September 21, 2023 

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The notion that business cycles are caused by changes in business sector investment expenditures triggered by the natural ebb and flow of market conditions. This investment explanation of business-cycle instability rests on the proposition that the seeds of each subsequent business-cycle phase are planted during the current phase. An expansion creates the conditions that cause a contraction and a contraction creates the conditions that cause an expansion. This explanation suggests a critical role for government intervention and stabilization policies to correct the business-cycle problems of inflation and unemployment.
Investment is one of dozens of potential causes of business-cycle instability and the onset of a business-cycle contraction. The key to this explanation is that the business sector, in the normal pursuit of profit, creates surpluses and shortages of capital goods as it reacts to interest rates, market conditions, and expectations of the future state of the economy. The result is relatively large changes in investment expenditures, which triggers the onset of expansions and contractions.

A business-cycle expansion generates higher interest rates and a surplus of capital that prompts a decrease in investment and a business-cycle contraction. A contraction then generates lower interest rates and a shortage of capital that prompts an increase in investment and a business-cycle expansion.

Interest rates and other market forces tend to induce a great deal of capital investment during some periods and very little during others. A flurry of investment boosts the volume of income and production in the circular flow and triggers the multiplier effect, leading to an expansion. The lack of investment at other times then dries up the volume of income and production in the circular flow, leading to a contraction.

An important implication of investment business cycles is that natural market forces are the primary source of business-cycle instability. This further implies that the way to correct business-cycle instability, and the associated problems of unemployment and inflation, is government intervention and the use of discretionary fiscal and monetary policies.

Working Through the Circular Flow

How is it that investment--which is only about 15 to 20 percent of GDP and usually the smallest of the three domestic expenditures--can possibly cause instability in the aggregate economy?

The answer lies with the circular flow. A decrease in investment means a reduction in the production of capital goods, which means fewer factor payments to the resources that produce capital goods. With less income, these resources buy fewer consumption goods, which reduces the revenue of other producers. As the revenue received by these other producers drops they reduce factor payments to their resources, which means these resources have less income and thus reduce their consumption. But as they consume less, production declines, factor payments fall, income goes down, and consumption is lower. And on it goes, around the circular flow, each time the circular flow shrinks.

By triggering a series of changes in production, income, and consumption through the circular flow, a relatively small change in investment can cause magnified changes in the aggregate economy, a process referred to as the multiplier. A ten billion dollar drop in investment might prompt a fifty billion dollar drop in GDP.

Combining the volatility of investment with this circular flow magnification is the mechanism underlying business-cycle expansions and contractions.

Four Propositions

Investment as a source of business-cycle instability rests with four propositions:

  1. Investment expenditures are sensitive to interest rates. Because interest rates affect the cost of borrowing and because most investment is financed by loans, higher interest rates discourage profit-minded, competitive businesses from undertaking investment and lower interest rates encourage them to invest more.

  2. Interest rates tend to rise during an expansion and fall during a contraction. The expansionary rise in interest rates eventually reaches a level that discourages investment, which triggers the onset of a contraction. But, interest rates fall during the contraction, eventually reaching a level that entices business to begin investment once again, which triggers a new expansion.

  3. Competitive forces induce businesses to create capital surpluses and shortages. Individual businesses tend to react in a similar manner to the shortage of capital goods by boosting investment. They do so without necessarily considering the investment by others. When numerous businesses react in the same manner, a surplus of capital results. This surplus then prompts the businesses to simultaneously reduce investment, which then creates a shortage of capital. The market for capital goods tends to ebb between shortage and surplus.

  4. Investment expenditures are lumpy. Investment expenditures are used to purchase capital goods that take months or even years to produce. Once businesses have committed to the production of capital goods, they do not react immediately to higher or lower interest rates. This is a prime reason for excessive investment and the creation of surpluses. Businesses tend to begin lengthy capital investment projects at the same time, then once completed reduce investment for an extended period.

