Business Economics · Business Cycles

Causes of Business Cycles: Internal and External Factors (CA Foundation)

Updated 1 October 2026 · Fact-checked

Business cycles are caused by factors that push economic activity up and down. Internal (endogenous) causes arise inside the economy, such as changes in demand, investment, credit and money supply. External (exogenous) causes come from outside, such as wars, technology shocks, weather, and political events. To solve MCQs, classify the cause as internal or external first.

Understand Causes of Business Cycles

A business cycle is the recurring rise and fall of overall economic activity, seen in output, employment, income and prices. This page answers one question: what pushes the economy into a boom or a slump?

Economists group causes into two families. Internal (endogenous) causes start inside the economic system. The economy itself creates the swings. External (exogenous) causes start outside the system. A shock hits the economy from outside and sets off the swing.

Internal causes you must know:
- Fluctuations in effective demand: when total spending rises, output and jobs rise. When it falls, firms cut output.
- Fluctuations in investment: investment is unstable because it depends on expected profits. Optimism raises it, pessimism cuts it.
- Monetary factors: expansion of bank credit and money supply fuels a boom. Credit contraction and high interest rates cause a slump. This is the idea behind the monetary theory of Hawtrey.
- Macroeconomic policies: changes in government spending, taxes or interest rates can also start or deepen a cycle.
- Psychology and expectations: waves of optimism and pessimism spread among businesses and consumers and become self-fulfilling.

External causes you must know:
- Wars: they change spending, production patterns and government finances sharply.
- Technology shocks and innovations: a major invention raises investment and growth, and later the boom fades. This is Schumpeter's innovation idea.
- Weather and natural events: poor monsoons or floods hit agriculture and then farm incomes, industry inputs and demand.
- Political and global events: changes in government, oil price shocks, and population or migration shifts.

A useful test: ask whether the economy produced the change by its own working (internal) or whether it was imposed from outside (external). Many real cycles mix both. A weather shock (external) can lower farm income, which lowers demand (internal), and the downturn spreads.

Key formulas to remember

Internal (endogenous) causes: Demand + Investment + Money/credit + Policy + Expectations; These arise inside the economic system. Remember as the economy's own working.
External (exogenous) causes: Wars + Technology + Weather + Political events + Oil/global shocks; These arise outside the economic system and act as shocks.
Classification test: Originates within the economy → endogenous; imposed from outside → exogenous; Use this to classify any option in one step.

How to solve Causes of Business Cycles questions

Use this method for any MCQ on causes of business cycles.

1Read the question stem and mark the key word: internal, external, endogenous, exogenous, monetary, innovation, weather, and so on.
2Decide what is being asked: a definition, a classification of a cause, or a match of a cause with its theory.
3Apply the origin test: does the factor arise inside the economy's own working, or from outside it?
4Match known pairs: demand, investment, credit and expectations are internal; war, weather, technology shock and politics are external.
5Eliminate options that put a cause in the wrong family or use extreme words such as only or always.
6Check the remaining option against the stem once, then mark it. Skip if you are unsure between two after this check.

Quickest way: Origin test and keyword scan

When to use it: Use it for any classification or match-the-following question under time pressure.

Scan the stem for the family: internal or external.
Recall one-line lists: internal = demand, investment, money, credit, expectations; external = war, weather, technology, politics.
Strike out options in the wrong list.
If two options remain, pick the one that fits the stem's exact wording. Leave it if still 50:50, since a wrong answer costs 0.25.

Common mistakes in Causes of Business Cycles

Calling monetary factors an external cause because the central bank is outside firms.
Students think of the bank as a separate body rather than part of the economic system.
Fix: Money supply, credit and interest rates are part of the economy's own working, so treat them as internal.
Treating technology as always internal.
Firms do research, so it feels internal.
Fix: In this classification, technology shocks and major innovations are listed as external causes. Follow that grouping in exams.
Mixing up endogenous and exogenous.
The words look and sound alike.
Fix: Remember: endo = within, exo = outside. Write it at the top of rough work.
Saying a cycle has only one cause.
Students memorise a single theory.
Fix: Choose options saying causes are many and often interact, unless the question names one theory.
Placing weather as a cause of demand changes only, ignoring that it is itself external.
Students follow the chain of effects instead of the origin.
Fix: Classify by where the first shock came from. Weather starts outside, even if it later changes demand.

Worked examples

Example 1

Which of the following is an external (exogenous) cause of a business cycle?
(a) Fall in investment due to pessimism
(b) Expansion of bank credit
(c) A war that disrupts production
(d) Fluctuation in effective demand

Show the solution

Apply the origin test to each option.
(a) Pessimism among firms arises within the economy, so it is internal.
(b) Credit expansion is a monetary factor inside the system, so it is internal.
(d) Effective demand is internal.
(c) A war comes from outside the economic system, so it is external.

Answer: (c) A war that disrupts production

Example 2

Which of the following is an internal (endogenous) cause of business cycles?
(a) Poor monsoon
(b) Change in the money supply and credit
(c) Major political upheaval
(d) Oil price shock from abroad

Show the solution

Poor monsoon is a weather event, so it is external.
Political upheaval starts outside the economic system, so it is external.
An oil price shock from abroad is external.
Money supply and credit are part of the economy's own working, so they are internal.

Answer: (b) Change in the money supply and credit

Example 3

A new invention raises investment sharply and starts a boom. Under the usual classification, this cause is:
(a) Internal, because investment rose
(b) External, because it is a technology shock
(c) Internal, because demand rose
(d) Neither internal nor external

Show the solution

Find the first source of change: the invention, a technology shock.
Technology and innovation are listed among external causes.
Investment and demand rose later as effects, not as the first cause.
Option (d) is wrong because every cause falls in one of the two families.

Answer: (b) External, because it is a technology shock

Exam tips

Memorise the two lists, internal and external, as short keyword sets. Most MCQs are direct classification.
Watch for options that swap families, such as monetary factors placed under external.
Expect match-the-following with theories such as monetary and innovation. Link Hawtrey to credit and Schumpeter to innovation.
Leave a question blank if two options still seem right after the origin test. A wrong answer costs 0.25 marks.

Practice questions from Business Cycles

Causes of Business Cycles: frequently asked questions

What is the difference between internal and external causes of business cycles?

Internal (endogenous) causes arise within the economy, such as demand, investment and credit. External (exogenous) causes come from outside, such as wars, weather and technology shocks. The origin of the first shock decides the family.

Are monetary factors internal or external?

Monetary factors such as money supply, credit and interest rates are treated as internal causes. They are part of how the economy works and can start booms or slumps.

Is technology an internal or external cause?

In the usual CA Foundation classification, technology and innovation shocks are listed as external causes. Learn them under the external list.

Can one business cycle have both internal and external causes?

Yes. An external shock like a drought can reduce income, which cuts demand and investment inside the economy. The downturn then spreads through internal channels.