consumer goods are ignored in such cases. Therefore, the economy experiences a downturn during wars. Years after the war, a huge amount and resources are needed to be spent on the rebuilding of that particular place. People start working for their livelihood. This slowly and gradually results in the increase in demand in an economy due to which the economy experiences progress.

2. Technology

With an increase in modernization and industrialization, we can see a development in new technologies each day. Development and investment in new technologies, machinery, and advancement results in new investments. Even for building up any machinery, a large amount of employment is required. Hence it also increases employment opportunities for people, resulting in a better monetary flow in the economy. Therefore, it is always correct to say that an increase in technology always results in a boost in the economy.

3. Natural Factors – Weather or Climatic Conditions

The economy can experience considerable slowdown in the case of natural calamities. Floods, hurricanes, droughts being the threatening conditions for human lives as well as for the economy. Loss of agriculture brings a shortage of food availability, thus increasing the price, even when there is the least monetary availability with people. The focus on capital goods is reduced. The flow of money and employment undergo a gradual decrease. Therefore, natural calamities can cause depression in the economy.

4. Population Expansion

Have you ever thought about why the government makes so many policies to maintain population growth? It is because the gradual expansion or excessive population can lead to slower economic growth. If the population in any country goes out of control, the total savings start dwindling. Due to an increase in expenses, investments are reduced, resulting in a slow down of the economy.

FAQ (Frequently Asked Questions)

Q1. What Does Recession in the Economy Mean?

Answer: When the decline in the economy of any place lasts longer than months, it is known as a recession in the economy. In terms of the business cycle, the period between a peak and the trough is termed as a recession in the economy. Many factors can lead to a recession in an economy. Some of them are listed below.

  1. Decrease in demand 

  2. Excessive wars and unpeaceful conditions 

  3. Natural calamities 

  4. Plague 

  5. Increase in taxes 

  6. Increase in interest rates

Q2. What are the Prime Factors that Lead to Inflation in an Economy?

Answer: Inflation simply means an excessive flow of money in the economy that further leads to an increase in demand in the economy. The prime factors that can cause inflation in the economy are:

  1. Increase in the money supply

  2. Higher wages 

  3. Increase in public expenditure by the government

  4. Cheap monetary policies set up by the government 

  5. Reduced tax rates and interest rates 

  6. Deficit financing 

  7. Increase in exports 

  8. Black money prevailing in the market 

Therefore, all the factors leading to an increase in demand in the economy can be considered responsible for inflation in the economy. 

Q3. What Does the Term Economy Mean?

Answer: The term ‘Economy’ can be broadly defined as careful use as well as the management of money, time, or energy in a country. Moreover, it is a complex system of trade and industry in any country that affects the wealth of the country.