There are various theories as to cause of the business cycle.
The traditional theory of the business cycle is that is caused by upturns and downturns in the behavior of companies in terms of mostly their investments and stocks, and in particular the fact that when demand pressure is very strong that companies are running at their high levels of capacity they are using their plant to the full and then they tend to invest overmuch and if demand weakens a little bit you have an overreaction inn investment, people stop investing completely that feeds right back into the stock cycle and pushes the economy down to a low level until companies have to invest to replace investment rather than investing to increase capacity. It’s a standard theory of the cycle.
Internal(or endogenous) theories consider it to be self-generating, regular, and indefinitely repeating. The business cycle is caused by pessimistic and optimistic expectations. If people feel good about the future they spend and run up debts. If people are worried about the possibility of losing their job in the near future they tend to save more.
Another theory is that sooner or later during every period of economic growth – when demand is strong, and prices can easily be put up, and profits are increasing – employees will begin to demand higher wages or salaries. As a result, employers will either reduce investment, or start to lay off workers and a downswingwill begin.
External(or exogenous) theories look for causes outside economic activity: scientific advances, natural disasters, demographic changes. Joseph Shumpeter believed that the business cycle is caused by major technological inventions, which lead to periods of ‘creative destruction’. He suggested that there was a 56-year Kondratieff cycle.
A simpler theory is that, where there is no independent central bank is caused by governments beginning their periods of office with a couple of years of austerity programmes followed by tax cuts and monetary expansion in two years before the next election.
The 18th and 19th classical economist Adam Smith in “Wealth of Nations” argued in favour of laissez – faire and insisted that natural forces such as individual self interest and competition determine prices and income. He believed that a perfectly competitive economy would produce a general equilibrium. This would lead to “allocative efficiency”, the point at which all the resources of an economy are being fully and efficiently employed.
1930s was the period of a great depression; the market system does not automatically lead to full employment. If people are pessimistic about the future, they will save more money and consume less, leading to a fall in production and employment. John Keynes recommended governmental intervention in the economy: to increase in governmental spending or decrease in taxation during a recession; and a decrease in governmental spending or increase in taxation in a period of inflation.
Many countries began to experience "stagflation" - a prolonged recession or stagflation at the same time as high inflation. This showed that Keynesian attempts to increase demand and reduce unemployment worked in the short term, and didn't work in the long term. As far back as in the 1950s and 1960s monetarists, most notably Melton Friedman criticized the Keynesian fiscal policy. Unlike Keynesians, monetarists insisted that money is neutral. By the neutrality of money the mean that in the long run the only effect of changing the money supply (the amount of money in circulation) are ñhanges in price and that the money supply doesn't influence demand, output or employment. So governments should guarantee that there is a constant and non-inflationary growth in the money supply. According to monetarist, recessions are not caused by long-term market failures. They're caused by short-run errors by firms and workers who don't reduce their prices and wages quickly enough when demands fall. But the government is usually not able to recognize a coming recession more quickly than the companies. Consequently, its intervention and fiscal measures come too late and take effect when the economy is already recovering.
1970s and 1980s were the era of Keynesianism, neo-classicism appeared. These people were opponents to Keynes; they argued that medium or long-term economic growth is damaged by short-term Keynesian or “stop-go” government policies to stabilize the economy.
In the 1870s, the Rational Expectations School, led by Robert Lucas and Tomas Sargent, began to argue that people make rational choices according to the information available to them. If people anticipate that the government will cut taxes or allow the money supply to grow or interest rates to fall, so as to boost employment and stimulate demand, they will plan and behave accordingly.
Monetarists such as Milton Friedman argue that free markets and competition are efficient and should be allowed to operate with a minimum of governmental intervention. The role of the government should be to ensure a fixed growth rate for the money supply. Supply-side theorists agree with Keynes, The recommend boosting supply in a stagnant economy by lowering taxes on capital and business profits.