What are the causes consequence of business cycle
Answers
Causes of the business cycle
1) Interest rates. Changes in the interest rate affect consumer spending and economic growth. For example, if interest rates are cut, this reduces borrowing costs and therefore increases disposable income for consumers; this leads to higher spending and economic growth. However, if the Central Bank increase interest rates to reduce inflation, this will tend to reduce consumer spending and investment, leading to an economic downturn and recession. See: Interest rate cycle.
High-interest rates in 1991-92 were a major factor in the recession of that year. The cut in interest rates post 1992, helped the economy to recover.
2) Changes in house prices
uk-house-price-inflation-1980-2013
A rise in house prices creates a positive wealth effect and leads to higher consumer spending. A fall in house prices causes lower consumer spending and bank losses. (house prices and consumer spending) In the late 1980s, the boom in house prices caused an economic boom. The drop in house prices in the early 1990s was a significant factor in causing the recession of 1991-92.
3) Consumer and business confidence
Fall in confidence in May 2008, contributed to the deepest recession for a considerable time.
People are easily influenced by external events. If there is a succession of bad economic news, this tends to discourage people from spending and investing, making a small downturn into a bigger recession. But, when the economy recovers this can cause a positive bandwagon effect. Economic growth encourages consumers to borrow and banks to lend. This causes higher economic growth. Confidence is an important factor in causing the business cycle.
4) Multiplier effect. The multiplier effect states that a fall in injections may cause a bigger final fall in real GDP. For example, if the government cut public investment, there would be a fall in aggregate demand and a rise in unemployment. However, those who lost their jobs would also spend less, leading to even lower demand in the economy. Alternatively, an injection of investment could have a positive multiplier effect.
5) Accelerator effect. This states that investment depends on the rate of change of economic growth. If the growth rate falls, firms reduce investment because they don’t expect output to rise as quickly.
UK-business-investment-05-15
Drop in business investment caused by lower growth and credit crunch made the recession deeper.
This theory suggests investment is quite volatile and small changes in the rate of growth have a big effect on investment levels. This contributes to a more volatile business cycle.
6) Lending/finance cycle. Up until the 2008 recession, less emphasis had been placed on the state of the financial system. However, the credit crunch of 2008 was the primary cause of the 2008/09 recession. A boom in credit and lending (especially sub-prime mortgages in US) was a factor in promoting economic growth during the 2000s. But, when banks became over-stretched and needed to call in loans, the financial system was short of liquidity. After the credit crunch, more attention has been given to theories of financial instability. For example, H. Minsky ‘Financial instability hypothesis‘ as a cause of business cycles.
7) Inventory cycle. Some argue that there is a natural inventory cycle. For example, there are some ‘luxury’ goods we buy every five years or so. When the economy is doing well, people buy these luxury items causing faster economic growth. But, in a downturn, people delay buying luxury goods, and so we get a bigger economic downturn.
8) Real business cycle theories. Real business cycle theories – e.g. Kydland and Prescott (1982) – emphasise supply-side causes of the business cycle. For example, periods of technological change can go in cycles, leading to variations in rates of growth. Real business cycle theories tend to assume rates of unemployment reflects changes in people’s willingness to work. See more at Real Business Cycle models
Explanation:
There are many different factors that cause the economic cycle – such as interest rates, confidence, the credit cycle and the multiplier effect. Some economists also point to supply side explanations, such as technological shocks.