Causes of Business Cycle

Business cycle, term used by economists to designate a periodic increase and decrease in an economy’s production and employment. Ever since the Industrial Revolution of the 1800s, the overall level of production in industrialized capitalist countries has varied from high output and employment to low output and employment. Economists study business cycles because they have a significant impact on all aspects of an economy.

A variety of explanations have been offered for business cycles. The Austrian American economist, Joseph Schumpeter published his innovation theory in the late 1930s. He relates upswings in the business cycle to new inventions, which stimulate investment in capital-goods industries. Because new inventions develop unevenly, business conditions alternate between expansion and contraction, according to Schumpeter’s theory.

Economists believe that business cycles are caused by many factors out of which the important ones are:

i) Changes in capital expenditures

When the economy is strong businesses have expectations of sales growth; they invest heavily in capital goods (e.g., machines, equipment, factory buildings, etc.). After a while businesses may decide that they have expanded to their limit, so they begin to pull back on their capital investments and cause an eventual recession.

ii) Innovation and imitation

Invention and innovations are assumed to the sources of business cycle. Innovations include new products, new inventions, or a new way of performing a task. Joseph Schumpeter early in the twentieth century pointed out the importance of invention and innovation in causing the business fluctuation. When a business innovates, it often gains an advantage on its competitors because of its costs decrease or its sales increase. Whatever the case, profits increase and the business grows. If other businesses in the same industry want to keep up, they then copy (imitate) what the innovator has done or they come up with something better. Imitation/Replication companies usually invest heavily and an investment boom follows. Once the innovation spreads to another industry, the situation changes. Further investments are unnecessary and economic activity may slow.

In modern time the real business cycle (RBC) theory developed by Edward Prescott, Finn Kydland, P. Long, and Charles Plosser in the twenty first century regard ‘technological shocks’ as the main cause of business fluctuations.

iii) Credit and loan policies

Economists also regard ‘credit and loan’ policies of commercial banking as the important source of fluctuation in economic activities. Monetarist economists claim that improper management of money and credit supply is the main cause of cyclical fluctuation in a market economy. When “easy money” policies are in effect, interest rates are low and loans are easy to get. They encourage the private sector to borrow and invest, thus stimulating the economy. Sooner or later, the increased demand for loans causes the interest rates to rise, which discourage new borrowers. As borrowing and spending slow down, the level of economic activity declines. The economy keeps declining until interest rates fall and the business cycle begins over again.

iv) External shocks

Economists also regard ‘external shocks’ as the cause of cycle. Shocks such as increases in oil prices, wars and international conflict, have the capacity to either drive the economy up, or drive it down. The economy may benefit when a new supply of natural resources is discovered. Such was the case with Great Britain in the 1970s when an oil field was discovered off its coast in the North Sea. The British economy of course profited seeing that world oil prices were at an all time high, but the high prices hurt the United States at the same time.

American economists Robert J. Gordon has stressed in supply shocks as the main cause of business cycle. Supply shocks in an economy occur when business fluctuations are caused by shifts in aggregate supply. In the USA, the classic examples came during the oil crises of the 1970s, when sharp increase in oil prices contracted/reduced aggregate supply, increased inflation, and lowered output and employment. Many economists think that the low inflation and rapid growth of the American economy in the 1994-2000 periods may be explained by favorable supply shocks. During this period, costs grew slowly because of declining oil and commodity prices, declining import prices, rapid productivity growth, and below-par increases in medical care prices.

v) Political business cycles

Many analysts link/connect fluctuations to politicians who manipulate economic policies in order to be re-elected. Initially credited to German political economist Karl Marx (1818 – 1883) but later revised by, among others, Polish-born engineer and economist Michal Kalecki (1899 – 1970), political business cycle regards that economic fluctuations are caused by politicians who use fiscal and monetary policies (choosing between employment or inflation) in order to get elected/re-elected.

The evil effects of cyclical fluctuations of business firms

Certain effects of business cycles on individual concern are favorable. During revival and expansion, demand increases, selling prices rise more rapidly than costs, profits increase and individual manufacturer and merchants generally feel happy.
  1. Business cycles, however, land individual business firms into a number of disabilities and difficulties. Even during revival and the beginning of expansion phase, certain ill effects start appearing. The increase in raw materials price, in labor costs and routs, and the higher rates charged for credits accommodation increase the costs of carrying on business when the situation becomes more difficult, the evil of cancellation develops.
  2. The businessman that his customers are refusing to take goods, which they have ordered, and that there is a decline in the volume of orders.
  3. During the later stages of expansion, business enterprises are conformed by much more severe competition. Prices are maintained with difficulty.
  4. The decline in prices, which is characteristics of the period of recession, usually finds merchants and manufacturers with large inventories, which depreciate materially in value at this time. These excessive inventories are usually made up of finished goods rather than raw materials.
  5. The individual businessman usually suffers through being compelled to sell his goods at a loss in order to meet his obligations. This may result in either at least a sacrifice of profits, or possibly necessitating the carrying on of business at an actual loss.
  6. During contraction, one of the most important reasons for financial loss during such a period is found in the continuation of fixed charges of all sorts. It is possible during contraction for an individual concern to reduce its direct costs by the discharges of labor and the reduction of purchases of raw materials, but most of the elements of overhead cost cannot be so reduced.

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