The two causes of business cycles


business cycles
the two causes of business cycles


During the last hundred years ago, great economist, philosophers, stock brokers, men and women in the society have tried to explain various causes of business cycles. Some of them were of the notion that monetary and non monetary factors while others are of the opinion to physiological factors. Samuelson who is an expert in economy matters attributes business cycles to external and internal factors which will be the subject of our discussion and is explain below as you read on:


1.    The external factors causes of business cycles:


The external factors show that the causes of business cycles in the fluctuations of something outside the economic system. And such external factors are:

1.       wars,

2.      sunspots,

3.      political events,

4.       growths rate of population

5.      Revolutions

6.      Gold discoveries

7.      Migration

8.      Innovations and

9.      Discoveries

These outside factors change the level of national income by affecting either the investment or consumption component of aggregate demand. For example, a drought that damage many farm produce due to high sunspot may reduce the quality and quantity of the goods to be produced in the nations and adversely affect both consumption and investment. An innovation by opening the door to new business markets, raw materials, production process and products encourages more investment opportunities in the equipment and plant. The invention of the rail way, electricity, telephone, automobiles, television, computers and many other innovations have led to the growth of investment in both consumer goods and capital from time to time in the economy. The discovery of precious mineral resources such gold, oil, and other natural resources have led to a growth in the scale of investments. Again, the growth in population and migration are the causes of major investment in both housing projects and other facilities and consumer durables. All the above explain factors have been for booms in business cycles.


2.    The internal factors causes of business cycles:


The internal factors relate to “mechanism within the economic system itself which will give rise to self generating business cycles, so that every expansion will breed recession and contraction, and every contraction will in turn breed revival and expansion, in a quasi regular, repeating, never ending chain” Haberler divides the internal factors into monetary and non monetary which we briefly explain.


1.     Bank credit. Haw trey, Friedman and other monetarists regards business cycles “as a purely monetary phenomenon”. According to haw trey, cyclical fluctuation is caused by expansion and contraction of bank credit, these in, lead to changes in the demand for money on the part of producers and traders. Bank credit is the principal means of payment. Credit is expanded or reduced by the banks by lowering or raising the rate of interest or by purchasing and selling of securities to traders. This increase or decrease the supply of money in the economy. An increase in the money supply brings about prosperity and a decrease in the money supply leads to depression.

2.     Over saving or under consumption. According to economist like Hobson, foster and Douglas, business cycles are caused by over saving or under consumption. They argue that wide disparities of income and wealth lead to depression in the country. The rich people are not able to spend their entire income. So they save more and invest more in producing consumer goods. On the other hand, the poor people have low income or wages. As a result, their demand for consumer goods in low which means that there is under consumption. According to Hobson, over saving leads to production of consumer goods in large quantities and to a boom. But under consumption on the part of the workers due to low salaries brings a fall in the demand for consumer goods. Stocks will then pile up at the current level of prices. This will in turn, lead to a fall in the prices of consumer goods and the income of the produce. As a result of this depression will then set in the economy.

3.     Over investment. Hayek, cassel, Robertson and spiethoff find the root cause of business cycles in over investment. According to on of the scholar, it is the bank loans which lead to over investment in the capital goods sectors relative to consumer goods sectors that will ultimately bring economic depression. When the total supply of money exceeds the amount of voluntary savings, it leads to increase in the investment activities and will ultimately lead to a boom in the economy. But banks cannot continue to give credit for long due to the shortage of voluntary savings. As a result, production will reduce which will result to depression in the economy. Thus it is over investment in the capital goods sector or industries which is the cause of a depression and a boom.

4.     Competition. According to a scholar called Chapman, the main causes of business cycles is the existence of competition in an economy which will lead to over production and ultimately to a crisis such as economic depression. Under competitive conditions, firms produce in anticipation of demand. The profit motive attracts other new firms. Production will increase and economic boom will start. Competition and profits leads to over production and glut of commodities in the market and to fall in prices. On the other hand, the race to produce more and profit more on the part of producers increases the total demand for factors of production. Competition among producers to hire more factors will raise their prices. Thus costs rise which raise the prices of products in the market. Demand falls and there is a glut of commodities which will eventually result to a fall in prices and to a depression.

5.     Psychological causes. According to a scholar called pigou, the alternating waves of ‘over optimism and’ are the sole causes of the industrial fluctuation. He traces cyclical fluctuation to the tendency of businessmen and women to react excessively to the changing conditions of the economy. It is this tendency that causes alternating periods of over of over production and under production. Errors of optimism and pessimism are interacting factors. As soon as the business community discovers that it has made an error of optimism, it tries to correct it by making error of pessimism. Each phase of the cycle produces a state of psychology which produces forces that brings about reversals, is the main causes of business cycles.

6.     Innovation. According to Schumpeter, innovation in the structure of an economy is the source of economic fluctuation. To him the cause of depression is prosperity. The boom consists in the carrying out of innovations in the industrial and commercial field. The cyclical upswing is set in motion when an innovator starts making investment in his innovation of new product. This enables him to make profit. Soon other entrepreneur will adopt this new product in swarm like cluster. Innovation in one field induces innovation in related fields. There is large increase in the output of new products. Consequently, money incomes and price rise and help to create a cumulative expansion in the economy. Over optimism adds further to the boom. When there is glut of new product in the market, their prices fall, and profit margins of entrepreneurs are reduced. Banks ask for repayment of loans. The quantity of money is reduced and prices fall further. Some entrepreneurs cut down production and others are forced into liquidation. Thus the economy enters into depression.

7.     Marginal efficiency of capital(MEC). According to Keynes, the cycle consist primary of fluctuations in the rate of investment. And fluctuation in the rate of investment is caused mainly by fluctuation in the MEC. The MEC depends on the supply prices of capital assets and their perspective yield. The supply price of capital assets being stable in the short run the MEC I s determined by the prospective yield of capital assets. The prospective yield, in turn depends on the business expectation. Fluctuation in the rate of investment is also caused by fluctuations in the rate of interest. But it is fluctuation MEC which are the principal cause of cyclical fluctuations.


To conclude with Samuelsson, the causes of business cycles are caused both by external and internal factors. The economic system responds to fluctuation in external factors according to its internal factors, and vice versa.


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