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Theories of Business Cycles

Updated on November 4, 2009

Theories of Business Cycles

For many centuries, it has been observed that economic activities have not been constant. There have been always fluctuations in the economy due to crop failures, seasonal cycles in an agricultural economy, or technological changes. In modern times, economists have noted the repetitive pattern of peak, contraction, recovery, and expansion to be a regular cycle of about seven to ten years' duration. However, there are some cycles which have longer and shorter periods.

Several theories explain the changing behavior of the economy. One economist even linked the business cycles to spots on the sun, and another one claimed that what goes up must come down. In general, the theories of business cycles can be classified into two categories:

1.               Exogenous theories. Forces outside the economic system create the business cycle. Examples of these forces are wars, political developments, natural disasters, or major innovations. Clearly, governments which are not stable do not attract both local and foreign invents. Typhoons and floods can easily wipe out,in a week's time, the output of an agricultural country. Droughts in Africa are one of the root causes of the extreme poverty of many African states. Likewise, civil wars have destroyed the economies of all countries which have been afflicted with said human misunderstandings or greediness for political powers among the leaders.

2.               Endogenous theories. Forces within the economic system cause the fluctuations in the economy. Examples are accelerators, multipliers, innovations, or monetary policies. An increase in aggregate demand results to a greater increase in investments. Aggregate demand is composed of household consumption, business investment, and government expenditure. These three kinds of expenditure create an economic expansion. Precisely, this is a situation which attracts more investments. And the latter generate more national income or output. In the case of innovation (many consider this as exogenous) it is the application of an invention for commercial use. Evidently, innovations (like new techniques of production or better machines) improve economic activities. Likewise, favorable monetary policies (more details are presented in the next chapter) lead to better economic conditions.


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