It’s what is inside that matters

Some factors are considered internal causes of business cycles because they take place within the economic system itself. Let’s examine these internal factors.

Aggregate demand
The total demand for an economy’s goods and services is known as aggregate demand. It can pull the GDP and employment up or down to cause business cycles.

Aggregate demand rises when consumers want more goods and services. When this occurs, businesses increase production. With increased production, more workers are hired to meet the demand, and employees earn more wages to spend on even more goods and services.

If aggregate demand continues to go up, production may not be able to meet the growing demand. If this happens, inflation may occur. As a result, consumers must pay more for the same goods and services. Inflation that occurs because aggregate demand exceeds the available supply is called demand-pull inflation.

If aggregate demand decreases, production and employment also decrease. During this time, unemployment becomes common. Businesses’ product inventories are large, and production slows. If aggregate demand stays too low for a long time, there could be a recession or depression. When aggregate demand starts rising again, expansion and prosperity return.

Money supply
The total quantity of money that exists at any one time in a nation is known as the money supply. If the money supply of a nation goes up or down, the economy soon follows suit.

The federal government can manipulate the nation’s money supply in a couple of ways—through monetary policy and/or fiscal policy. The government uses monetary policy to determine the amount of money that is in circulation and the level of interest rates. Fiscal policy involves using taxation and government spending to influence the flow of money.

The federal government restricts the flow of money by raising taxes, by raising the interest rates to borrow money, or by purchasing fewer goods and services with which to run the government. On the flip side, the government increases the amount of money in circulation by spending more, lowering interest rates, and lowering taxes.

When interest rates are low, more money is borrowed to build houses, office buildings, and industrial plants. Because of greater production, more work is available, and unemployment is low. As a result, economic activities grow or expand.

When money is in short supply, unemployment is high. Business activities slow down, and a period of contraction begins.

Investment in capital goods
When producers are hopeful about the future of business, they buy new equipment, build new business facilities, and/or expand their existing facilities. This increase in capital goods investment encourages the expansion of economic activities. There comes a time, though, when producers begin to decrease their investment in capital goods—eventually causing the economy to contract.

Inventory levels
Major changes in inventory levels can create changes in business cycles. When producers are optimistic about business activity, they increase their inventory levels to prepare for the expected increase in demand. This action expands economic activities. However, at some point, producers become less hopeful about business and become concerned that consumers will not purchase all of the products that they have in stock. As a result, they decrease their buying of new goods and focus more on selling the goods that they already have on hand. This action causes the economy to contract.