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The 8 Causes of the Business Cycle

The business cycle are periods of economic expansion and contraction as measured by gross domestic product or a similar measure of economic output. The cause of business cycles is somewhat contested as it is likely that a large number of factors play a role as opposed to a single cause. The following are contributing factors to the business cycle.

Economic Output

The business cycle is defined by the economic output of a nation. This has four phases: expansion, crisis, recession and recovery.
A period of economic growth.
A market realization that there is a problem with the economy leading to a crisis such as a market crash.
A period of economic decline whereby GDP falls.
A period of stabilization that sees the economy return to growth.

Credit Cycle

The credit cycle are periods of credit expansion and contraction that generally coincide with the business cycle.
Credit is usually easy to get during an economic expansion as loans are performing well.
In a crisis, loans suddenly start to perform badly and banks halt lending. It becomes more difficult to secure business funding or consumer loans.
When the business cycle falls into recession both businesses and consumers may be hesitant to take out loans. Likewise, banks may be conservative about giving out credit. This has to do with confidence in the economy. Many firms and individuals may enter a recession heavily indebted and may focus on repaying debt over investment and spending.
Governments encourage recovery by lowering interest rates and providing liquidity to banks. With time, this tempts businesses and consumers to take out loans to boost investment and spending.


Businesses go through a cycle of ramping up supply and cutting back in response to economic conditions. This may coincide with the business cycle or industry specific cycles whereby supply follows a boom and bust pattern.
In an economic expansion, firms ramp up supply by investing in new capacity and hiring employees.
As many firms expand production the market can become oversupplied. When producers realize that the market will be oversupplied they immediately cut prices to avoid ending up with excess inventory. This can cause losses for all suppliers who quickly cutback production by laying off employees or reducing hours.
During a recession firms may produce below their capacity. This can mean that capital sits idle.
In a recovery demand improves and idle capacity comes back on line. Firms begin hiring and may eventually invest in more capacity as demand heats up.


Businesses and consumers go through a cycle of increasing their spending in the good times and reducing spending in an economic contraction.
In an economic expansion, both businesses and consumers may have excess cash to spend and ample access to credit. This buying power and the general feeling of optimism that accompanies an expansion drives increased spending. This can cause demand to exceed supply leading to rising prices, also known as inflation.
In a crisis, the value of assets decline making businesses and consumers less wealthy. Business revenue may drop and employees may face layoffs. Optimism turns to fear and spending drops.
Demand for basic goods such as consumer staples may remain stable during a recession while demand for optional purchases such as industrial equipment and consumer discretionary goods may be low.
A recovery can be driven by a return to confidence that causes consumer demand to improve.

Monetary Policy

Monetary policy is a tool that governments use to increase the length of economic expansions and reduce the frequency and severity of contractions.
In an economic expansion demand for products, services, resources and labor is high. This causes prices to rise. If inflation gets too high this can destroy wealth and cause hoarding as it becomes more profitable to hold on to goods than to sell them. Monetary policy seeks to avoid high inflation by increasing interest rates and decreasing liquidity. A monetary authority may also watch out for market bubbles and credit bubbles whereby questionable loans are going to questionable investments.
In a crisis, monetary policy may dramatically change in order to reassure the market and restore confidence. This generally involves decreasing interest rates and providing liquidity to banks suffering from the prospect of bad debts and other issues.
Monetary policy generally involves low interest rates and high liquidity in a recession in order to stimulate supply and demand. There are exceptions to this, such as stagflation whereby a monetary authority is battling high inflation and low economic growth at the same time.
A monetary authority may keep interest rates low throughout the recovery phase.

Fiscal Policy

Fiscal policy is government spending and tax policy. These have an influence on business cycles and can be used as tools to cool an expansion and stimulate a recovery.
In theory, a government should cut back on spending and increase taxes in an expansion to build reserves to fight the next recession. In practice, governments often get overly excited by the good economic conditions and may begin overspending. This can help to trigger inflation and bring an end to the economic expansion. Overspending can also lead to large government debts that make it more difficult to mitigate a recession.
In some cases a crisis is caused or made worse by high levels of government debt that necessitate money printing to pay interest leading to high inflation or hyperinflation.
In theory, a government should reduce taxes to stimulate consumer spending and business investment in a recession. Governments may have little ability to do this if they are overburdened with debt. Governments can also fight a recession by spending in areas such as soft and hard infrastructure. In practice, governments may cut back spending during a recession as their tax revenue falls and their debt becomes harder to repay. This can cause a prolonged recession as government cutbacks add to the reduced spending by firms and consumers.
Any stimulative measures introduced by government in a recession are typically sustained throughout a recovery and only reduced when the expansion is well underway.


The confidence of businesses and consumers plays a role in the business cycle. Confidence is also impacted by the business cycle such that it can be difficult to separate cause from effect.
The confidence of businesses and consumers surges during an expansion. This stimulates lending, capital spending, hiring and consumer spending.
At some point people realize that bubbles exist in an economy such as excessive capacity and debt. This can result in stock market crashes as investors lose confidence in future earnings. Stock market crashes further shake the confidence of businesses and consumers leading to less spending and layoffs. News of layoffs can further reduce consumer confidence.
Businesses and consumers become accustomed to lower economic expectations and the sense of panic from the crisis subsides. Businesses and consumers may become conservative with less spending and more saving or debt repayment.
Low interest rates and ample liquidity provided by a government can cause business and consumer confidence to slowly return leading to recovery.


Innovative new technologies, products or services may have an impact on the business cycle.
A valuable innovation may spark both business and consumer spending. Excitement may grow around the innovation leading to increased business and consumer confidence. Entrepreneurs rush to start companies and investors flock to fund startups. Incumbent firms may see this as a threat and invest to keep up with the pace of change.
People get too excited about the innovation causing inflated expectations and poor quality investment decisions triggered by a fear of missing out. This inevitably leads to crisis as the innovation fails to meet inflated expectations and people suddenly see their ill-considered investments in a more pessimistic light.
During a recession investors become more cautious such that innovative new ideas are less likely to get funding. Nevertheless, it is common for innovative startups to emerge in the harsh environment of a recession.
The tendency for investors to be cynical about innovative firms during a recession creates an opportunity to invest at a relatively low price. This can spark a market recovery as risk taking investors begin to reinvest in innovation.
Overview: Business Cycle
Definition (1)
Periods of expansion and contraction of economic output.
Definition (2)
A repeated pattern of economic expansion, crisis, recession and recovery that is considered a pervasive feature of the global economy.
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