Why Is Recession Bad For The Economy
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Published: Tue, 02 May 2017
A business cycle is the recurring and fluctuating levels of economic activity that an economy experiences over a long period of time. There are five stages in a business cycle. The five stages are growth (expansion), peak, recession (contraction), trough and recovery. A recession is a point in the business cycle where there is a general slowdown in the economic activity over a period of time.
A recession can be confirmed if the GDP (Gross Domestic Product) growth is negative for a period of two or more consecutive quarters. The GDP is the market value of all final goods and services produced within a country in a given period of time. The GDP (Y) consists of Consumption (C), Investment (I), Government Purchases (G) and Net Exports. The GDP can be represented with the following formula.
Y = C+I+G+NX
A fall in any of the following components could lead to a recession. The major cause of recession is the fall in the aggregate demand for goods and services. Although the decrease in the aggregate supply of goods of services causes recession, it is known as stagflation as inflation, recession and high unemployment takes place at the same time.
The aggregate demand curve in this graph is represented by the four components of the GDP. A decrease in any of the four components of the GDP will cause the aggregate demand curve to shift from AD1 to AD2 causing a recession if conditions persists for two quarters. The aggregate demand curve is downward slopping because of three main reasons which are the wealth effect, interest rate effect and the exchange rate effect. The wealth effect states that the decrease in price level makes consumers feel more wealthy thus encouraging them to spend more at lower price levels. The interest rate effect on the other hand states that interests rates are lower when price levels are low and therefore it encourages consumers to spend on investment goods. Lastly, the exchange-rate effect relates the falling of price level with the fall in interest rates. This causes the exchange rate to depreciate and it in turn stimulates the net exports of the country.
The aggregate supply curve in this graph will shift if there is a rise in labor, capital, natural resources, technology, or expected price level. The rise in the aggregate supply will cause to curve to shift from AS to AS1. This causes not only the real national income to fall causing recession but also causing unemployment and inflation rate to increase. The aggregate-supply curve slopes upwards in the short-run while it is vertical in the long run. The aggregate-supply curve in the short run slopes upwards because of three main theories which are the misperceptions theory, sticky-wage theory and the sticky-price theory. The misperceptions theory explains how the increase in overall price level temporarily can mislead the suppliers into increasing their outputs when the price level increases to gain more profit. Meanwhile, the sticky-wage theory states that the wages paid to the employees are slow to adjust to the fall in price levels. This causes firms to reduce their production level as it is less profitable to produce goods or services at lower price levels. Lastly, The sticky-price theory relates the unexpected fall in price levels with the higher-than-desired prices of goods sold by firms. Firms has to reduce the quantity of goods and services they produce to prevent a surplus in the market. In the long run, the aggregate supply curve is vertical as price levels those not affect the five variables mentioned above.
Following the recession which hit the US in 2007, many countries were pulled along as trades and stock markets fell. Malaysia, Cambodia and UK were among the many countries who suffered recession as a result of the recession in US. The main reason which contributed to the recession that hit the US was because of the collapse of the housing bubble. Before the collapsing of the housing bubble, in 1997 to 2006, the prices of houses continued to rise. This attracted people all around the world to start investing in housing properties. People started to take up loans to purchase housing properties. The prices of houses raised by 124% within that period of time. However, when the interest rates of loans increased, the prices of housing properties began to drop. It also became difficult for people to pay off their debts. This created a huge amount of uncovered debt. Thus, causing a recession as the US suffered negative growth in GDP for more than two consecutive quarters.
The above shows the rising of the GDP from 1995 to 2005 before its took a dive down in 2006.
The above diagram shows the sharp fall in housing prices from year 2006 to 2009.
Lastly, this diagram shows the fall of US GDP after year 2006 due to the fall in housing prices and the unsolved debts.
Causes of recession
There can be many causes of recession. The primary cause of recession usually involves inflation and the aggregate demand. As we all know, inflation refers to the overall increase in general price of goods and services over a period of time. Hence, the higher the rate of inflation, the percentage of goods and services that can be purchased with the same amount of money is lesser. Thus, in an inflationary environment, people will definitely tend to spend less or even reduce their overall spending in order to save much more money. However, as this is happening, the Gross domestic product (GDP) declines. Therefore, output of goods and services will decrease, and unemployment will increase. When this happens continuously for two quarters of the year, recession happens.
