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 Business Cycles: Causes and Effects
1. What is a business cycle and why is it also referred to as a trade cycle?
A business cycle, as per the CBSE curriculum for the 2025-26 session, refers to the periodic fluctuations of a country's Gross Domestic Product (GDP) around its long-term growth trend. It is also called a trade cycle because these economic fluctuations directly impact the volume of trade, production, and commercial activities within an economy.
2. What are the four main phases of a business cycle?
The four primary phases that characterise a business cycle are:
- Expansion: A period of economic growth where GDP, income, and employment rise.
- Peak: The highest point of the business cycle, where economic growth hits its maximum rate.
- Contraction (or Recession): A period following the peak where economic activity slows down, leading to falling GDP and rising unemployment.
- Trough: The lowest point of the business cycle, marking the end of the contraction phase before recovery begins.
3. What are the key internal causes that trigger a business cycle?
Internal causes are factors originating within the economic system that influence the business cycle. The main internal causes include:
- Fluctuations in Investment: Changes in investment by firms, driven by profit expectations and interest rates.
- Changes in Demand: Shifts in aggregate consumer or government demand for goods and services.
- Macroeconomic Policies: Government actions related to fiscal policy (taxes, spending) and monetary policy (interest rates, money supply).
- Supply of Money: Variations in the availability of credit and money in the economy, affecting spending and investment.
4. How do external factors cause fluctuations in a business cycle?
External factors, or exogenous shocks, are events that originate outside a country's economic system but significantly impact it. Examples include:
- Wars and Political Instability: These events divert resources to non-productive uses and create uncertainty, often leading to economic contraction.
- Technological Shocks: Major inventions or technological advancements can create new industries and spur an expansion phase.
- Natural Disasters: Events like floods, droughts, or famines can disrupt agriculture and supply chains, causing a sharp economic downturn.
- Changes in Population Growth: Rapid population changes can put pressure on an economy's resources and demand, affecting long-term cycles.
5. What are the common effects of a business cycle on an economy?
The effects of a business cycle are felt across the economy. During an expansion, employment rates are high, wages and profits rise, and consumer confidence is strong. Conversely, during a contraction or recession, the key effects are rising unemployment, falling corporate profits, reduced consumer spending, and lower investment levels.
6. Why is 'fluctuation in investment' considered a major internal cause of business cycles?
Fluctuations in investment are a major cause because of the multiplier effect. An increase in investment creates jobs and income. This new income leads to higher consumer demand, prompting more production and further investment, accelerating an expansion. Conversely, a fall in investment reduces income and demand, causing firms to cut back on production and employment, which can trigger or deepen a recession.
7. How do a government's macroeconomic policies influence the expansion and contraction phases?
A government can use macroeconomic policies to manage the business cycle. To combat a contraction, it can implement expansionary policies like cutting taxes or increasing government spending (fiscal policy), or lowering interest rates (monetary policy) to encourage borrowing and spending. To control inflation during a rapid expansion, it can use contractionary policies like raising taxes or cutting spending to cool down the economy.
8. What is the difference between a recession and a depression in the context of a business cycle?
The key difference lies in severity and duration. A recession is a significant decline in economic activity lasting for more than a few months, representing the contraction phase of a business cycle. A depression is a much more severe and prolonged recession, characterised by a substantial drop in GDP (e.g., more than 10%) and very high unemployment rates that can last for several years.
9. Why does the unemployment rate typically rise during the contraction phase of a business cycle?
During the contraction (or recession) phase, aggregate demand for goods and services falls. In response to lower demand and declining profits, businesses reduce their production levels. To cut costs associated with lower output, firms often resort to downsizing their workforce and freezing new hiring, which directly leads to a higher rate of unemployment in the economy.
10. Can technological advancements be both a cause of economic expansion and contraction? Explain how.
Yes, technology can have a dual impact. A major technological breakthrough can fuel an economic expansion by creating new products, increasing productivity, and stimulating large-scale investment in new industries. However, the same advancement can cause a short-term economic contraction in specific sectors by making older technologies and the jobs associated with them obsolete, leading to structural unemployment and disruption before the economy fully adapts.
