What Causes Recessions and Recoveries ? To see more of our products visit our website at Tom Allen

Non-inflationary consistent expansion (NICE), was the situation the UK enjoyed for 15 years until Governments promised ‘no more boom or bust’ But, it is very difficult to consistently manage internal or endogenous affairs within a country. And, it is even more difficult to manage external shocks

Growing an economy at a steady and predictable rate offers certainty and predictability to all economic agents. This all leads to a predictable growth in aggregate demand which helps demand management and improves the supply-side of the economy. Households have more certainty about employment prospects and inflation levels, which allows them to regulate spending and avoid hoarding savings. Firms can better anticipate returns from investment and so will invest more. Governments can better predict the stream of tax revenue and so fund capital spending on infrastructure and public and merit goods.

If an economic cycle is avoided countries tend to enjoy a higher trend rate of growth than those countries that move from boom to slump. In the UK, government sought steady growth by operating an inflation target since 1992 based on the RPIX and then CPI measures of inflation. The Bank of England then used short term interest rates to manipulate the economy. This seemed to work as between we had a ‘creeping’ rate of inflation of 1 to 5% and latterly 1 to 3%.

A recession is defined as two consecutive quarter of negative economic growth, i.e. falling real GDP. The UK over the last 30 years experienced three recessions: , and We start with a boom period of above average growth characterised by consumer and business confidence There are rising asset and property prices A worsening of the current account as more imports are bought Low unemployment Improved government finances as the tax take increases and benefits fall.

If the growth in AD exceeds that of AS then: Factors of production become scarce and their prices start to rise. Wage costs increase as does rent on corporate property and interest rates on loans. All this leads to demand-pull inflation. Firms raise prices to protect their profit margins.

The monetary authorities now try to curb AD by raising interest rates. If this is applied too late it can lead to a cut in spending which is too great. The economy is then tipped from boom to recession. People fear losing their jobs and increase their marginal propensity to save. Unemployment rises and businesses close leading to a reverse multiplier effect. This second round effect reduces AD even more and can lead to a downward spiral.

The fall in AD will have created excess capacity and a negative output gap, reducing demand-pull inflation. This will allow the monetary authorities to reduce interest rates. The government may also run an expansionary fiscal policy, raising spending and cutting taxes. Also, the cost of factors of production will fall e.g. as workers take pay cuts. Two automatic stabilisers ‘kick in’. A fall in investment flows into the country causes a depreciation of the exchange rate thus helping exports. And increased government spending on benefits will be a net injection into the circular flow.

A shift to the left in either AD or AS curves will cause a fall in real output. Aggregate demand may fall if there is a decline in: Consumption (comprising 65% of AD) Government Spending (about 23% of AD) Investment (15% of AD) Exports minus imports. (minus 3% of AD in 2009)

Aggregate supply may fall if costs of production rise caused by for example: Rising oil and other commodity prices A significant fall in the exchange rate pushing up prices of imported goods, components and commodities. Rising unit labour costs – wage rises unaccompanied by productivity increases. Finally, if AD or AS eventually increase this will move the macroeconomic equilibrium to the right and the economy will return to positive growth.

The recession of was not a typical recession. The primary cause was a shortage of credit as the US housing crash forced banks to restrict lending.. It takes on average about 3 years to recover from a financial recession compared to half that time for a conventional recession. Financial recessions tend to be longer-lasting than conventional recessions. The fall in UK GDP during this recession was so great that it may take 3-5 years to return to the real GDP level of 2007

Governments are usually keen to avoid business cycles. Political interference or shocks can cause growth to deviate from its trend rate. Governments can stimulate recovery but market forces also play a role. Financial recession tend to be deeper and longer-lasting than other recessions.

Why is price stability generally seen as a prerequisite for stable economic growth? Which demand and supply side shocks has the UK received in recent years? Why do factors of production become cheaper in a recession? Will the UK’s recovery be strong or week? Explain why.