The second primary cause of recession is actually the actions taken to control money supply in the economy. As we are aware, the Federal Reserve controls the money supply in the economy. However, assuming that the Federal Reserve loses balance in the money supply and for example injects huge amount of money into the economy, the economy will definitely spiral out of control. In fact what will happen is that interest rates will go down, but inflation actually continued to rise. Thus this will relate back to our first cause of recession-inflation.
Other causes of recession:-
Recession also happens when stocks are over-valued. When the stock market goes up, more and more people want to buy that particular share in the market. However, they fail to realize that the price of stock may not be what the company is actually worth and that it actually depends on the overall economy of the country. . Thus, the price of the shares has to go down eventually. The manifestation of this situation is investors will lose money meaning less wealth for the consumers (investors). Other than that, this also means that the funding for new businesses will be lessened. Overall, stock market crash causes a recession.
Other than that, recession is also caused by hike in oil price. If the price of oil (crude oil or even petroleum) were to increase, other prices would increase as well. It doesn’t really matter which sector is affected, eventually, all the sectors will be affected. For example, when oil prices soar high, the cost of a box of pizza increases as well. Although we can’t see a direct linkage, price of the pizza actually went up probably due to the transportation cost (which involves oil) of the raw materials/food. In the long run, if these prices were to continue rising, it will actually lessen the consumer demand. Hence, business and operators will slowdown and lessen their output, and then recession is witnessed all over again.
In addition to that, another cause of recession is overspending and high taxation. Since high taxation has been implemented, it takes a huge amount of the society’s wealth away. Thus, their spending power has decreased tremendously and hence, recession is yet again experienced.
Too high interest rates too can cause recession. Assuming the fed implies higher or excessively high interest rate, the spending of consumers will do down but savings will increase. Hence, the GDP will do down, economy will slow down, hence, recession will happen.
If we do a proper research we are able to relate some macroeconomic model studied. Attached is a graph for further explanation:-http://welkerswikinomics.com/blog/wp-content/uploads/2008/03/extended-as_3.jpeg
Based on the graph above, we can see how the aggregate demand (overall demand) decreases as prices soar high due to inflation. Thus, the AD curve will move to the left signifying a decrease. When it moves left, the price reduces. However, even the output (Y) decreases. Thus, production level decreases as well as output level. Hence, unemployment increases. Recession will happen.
Based on the graph above, we can see the money supply is controlled by the Fed Government. When the Fed decides to increase the money supple and inject more money supply, the curve shifts right. When that happens, value of money becomes low, and price levels soar high up. What will happen is that consumers will spend less and save more since everything is expensive, however they do not realize their actions are pushing the GDP downwards and the aggregate demand is bound to shift left like the above graph and the whole cycle is repeated all over again. Thus we can conclude that recession also happens because of lack of control of the money supply by the Fed.
EXAMPLES OF COUNTRIES THAT FACED RECESSION
The first country that we can see faced recession is the United States of America. The USA experienced it from the fourth quarter of 2007 to the second quarter of 2009.During this difficult time, household spending fell more than 2 % in 2009. On the other hand, GDP shrank at a 6.8 percent pace from October to December 2008, exceeding the prior estimate of 5.4 percent. The worst quarter of the current economic slump was the final three months of 2008, in the immediate aftermath of the collapse of Lehman Brothers Holdings Inc. Indeed the total output and production of the country had lessened. Profits and capital inflow had decreased as well (refer graph below) Reasons for such situations were:-
High price of crude oil – The high price of crude oil pushed upwards by the Middle Eastern countries. Increasing energy prices bring no good at all but instead only brought to higher cost of production, lower profits and reduced consumption.
Continuing decline in the value of money- The Federal Reserve had over supplied money.
However there were steps taken by the US government to overcome this situation. Some of these steps were as follows: – President of the USA, Barrack Obama introduced a stimulus package. This stimulus package that costs 787.2 billion USD is expected to grow the US GDP between 1.8 % – 4.8 % by the fourth quarter of 2009. Besides that, that stimulus package is also expected to create 2.3 million new jobs for the previously unemployed. 71 billion USD on the other hand went for investment – from energy conservation, transportation improvement, infrastructure improvement, and scientific research. With investment of these sorts, the GDP of the country will slowly yet surely boost up, while opening up job opportunities to many people by stages.
