CAUSES OF BUSINESS CYCLE

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 Euective Demand: 

• According to Keynes, fluctuations in economic activities are due to fluctuations in aggregate euective demand (Euective demand refers to the willingness and ability of consumers to purchase goods at diuerent 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 ou 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 euective demand causes conditions of expansion or boom and decrease in aggregate euective demand causes conditions of recession or depression. (You will study about these concepts in detail at Intermediate level in Economics for Finance.