Causes of Business Cycles CA Foundation Notes | EduRev

Business Economics for CA Foundation

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CA Foundation : Causes of Business Cycles CA Foundation Notes | EduRev

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CAUSES OF BUSINESS CYCLES
Business Cycles may occur due to external causes or internal causes or a combination of both. The 2001 recession was preceded by an absolute mania in dot-com and technology stocks, while the 2007-09 recession followed a period of unprecedented speculation in the U.S. housing market.
Internal Causes: The Internal causes or endogenous factors which may lead to boom or bust are:
Fluctuations in Effective Demand: According to Keynes, fluctuations in economic activities are due to fluctuations in aggregate effective demand (Effective demand refers to the willingness and ability of consumers to purchase goods at different prices). In a free market economy, where maximization of profits is the aim of businesses, a higher level of aggregate demand will induce businessmen to produce more. As a result, there will be more output, income and employment. However, if aggregate demand outstrips aggregate supply, it causes inflation. As against this, if the aggregate demand is low, there will be lesser output, income and employment. Investors sell stocks, and buy safe-haven investments that traditionally do not lose value, such as bonds, gold and the U.S. dollar. As companies lay of workers, consumers lose their jobs and stop buying anything but necessities. That causes a downward spiral. The bust cycle eventually stops on its own when prices are so low that those investors that still have cash start buying again. However, this can take a long time, and even lead to a depression.
The difference between exports and imports is the net foreign demand for goods and services. This is a component of the aggregate demand in the economy, and therefore variations in exports and imports can lead to business fluctuations as well. Thus, increase in aggregate effective demand causes conditions of expansion or boom and decrease in aggregate effective demand causes conditions of recession or depression. (You will study about these concepts in detail at Intermediate level in Economics for Finance.
Fluctuations in Investment: According to some economists, fluctuations in investments are the prime cause of business cycles. Investment spending is considered to be the most volatile component of the aggregate demand. Investments fluctuate quite often because of changes in the profit expectations of entrepreneurs. New inventions may cause entrepreneurs to increase investments in projects which are cost-efficient or more profit inducing. Or investment may rise when the rate of interest is low in the economy. Increases in investment shift the aggregate demand to the right, leading to an economic expansion. Decreases in investment have the opposite effect.
Variations in government spending: Fluctuations in government spending with its impact on aggregate economic activity result in business fluctuations. Government spending, especially during and after wars, has destabilizing effects on the economy.
Macroeconomic policies: Macroeconomic policies (monetary and fiscal policies) also cause business cycles. Expansionary policies, such as increased government spending and/or tax cuts, are the most common method of boosting aggregate demand. This results in booms. Similarly, softening of interest rates, often motivated by political motives, leads to inflationary effects and decline in unemployment rates. Antiinflationary measures, such as reduction in government spending, increase in taxes and interest rates cause a downward pressure on the aggregate demand and the economy slows down. At times, such slowdowns may be drastic, showing negative growth rates and may ultimately end up in recession.
Money Supply: According to Hawtrey, trade cycle is a purely monetary phenomenon. Unplanned changes in supply of money may cause business fluctuation in an economy. An increase in the supply of money causes expansion in aggregate demand and in economic activities. However, excessive increase of credit and money also set off inflation in the economy. Capital is easily available, and therefore consumers and businesses alike can borrow at low rates. This stimulates more demand, creating a virtuous circle of prosperity. On the other hand, decrease in the supply of money may reverse the process and initiate recession in the economy.
Psychological factors: According to Pigou, modern business activities are based on the anticipations of business community and are affected by waves of optimism or pessimism. Business fluctuations are the outcome of these psychological states of mind of businessmen. If entrepreneurs are optimistic about future market conditions, they make investments, and as a result, the expansionary phase may begin. The opposite happens when entrepreneurs are pessimistic about future market conditions. Investors tend to restrict their investments. With reduced investments, employment, income and consumption also take a downturn and the economy faces contraction in economic activities.
According to Schumpeter’s innovation theory, trade cycles occur as a result of innovations which take place in the system from time to time. The cobweb theory propounded by Nicholas Kaldor holds that business cycles result from the fact that present prices substantially influence the production at some future date. The present fluctuations in prices may become responsible for fluctuations in output and employment at some subsequent period.
External Causes: The External causes or exogenous factors which may lead to boom or bust are:
Wars: During war times, production of war goods, like weapons and arms etc., increases and most of the resources of the country are diverted for their production. This affects the production of other goods - capital and consumer goods. Fall in production causes fall in income, profits and employment. This creates contraction in economic activity and may trigger downturn in business cycle.
Post War Reconstruction: After war, the country begins to reconstruct itself. Houses, roads, bridges etc. are built and economic activity begins to pick up. All these activities push up effective demand due to which output, employment and income go up. Technology shocks: Growing technology enables production of new and better products and services. These products generally require huge investments for new technology adoption. This leads to expansion of employment, income and profits etc. and give a boost to the economy. For example, due to the advent of mobile phones, the telecom industry underwent a boom and there was expansion of production, employment, income and profits.
Natural Factors: Weather cycles cause fluctuations in agricultural output which in turn cause instability in the economies, especially those economies which are mainly agrarian. In the years when there are draughts or excessive floods, agricultural output is badly affected. With reduced agricultural output, incomes of farmers fall and therefore they reduce their demand for industrial goods. Reduced production of food products also pushes up their prices and thus reduces the income available for buying industrial goods. Reduced demand for industrial products may cause industrial recession.
Population growth: If the growth rate of population is higher than the rate of economic growth, there will be lesser savings in the economy. Fewer saving will reduce investment and as a result, income and employment will also be less. With lesser employment and income, the effective demand will be less, and overall, there will be slowdown in economic activities.
Economies of nearly all nations are interconnected through trade. Therefore, depending on the amount of bilateral trade, business fluctuations that occur in one part of the world get easily transmitted to other parts. Changes in laws related to taxes, trade regulations, government expenditure, transfer of capital and production to other countries, shifts in tastes and preferences of consumers are also potential sources of disruption in the economy.

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