What is a Business Cycle?
A business cycle is the fluctuations of Gross Domestic Products (GDP). It is a series of cycles of economic expansions and contractions, therefore, it is also called an economic cycle or a trade cycle. In this article, students will learn about the causes and the effects of the business cycle.
Internal Causes
The factors that are built within the economic system and influence the business cycle are called the internal causes of the business cycle. The major causes that affect the business cycle are as follows:
Change in Demand: A change in the demand of a good or service will lead to changes in production and supply of the concerned goods and services, thus, affecting output in an economy. This kind of change can also cause inflation in an economy if there is excessive demand. A decrease in demand will lead to lower output, lower employment affecting the income of the public eventually leading to a trough in the economy. If the situation is not resolved, it will lead to depression in the economy.
Investment Fluctuations: Changes in investments made will lead to differences in output in an economy much like what happens in changes in demand. So it naturally follows that an increase in investments will lead to expansion of the economy while a decrease will lead to trough or depression. There are a few factors affecting the investment decisions: expectation of profits, entrepreneurial and current rate of interests, and income generation.
Macroeconomic Policies: The monetary and other related policies set up by a government are the macroeconomic policies that immensely affect the business cycle. If the policies benefit businesses and investors, the economy will see an expansion or boom leading to economic growth, whereas, policies that will not benefit such businesses but discourage investment instead such as an increase in tax rates or removing subsidies will create recession in the economy.
Supply of Money: It is obvious that more supply of money will make people spend more which will, in turn, lead to growth or expansion in the economy and vice-versa. But excessive money in the economy will lead to inflation that will hurt the spending habits of the citizens whose income did not increase at the same rate as inflation.
External Causes
The factors or changes that arise outside of an economy but still affect it are called external causes of the business cycle. These are exogenous causes that affect economies in other countries as well.
Wars: During wars, economic resources and available capital are used for manufacturing weapons and providing for the army which increases the need for basic amenities among the general citizens as the focus shifts to the battlefield and other places of the economy are ignored. This slows down the economy and is one of the main causes of the Great Depression of the 1930s.
Technology: Changes and development of technology is an essential cause of changes in the demands and supply of different goods and services. It is also an influencing factor of employment opportunities and progress in different fields of the economy.
Natural Causes: Natural disasters like drought, famine or flooding greatly affect several factors of input in the economy such as transportation, employment, agriculture which results in an increase in existing prices of related products. Such natural calamities may cause depression.
Population Expansion: Excessive expansion in population puts pressure on the demands of an economy thereby affecting the supply and prices of products. There is a strict need to control the population through various policies in order to keep the economy in check.
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FAQs on Causes of Business Cycles
1. What Does Recession in the Economy Mean?
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.
Decrease in demand
Excessive wars and unpeaceful conditions
Natural calamities
Plague
Increase in taxes
Increase in interest rates
2. What are the Prime Factors that Lead to Inflation in an Economy?
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:
Increase in the money supply
Higher wages
Increase in public expenditure by the government
Cheap monetary policies set up by the government
Reduced tax rates and interest rates
Deficit financing
Increase in exports
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.
3. What Does the Term Economy Mean?
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.
4. What factors affect the business cycle?
There are a lot of factors that influence a business cycle, some of which include business decisions, interest rates, consumer and investor expectations, and external factors affecting the economy.
5. What are the phases of a business cycle?
There are four main phases of a business cycle: expansion, peak, contraction and trough. There are many factors influencing the current stages of a business cycle such as GD, interest rates, consumer spending habits and employment in an economy.
6. Why does the unemployment rate rise during the depression phase of a business cycle?
A recession in an economy is characterized by a decrease in output, therefore, less production of goods and services leads to the requirement of fewer workers and resorting to cost optimization by a business firm leads to downsizing in the workforce. This affects the employment rate in the recession phase of a business cycle.
