What causes business cycles?
The causes of business cycles are not completely understood. There are some cases in which the cause of a recession or an expansion is fairly clear. In other cases, there is not. Economists do, however, have two main theories as to why business cycles happen.
In some cases, the cause of a business cycle is clear. A good example of this is the expansion that ended the Great Depression. This was clearly brought on by a huge increase in government spending that occurred as World War II drew near. Another possible example is the recent “Great Recession.” This was triggered by the collapse of a housing bubble.
However, not all recessions and expansions are so easily explained. At times, they seem to happen without any clear cause. Let us look at two explanations for such cycles.
One explanation has to do with government. This says that politicians always want to have the economy be expanding at election time so they can get reelected. Therefore, they make decisions two or three years before an election that lead to expansion at election time. Once the election has passed, they realize that they need to cut back on spending so as not to produce excessive deficits and debts. The economy then contracts.
Another explanation has to do with business investment. This explanation says that economic expansion causes interest rates to go up because there is more demand for borrowing money. Eventually, the rates get too high and businesses stop borrowing as much to pay for investments. As they stop investing, economic activity slows and the economy contracts. As it does so, interest rates go back down. As they do, it becomes easier to borrow and firms start to invest again. This causes an expansion.
There are, however, other explanations. It would be a good idea to check to see which ones your text and/or instructor emphasize.