Historical evidence suggests that business-cycle instability is primarily the result of changes in aggregate demand. The aggregate expenditure underlying most demand-driven business cycles is investment expenditures. However, government purchases and consumption expenditures are also notable.

The Process

• Heading Down: After an expansionary period, a contraction is triggered by a decrease in one of the four expenditures, which causes a reduction in gross domestic product. The circular flow model indicates that, less revenue received by the business sector for producing goods and services, results in a decline in factor payments to the resources used in production. This means a decrease in national income.

  The decline in national income means the household sector reduces consumption, saving, and taxes. With less consumption, the household sector purchases less gross domestic product, which generates less revenue that the business sector can use for factor payments, which means a further decline in national income.

  With less saving diverted to the financial markets, investment expenditures on capital goods decline. The business sector purchases less gross domestic product, which generates less revenue that the business sector can use for factor payments, which means a further decline in national income.

  With fewer taxes diverted to the government sector, government purchases decline, especially those by state and local governments. The government sector purchases less gross domestic product, which generates less revenue that the business sector uses for factor payments, which means a further decline in national income.

  The cumulatively reinforcing decline in production, income, and expenditures is reflected by the multiplier. Regardless of which expenditure triggers the decline, the other expenditures cumulatively reinforce the downward spiral. The end result is a demand-driven contraction.



• Going Up: This circular flow and multiplier process also works in the upward direction to generate a demand-driven expansion. Near the end of a contractionary period, an expansion is triggered by an increase in one of the four expenditures, which causes an increase in gross domestic product. With more revenue received by the business sector for producing goods and services, factor payments to the resources used in production also increase. This means an increase in national income.

  The boost in national income means the household sector expands consumption, saving, and taxes. With more consumption, the household sector purchases more gross domestic product, which generates more revenue that the business sector can use for factor payments, which means a further increase in national income. Additional saving and taxes have comparable effects on investment and government purchases, all of which cumulatively reinforce the expansion. Regardless of which expenditure triggers the increase, the other expenditures cumulatively reinforce the upward spiral, leading to a demand-driven expansion.

Unemployment Or Inflation

• During the contraction phase of a demand-driven business cycle, unemployment tends to increase while inflation tends to decrease.


• During the expansion phase of a demand-driven business cycle, unemployment tends to decrease while inflation tends to increase.