The Causes of Recessions

By: Richard Pettinger
Submitted: 2007-01-17 16:25:25
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A recession occurs when there is a fall in economic growth for 2 consecutive quarters, however if growth is very low there will be increased spare capacity and people will feel there is a recession, this is sometimes known as a growth recession.

If there is a fall in AD then according to Keynesian analysis there will be a fall in Real GDP. The effect on Real GDP depends upon the slope of the AS curve if the economy is close to full capacity lower AD would only cause a small fall in Real GDP.

AD is composed of C+I+G+X-M, therefore a fall in any of these components could cause a recession. For example, if the MPC increased interest rates sharply this would cause the cost of borrowing to increase and make saving more attractive. This would have the effect of reducing consumer spending. AD could also fall due to deflationary fiscal policy, for example higher taxes and lower government spending would also cause a fall in AD.

If there was a fall in AD the multiplier effect may magnify the initial fall in AD, for example if there was a fall in output, workers would be made unemployed. These workers would then spend less causing a secondary fall in AD. This would make the fall in Real GDP greater.

A key feature in determining the rate of economic growth is the level of consumer and business confidence. If confidence was high then higher interest rates may not reduce demand. However if confidence is low and people fear they may be made unemployed, then they will start spending less, causing AD to fall (or increase at a slower rate). Therefore this shows that expectations are very important and it is possible for “people to talk themselves into a recession”

An important feature of the UK economy is international trade, therefore the UK would be affected by a global recession. For example a recession in the EU would cause a fall in demand for UK exports reducing our AD (EU accounts for 60% of our trade therefore is important). Also a recession in other countries would effect economic confidence if people see the US in a recession they are worried and will spend less. However a global recession may not cause a recession in the UK if domestic demand remains high.

Classical Economists believe that any fall in Real GDP will be temporary and will end when labour markets adjust to the new price level. Classical economists argue that if there is a fall in AD then in the short term there will be a fall in Real GDP. However with a lower price level wages will fall therefore the SRAS will shift to the right and the economy will return to the original level at Yf and the recession will be over.

However in the great depression of 1930s Keynes was very critical of this classical view he said that the long period of negative growth showed that markets do not automatically clear he argued that this was for various reasons.

1. Wages are sticky downwards, Firms should cut wages to reflect lower prices but in reality workers are very resistant to cuts in nominal wages
2. If wages were cut in response to unemployment workers would have less spending power therefore AD would continue to fall.
3. In a recession people have low confidence and therefore spend less. Keynes said this was the “Paradox of Thrift”

Case Studies of Recent Recessions in the UK

The recession of 1981 was caused by:

1. High strength of the pound which made exports more expensive and reduced AD.This recession particularly effected British manufacturing.
2. High interest rates, The govt was committed to reducing the inflation of 27% they inherited. They maintained a tight monetary policy which reduced inflation but at a cost of falling spending, investment and outpur.
3. Tight Fiscal Policy, To control inflation the govt were committed to reducing the levels of Government borrowing. This was influenced from Monetarist beliefs that controlling excess government borrowing was essential to the economy

The recession of 1991 was caused by

1. BOOM and BUST. In the 1980s economic growth was too fast and unsustainable therefore inflation increased, to reduce it the govt deflated the economy.
2. Joining the Exchange Rate Mechanism. The govt wanted to maintain a high value of the pound this required high interest rates of 15% which caused a big fall in AD.

Article source: Expert Articles