What causes a business cycle?

A business cycle is a natural characteristic of a free market economy where prices tend to find its right balance or equilibrium. There are many theories on this matter but to start off, when incomes rise the demand for goods, services or investment products rise with it. Incomes rise as a response to inflation, but the additional income recieved is what actually contributes slowly to inflation. Inflation, income, demand and supply are like mechanical components that make each other turn.

As an economy expands due to a rising demand, credit markets can become loose and thus allow more loans as a result of a rising income which is a deciding factor when determining the loan amount. Once credit is readily available, the demand for goods, services or investment products will continually rise. There would be a point where the entire cycle reverses direction which is the result of many possible factors. In terms of financial instruments, as the value of investments rise, profit taking is common. Taking a profit requires a sell off, once a level is hit it may trigger more sell offs as weary investors try to protect their capital.

In terms of goods, as the demand goes up, producers will try to match it by making more, increasing production means hiring more people or buying more equipment. This hiring and buying cycle turns into income for people and other businesses involved, thus creating jobs which contributes further to demand. When producers try to match demand, they tend to create a surplus on products which is most of the time hard to estimate the outcome. If their surplus is not met by buyers as a result of an adequate or satisfied requirement of need, surpluses will be purged out of their inventory by lowering the price.

But why would producers lower the price leaving money on the table? there are many possible answers, but one obvious reason is they have to pay bills. Producers would rather sell at a much lower price to find buyers and generate revenue than having to wait for potential buyers at that price which may take a while. Waiting may cost the producer a missed opportunity to invest the revenue into something that benefits the enterprise or pay a short term debt before it is due.

Sometimes, the show just keeps going until the rise in demand and income translates into a massive inflation. A governing body can intervene and make resources scarce such as the local currency or credit by imposing deflationary measures such as rasing interest rates or decreasing the bank reserve ratio.


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