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What Causes Recessions and
Recoveries?
Tom Allen
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Non-inflationary consistent expansion (NICE), was the situation the UK enjoyed for 15 years until 2008.
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Governments promised ‘no more boom or bust’
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But, it is very difficult to consistently manage internal or endogenous affairs within a country.
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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.
• 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.
• This all leads to a predictable growth in aggregate demand which helps demand management and
improves the supply-side of the economy.
• 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 1993-2008 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: 1980-81, 1990-91 and 2008-09.
• We start with a boom period of above average growth characterised by consumer and business
confidence
• There are rising asset and property prices
• Low unemployment
• A worsening of the current account as more imports are bought
• 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.
• Firms raise prices to protect their profit margins.
• All this leads to demand-pull inflation.
• 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.
• Unemployment rises and businesses close leading to a reverse multiplier effect.
• People fear losing their jobs and increase their marginal propensity to save.
• 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.
• 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.
• Also, the cost of factors of production will fall e.g. as workers take pay cuts.
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)
• Investment (15% of AD)
• Government Spending (about 23% 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
• Rising unit labour costs – wage rises unaccompanied by productivity increases.
• A significant fall in the exchange rate pushing up prices of imported goods, components and
commodities.
• 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 2008-09 was not a typical recession.
• The primary cause was a shortage of credit as the US housing crash forced banks to restrict lending..
• Financial recessions tend to be longer-lasting than conventional recessions.
• It takes on average about 3 years to recover from a financial recession compared to half that time for a
conventional recession.
• 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.