The second country that also experienced recession is Spain. Spain had experienced recession in last year, 2009. The National Statistic Institute said that the GDP of the country actually fell as much as 3.7 % in 2009. As a result, the level of import and exports too dropped drastically. Other than that, consumer spending fell by 3 %. Therefore, unemployment increased as well. However, what were the main causes of the recession in Spain? It was mainly regarded to the collapse of Spain’s building industry. According to sources, the overhung of properties unsold on the market or in fact still being built has reached 1,623,000. Thus, we can see how Spain owes pretty much a lot of money to these building that are unsold. Hence, due to this issue, sectors such as the construction sectors will even shrink -not forgetting other sectors too in a regular recession hit country. However, how did Spain get though this? The national Bank of Spain made efforts to urge all banks by putting aside extra reserves. The president also introduced their own version of a stimulus package which included Tax cuts for small businesses, aid to encourage car purchases and a plan to reduce a huge stock of unsold new homes and buildings.
Based on the graph above, we can see that the GDP of Spain went down tremendously in right after 2009. Among other countries that were affected by recession were Russia, Germany and Japan.
Impact of recession
1) Why recession is bad?
A recession happens when businesses stop the expanding, employment rate falls successively and unemployment rate rises, GDP (Gross Domestic Product) growth slows, and housing price decrease. These sources affect to an economy: Individual, Social, Economic, and political aspect.
2) Explain the effects of recession to an economy
Enormous credit card debt – Individual aspect
Mostly, recession and inflation is accompanied together – which also means that even as your income is under pressure, the expenses may still rise slightly. If the payments are made regularly by using credits cards, then there is high chance of losing track of your income as compared to how high your expenses have escalated; and finally one day, you will find yourself unable to pay off your credit card debts. If this happens, it could be very difficult for you with a lowered credit rating to get approval for new loans, leaving you no choice but to resort to loans where the interest rates could be higher compared to others – which could make the scenario even worse.
Fewer customer and lower income – Individual
As economies are a choke holding by the recession, you might find the decreasing number of customers walking through the doors of your business. To control the rising expenses, your existing customer may also seem to spend their money less or not at all. Income loss and down slope in your profit could be detrimental to your small business which could ruin everything unless you create new ways to improve your sales as well as your profit.
Putting your mortgages at risk – Individual
It is very dangerous if your small business has a retail location that has a mortgage loan on to it. The reason is that lenders have been consistently increasing their interest rates by using bid to replenish their losses due to other borrowers who has not paid their monthly installments. If your current mortgage period is reaching the deadlines, there is a low possibility you finding a new lender willing to give you a new mortgage at low interest rated. This could put you in an edge where you have no choice but to decide on which loans to settle off first.
It is hard to maintain the company – Individual
As graph of fuel prices increase exponentially, followed by inclined food, electricity and gas prices, it is not easy to sustain a business, especially if you run your business from a physical location. As you can not eat less or fill less fuel in your car, this elevates your monthly outcome, plus a dramatic drop in your income, could close down your small business.
Saving problems – individual
The world is arbitrary, and economy is really one of it. If there is an economic crisis and your small business are run by loans you have taken out from the bank, you would definitely need your saving that was back up before to tide you, otherwise you will be in a serious financial disaster.
Unemployment – social
The effect of recession on unemployment depends on how long recession lasts and how deeply it has taken root. A recession means that three successive quarters of GDP (Gross Domestic Product) being in the negative. Thus, there is no growth in the economy during that period. The harder country has a serious recession, the more increasing the unemployment rate. Nowadays, changing the effects of a recession on unemployment happens. It takes time for customers to feel safe enough in order to begin spending money again. When this takes place, companies gradually enlarge their workforce then make more jobs. Government is also trying to decrease the unemployment rate by making more jobs and giving to workers about new skills in order to qualify for new jobs and information of jobs and decreasing the interest rate.
Influence on individual
Because economic growth falls dramatically in a recession, the stock market decreases and normally enters a bear market causes a flight to safety, where investors buy treasury bonds, which causes interest rates to fall. According to this reason, employers reduce new hiring and start lain off workers so you can lose your own job if you are in an industry that has layoffs. Unless you are laid off, then you will possibly be suggested to work longer hours to make up the new employees who are not hired. And you have already felt the impact on your value of your home, home equity. This declines your wealth. In addition to, you will continue to feel the influence on your retirement savings as stock prices decrease.