The Investment Business Cycle in Action

Combining these four propositions indicate how business cycles might be caused by volatile investment expenditures. The story goes something like this:
  • First, interest rates are relatively low near the end of a contraction. In addition, the market for capital goods is likely to have a shortage because existing capital depreciated and business undertook very little investment during the contraction. Moreover, new products and technologies needing capital may have been developing by idle resources during the contraction.

  • Second, these conditions prompt a big increase in capital investment expenditures by the business sector. The production of this capital triggers the multiplier effect and stimulates the circular flow. Resources used to produce the capital receive more income, which they use to purchase consumer goods and services. Resources used to produce these consumer goods then receive more income, which they use to buy other goods and services. This generates additional rounds of extra production, income, and consumption expenditures.

  • Third, this cumulatively reinforcing increase in production, income, and consumption is seen as the onset of a business-cycle expansion. With this expansion, the extra household income leads to greater saving and taxes. The government sector receives the revenue for increasing government purchases. The business sector receives the revenue for even more investment expenditures. All is great with the economy.

  • Fourth, the seeds of a contraction are planted during the expansion. Investment opportunities begin to dry up. The deluge of investment changes shortages of capital goods into surpluses. Intense investment borrowing and a bit of extra inflation cause interest rates to rise.

  • Fifth, these conditions eventually prompt a decrease in capital investment expenditures by the business sector. The reduction of capital production triggers the multiplier effect in the downward direction and shrinks the circular flow. Resources used to produce capital receive less income, so they reduce expenditures on consumer goods and services. Resources used to produce consumer goods also receive less income, which forces them to buy fewer goods and services. This generates further shrinkage of production, income, and consumption expenditures.

  • Sixth, this cumulatively reinforcing decrease in production, income, and consumption is seen as the onset of a business-cycle contraction. With this contraction, the drop in household income leads to less saving and taxes. The government sector has less revenue and decreases government purchases. The business sector also has a drop in revenue and reduces investment expenditures even more.

  • Seventh, during the contraction interest rates decline. Existing capital is depreciated and needs replacing. Eventually interest rates drop enough, capital shortages emerge, and new technologies are developed, which prompts an increase in capital investment. The process begins again.

What It Means

This explanation implies that investment-induced instability is a natural consequence of a market-based economy. In the pursuit of profit, businesses make individual decisions that collectively trigger business-cycle expansions and contractions and the associated problems of inflation and unemployment.
  • An expanding economy, caused by greater investment, induces higher interest rates that eventually discourages investment and triggers a contraction.

  • A contracting economy, however, causes lower interest rates that eventually entices greater investment that prompts the onset of another expansion.
This investment cause is well-received by many economists, in part because it is supported by historical events. Investment is the most volatile of the four aggregate expenditures and tends to be correlated with business-cycle instability. However, the explanation also fits some political beliefs and/or vested interests. By implying that instability is caused by natural market forces, the logical conclusion is that stability is best achieved by government intervention in the economy. In particular, the use of fiscal policy--government spending and taxes--is the recommended way to counter the volatility of investment.

For those with a pro-government outlook on life, with the belief that government is the only solution to economic problems, this explanation is well received. In addition, for those with a vested interest in government spending, such as employees of a federal government agency, then this explanation is also well received.


Recommended Citation:

INVESTMENT BUSINESS CYCLES, AmosWEB Encyclonomic WEB*pedia,, AmosWEB LLC, 2000-2023. [Accessed: September 21, 2023].

Check Out These Related Terms...

     | political business cycles | demand-driven business cycles | supply-driven business cycles |

Or For A Little Background...

     | business cycles | expansion | contraction | capital | business cycle phases | potential real gross domestic product | peak | trough | long-run trend | full employment | shortage | surplus |

And For Further Study...

     | business cycle indicators | leading economic indicators | coincident economic indicators | lagging economic indicators | stabilization policies | government functions | political views | multiplier principle | interest rates, aggregate demand determinant |

Related Websites (Will Open in New Window)...

     | The Conference Board | National Bureau of Economic Research |

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