The Causes of Recessions
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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
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
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.
About the Author
Richard Pettinger studied Politics and Economics at Lady Margaret Hall, Oxford University. He now works as an economics teacher in Oxford. He enjoys
writing essays on Economic and he edits an Economics Blog focused on UK and US economies: http://www.economicshelp.org/econ.html.
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Article Published/Sorted/Amended on Scopulus 2007-04-01 23:45:44 in Economic Articles