There are a number of explanations of the business cycle but changes in the level of investment seem to be the most likely. In the simplest Keynesian model an increase in investment leads to a larger increase in income and output in the short run. Higher investment not only adds directly to aggregate demand but by increasing income adds indirectly to consumption demand. A process known as the multiplier. The reasons for change in investment may be explained as follows. Firms invest when their existing capital stock is smaller than the capital stock they would like to hold. When they are holding the optimal capital stock, the marginal cost of another unit of capital just equals its marginal benefit, this is the present operating profits to which it is expected to give rise over its lifetime. This present value can be increased either by a fall in interest rates at which the stream of expected profits is discounted or by an increase in the future profit expected. In practice, it is generally believed that changes in expectations about future profits are more important than interest rate changes. If real interest rates and real wages change only slowly, the most important source of short term changes in beliefs about future profits is likely to be beliefs about future levels of sales and real output. Other things being equal, higher expected future output is likely to raise expected future profits and increase the benefits from a marginal addition to the current capital stock. This kind of explanation is known as the accelerator model of investment. In this theory it is assumed that firms estimate future profits by extrapolation of past growth of output. While constant output growth leads to a constant rate of growth of capital stock, it takes accelerating output growth to increase the desired level of investment. Though the accelerator model is acknowledged to be a simplification of a complex process its usefulness has been confirmed by empirical research.
Just how firms respond to changes in output will depend on a number of things including the extent to which firms believe that current growth in output will be maintained in the future and the cost of quickly adjusting investment plans. The more costly it is to adjust quickly, the more likely are firms to spread investment over a long time period.
The underlying idea of the multiplier-accelerator model is that it takes an accelerating output growth to keep increasing investment, but it must be noted that once output growth settles to a constant level investment also becomes constant. Finally if output falls then the level of investment must fall also.
The limits of the fluctuations around the trend path of output are referred to as ceilings and floors. If we assume that the circular flow of income is in equilibrium at less than full employment and there is an increase in investment, the effect of this will be to raise national income by more than an equivalent amount because of the effect of the multiplier. This will in turn produce a more than proportionate increase in investment because of the effect of the accelerator which will produce a more than proportionate rise in incomes and so on. This cumulative growth of income will continue until the economy's full employment ceiling is reached. The process then goes into reverse with an accelerated decline in the absolute level of net investment, followed by a multiplied reduction in income and so on. The bottom of 'floor', of the recession will come when withdrawals once more equal the reduced level of injections.
It is argued that modern economies do not fluctuate as much as they did in the past because of built in stabilizers which operate automatically and the use of discretionary measures which are available to governments. The taxation system is said to act as a stabilizer that operates automatically and the use of discretionary measures which are available to governments. The taxation system is said to act as a stabilizer in the following way: As income rises a progressive taxation system takes larger and larger proportions of that increased income; when income falls revenue drops more than proportionately. Other built-in stabilizers are unemployment benefits and welfare payments because expenditures on these rise and fall with the unemployment rate. Despite these built-in stabilizers and the actions of government in their use of discretionary measures to stabilize the economy, the cycle is still with us as recent experience has demonstrated.
In conclusion, it must be added that the causation of business cycles is a complex matter and the above is only one of a number of possible explanations.