Social impact of recession
-People eat healthier food, cooking at home more and avoiding expensive fatty food.
-People want to study more. Particularly, people who feel it will be useful to extend their education and increase of libraries in lending.
-Prices for necessities tend to level out and then fall, so people buy and sell more second hand goods.
-Many people lose their houses and livelihoods
-People can indulge in gambling easily during the recession. Bookmakers recognize their main customers tend to be made up largely of those low incomes or already in financial trouble.
-Minority parties expected to do well during a recession have benefits from disillusionment with the conventional order.
Economic impact of recession
Recession speeds up the process of business evolution, forcing companies to decrease cost and adopt new practices. Recession in the wealth market opens up opportunities for first time buyers because prices fall in common and the buy-to-let sector agreements, making more possessions. Businesses and individuals are more likely to think as greater efficiency. For instance, they may change to renewable sources of energy or insulate their properties. This will produce work for other companies in this part. Recession has decreased at a record rate as consumers control in their spending in the manufacturing aspect. Building firms have been terribly hit by decaying economic situations, especially house constructors. The most suffer part is service sector such as leisure, financial service and retail which is takes 75 % of the total economy. Cost-cutting in the public sector is also highly likely.
Political effects of recession
Government encourages exports by focusing on this company section because it will bring about necessary foreign currencies. Next one is that they provide accessible credit for firm. Company should be encouraged by the government to compensate for unemployment. The more businesses mean more jobs available for the people. Government also set aside large amount for social welfare. According to this policy, positive view will be developed in the process, thus people enable to get back on their feet and new start. To cut expenditures in other areas such military, executive, other branches, and legislative can be useful to overcome a recession by government. They can stimulate to increase tourism in the domestic country not foreign traveling. More tourists mean more money injected to the economy. The main political effect to overcome recession by government is to inspire the injection of money back to the country.
3) Relate to examples of countries that faced recession
The economic recession affects to slow export growth, decrease GDP (Gross Domestic Product) and increase the unemployment rate.
Unemployment in Europe, August 2008
GDP of EU (27 countries)
Explain: Every GDP went down before year, 2007. For instance, GDP of Germany declined 19.4 % than before year 2007.
For example, Ireland seems to have recession as you can see the GDP is decreasing continuously from the end of the 2007 and still in negative growth. Next Greece is another country facing recession not a U- shaped recession like the others. Only Germany, Italy, France, and the UK are maintaining the positive GDP growth until now. The clearest winner is Germany with an impressive 3.7 % Growth rate although negative percentage occurred at around 2009.
Most of countries comparatively have similar changes in employment levels, with Germany is slightly better than the rest with having very little negative change, except Ireland and Spain. Ireland and Spain considerably plunge into their employment. Both of the countries are starting to get minus percentages from roughly middle of 2008, but Ireland has slightly more serious than Spain in the graph. Ireland was also the worst performer on GDP with Spain, there does not seem to have been a very close link between the size of the recession and the impact on employment.
The last charts compare between the changing of employment and that of in the GDP in each country. In Germany, Italy, the UK, and France fall in GDP has been a little greater that the decrease in employment.
– Ireland and Greece
Employment and growth have followed each other logically closely in Greece and Italy.
However, employment has fallen faster than GDP in Spain. This means that this disparity could reflect on the quality of the data which is one or the other of the Spanish series is not telling the whole truth. Its meaning is we cannot know everything. Though this shows that the statistics are worth having a close look at and that such discrepancies need to be explained to understand how countries are faring in hard time.
The good effects of recession:
Increased money supply (government spending) by the government.
During a recession, inflation normally occurs and the economy slows down. When this happens, the government implements the monetary policy to stimulate the economy and to maintain the output of goods and services. Therefore, the Fed increases the money supply, lowers the interest rate and increases the quantity of goods and services demanded for any given price level, shifting the aggregate-demand curve to the right. The government would be able to identify what is wrong with the economic policies that are currently implemented and make the necessary changes. Other examples of government spending are bailouts, housing subsidies and other stimulus packages.
