In a downturn, or recession, unemployment will rise, companies may be forced out of business, and prices tend to fall. Such economic cycles must not be confused with business fluctuations. A fluctuation of supply and demand, or of prices, may occur in a specific segment of the economy (or in several segments) without severely damaging the whole economy. In a business cycle the whole economy is affected simultaneously, in both its upswing and its downturn. Some geographic areas of a country may be more affected than others, depending on the types of local industries or agriculture.

A business cycle usually takes several years to complete itself. When the economy as a whole is slowing down, a recession is under way. (A severe and extended recession is called a depression.) In the United States between 1948 and 1992, there were nine recessions. They reached their lowest points in October 1949, May 1954, April 1958, February 1961, November 1970, March 1975, the summer of 1980, the end of 1981, and mid-1991. The recession of 1981–82 was the most severe since the Great Depression, but it was followed by one of the most robust expansions in American history.

Economists, politicians, and others have been puzzled by business cycles since at least the early 19th century. One of the more unusual explanations was proposed by English economist William Stanley Jevons in the 19th century. He believed the ups and downs of an economy were caused by sunspot cycles, which affected agriculture and caused cycles of bad and good harvests. This hypothesis is not taken seriously today.

Most business-cycle theories fall into one of two categories. Some economists assert that economies have basic flaws which, for some reason, lead to cycles. Other economists insist that only some form of outside interference can cause swings from high to low unemployment. Unemployment and business failures are the most visible and characteristic signs of a recession (see Unemployment). Those who accept the flawed-economy theory usually insist that economies are far too large and complex to operate without a significant degree of government guidance and regulation. Those who hold the opposite view believe that economies are not inherently flawed and that there will be no business cycles as long as there is no outside interference from governments, banks, or other sources.

All economies undergo stress and shock from time to time. Natural disasters, such as hurricanes, tornadoes, floods, and earthquakes, can do serious economic damage, but the damage tends to be localized. If a severe freeze wipes out the Florida orange and grapefruit crops, the growers lose money; and the consumers are forced to pay more for these goods, since there are fewer of them. A more severe shock, such as the increases in oil prices during the 1970s, can have far-reaching consequences. But economies adjust to the new situation in a few years.

Shifts, changes, and temporary fluctuations do not constitute business cycles. They are adjustments that economies have always endured. The question that must be answered is, What causes a widespread buildup of prosperity followed by a sudden decline? Since money is the connecting link between all economic activities, the answer must be sought there.

Economies exist because people exchange goods and services for money. This means that economies are consumer-driven. Everyone is a consumer, though not everyone is a producer. Producers spend money for land, buildings, machinery, resources, and workers. Money circulates through the economy as producers pay owners of land, builders of buildings, makers of machinery, sellers of resources, and a labor force. Products, when they are sold, circulate money back to the producers to keep production going.

The money that producers use to start a business comes from investment. Investors believe that a product or service will have a good chance of success, so they want to put money into a business. Some people invest by buying stock, which is ownership in a company. Others invest by making loans—buying bonds issued by the company. Once a business is operating, it gets the bulk of its funds for future growth and continued operations from borrowing.

Getting investment money together is the start of a process called capital formation. Investment money is the initial capital. It is used to pay for capital goods: the land, buildings, machinery, and labor force. The source of investment money is savings. A large number of consumers do not spend all of their money in the present. They save part of it. Saving is postponed consumption. Instead of spending today to consume now, some people save in order to be able to consume later. Money set aside in savings earns interest. Both the interest and the original investment can be used for consumption in the future.

The money available for investment, especially for loans to business, comes from the savings of all economic units—individuals and organizations. It may be a very large amount, but it is a fairly stable amount. This means there is competition for it. Money, like any commodity, has a price because it is scarce. The price is called interest. If savings exceed demand, interest rates will be low. If demand exceeds savings, interest rates rise. But there is generally a balance between savings and investment in the normal course of economic activity. In other words, supply and demand tend toward equilibrium.

Businesses borrow money to expand their enterprises based on the money available for loans. They take it for granted that the money available for lending represents an overall consumer preference for future consumption. Guided by this preference, business operators adjust their plans for the future.

If an outside agency interferes with the money supply, the equilibrium between savings and investment is disturbed. This happens in the United States when the Federal Reserve System increases the money supply. Banks have more money to lend, but this money does not come from the original stock of savings. Unfortunately, the businesses that are borrowing do not know this. A loan is a loan, as far as the borrower is concerned. Business expansion, using the new larger supply of money, is no longer being guided by consumer time preferences. But businesses do not know that. Instead of realistic expansion for future needs, they are making malinvestments—a term coined by Austrian economist Ludwig von Mises. These are investments that will not pay off— somewhat like borrowing to build a factory to make a product no one wants.

The process of malinvestment can take several years, as an inflated supply of money courses through the economy and borrowing is easy. New office buildings are constructed, factories are expanded, machinery is purchased, workers are hired—all to be ready for a great surge of consumer buying power. Meanwhile, prices rise. But the explosion of consumerism never happens. Consumers never voted with their money, by means of savings, to underwrite an excessive expansion. The expansion was due to an inflated money supply. (See also Inflation.)

The awareness of this fact gradually works its way through the economy. Businesses realize they are in trouble. They have too many workers, too much machinery, too large inventories, and too much debt. It is time to wind down. So the economy, which has grown like a balloon, begins to contract. People lose their jobs, businesses fail or are sold. Inventories are unloaded at bargain prices. A great inventory adjustment, called a recession, takes place—inventories of goods, machinery, resources, and workers. This progress from money inflation to malinvestment to collapse is the business cycle.

Creating a business cycle has never been the goal of the Federal Reserve or any other government agency. Attempts by the federal government to guide and stabilize the economy began early in the 20th century, when, for the first time, unemployment became a political issue. For three quarters of the 19th century, most Americans lived in rural areas and were largely self-employed. Industrialization changed that. Cities grew as job-seekers moved into them. A downturn in the economy that put many people out of work suddenly brought unemployment to the attention of social workers and politicians.

The Federal Reserve was very active following World War I in monitoring the money supply. Its inflationary policies probably had a great deal to do with promoting the prosperity of the Twenties and the subsquent collapse (see Great Depression). Unemployment remained above 10 percent during the 1930s, in spite of federal programs. After World War II, the federal government deliberately established a full-employment policy to avoid another depression. By then it had become generally accepted by economists and politicians alike that the government could fine-tune the economy through adjustments in tax policy, government spending, and control of the money supply. The writings of British economist John Maynard Keynes were extremely influential in spreading this view (see Keynes, John Maynard).

By the 1990s persistently high unemployment had become a significant political problem, and business cycles showed no sign of disappearing. By the mid-1990s, public confidence in economic management by government was declining worldwide. This occurred as economies were undergoing dramatic changes in workforce composition, spurred by the information revolution.