The decrease in AD leads to a lower price level.
Firms become more efficient. In a recession the market implement cuts while maximizing efficiency. The management of a firm does not make hasty decisions and more careful analysis and planning is made. Employees become wary of being fired thus they work harder to prevent from becoming unemployed. This increases the efficiency of firms and ensures that its human capital is operating at full efficiency. Companies also learn to evaluate their overall costs and expenditures which enable them to improve the growth of the company in the future.
Households spend less on unnecessary items. Families tighten their spending and also purchase goods wisely. Children are taught to save more and spend less. This period also enable assessment of the effectiveness of the family budget.
Business has also learned lessons during the past recessions. Experts in business say that a recession is necessary for business. During a recession the weak and unnecessary ones will fall and only strong businesses will survive the storm. The national economy, according to them should not thrive on businesses which could not stand whenever the market is down.
Undervalued stocks and bonds. The stock market crash will lead to extremely underpriced stocks and bonds which are actually valued at much more than they are worth during a recession. But this stock market low is a timely opportunity for long-term investors to invest in some good value stock and pick them company by company. When the economy improves, the prices of the stocks will once again return to their approximate actual worth and will bring large returns to investors.
Lower interest rates. During a recession, the Fed will lower the federal funds target interest rates to encourage consumers to spend more. It is thus easier for banks to obtain liquidity. Lower interest rates also cause the real value of the U.S. dollar to decline in foreign exchange markets. This depreciation stimulates U.S. net exports and thereby will increase the quantity of goods and services demanded. This is in accordance to the Interest-Rate Effect and Exchange-Rate Effect.
Falling house prices. During a recession, real incomes decline and many people are eager to sell off their properties and houses to earn some money or to pay off their debts. As a result, supply of houses far outstrips demand. Investors interested in purchasing property at prices lower than their actual values will benefit from the drop in house prices. Not only that, the mortgage rate on houses will also be lower in order to stimulate economic activity.
Another solid benefit of recession is that the government would be able to identify what is wrong with the economic policies that are currently implemented and make the necessary changes. In so doing the fiscal management of government becomes adaptable to the highs and lows of the market and at the same time they could spot irregularities and abuses of business firms that result to the detriment of the economy.
Measures to overcome recession
1. Monetary Policy
Monetary policy can be described either in terms of the money supply or in terms of the interest rate. When the government changes the money supply or the interest rates, they shift the aggregate demand indirectly by influencing the spending decisions of firms and households.
Lower Interest Rates
Lower interest rates usually increase consumer spending and investment.
Lower interest rates:
Can reduce the cost of borrowing and obtaining loans to encouraging investment
Can reduce the cost of mortgage payments by increasing disposable income of homeowners
Can reduce the incentive of households to save.
Increase Money Supply
During periods of deflation, especially in the early stages of recession, the authorities are pressed to undertake drastic measures. They need to increase the money supply. They need to create some inflationary expectations.
The problem is that this concept is too radical for many monetary authorities to contemplate. They are experienced in trying to control inflation; thus the idea of creating inflationary expectations is deemed too extreme. During 2008-2009, Japan was reluctant to increase money supply, despite deflation and economic recession, because of this overwhelming fear of inflation.
a) The Money Market
The graph above shows that when the Fed increases MS (money supply), i (interest rate) falls.
b) The Aggregate-Demand Curve
This in turn increases the quantity of goods and services demanded at a given price level.
2. Fiscal Policy
When the government alters its own purchases of goods and services, it shifts the aggregate-demand curve directly.
In theory however, lower taxes and higher government spending should provide a boost to aggregate demand and increase economic growth to curb recession.
Massive tax cuts are introduced to place more income in the hands of households to enable them to increase spending and thus push up aggregate demand. For example, the United States passed a stimulus package which included a payroll tax exemption for companies that hired new workers. Besides that, unemployment benefits should also be increased as this provides some sort of income for the unemployed.
Public spending should be increased. Some economists are sceptical of Keynesian style public works scheme. When faced with recession and mass unemployment, these schemes work. They get unemployed people back into work and create a multiplier effect throughout the economy.
An increase in government purchases can shift the aggregate-demand curve to the right by more than half. The multiplier effect arises because increases in aggregate income stimulate additional spending by consumers.
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