Recession: a Definition – 1900 word essay

Recession – Definition

The Economist (2009) defines recession as a period characterized by slow or negative growth accompanied by a rising unemployment rate, a fall in GDP (Gross Domestic Product), a fall in business profits, and a fall in household income and spending (Economist.com, 2009)

The economy is said to be in recession when the total output of that economy falls (Wessels, 2000). For recession to happen in countries such as the UK, the total GDP for the country has to contract from one quarter to another during a period of six months, causing the government to declare a recession which can only be done after the recession has occurred (BBC.co.uk, 2008)

Recession is part of the business cycle.  It is the level of the business cycle where the economy heats a point known as trough.

Figure 1; Business Cycle

The figure above shows a simple business cycle. The peak is when the economy is at its maximum output with very low unemployment rate, high demand and increase GDP. The main focus here is on the trough period, also known as recession. The main aim of carrying out policies is to move the economy from recession to expansion and get it to the peak period.

Figure 2; Index of Production in the Manufacturing Sector in the UK

Source; UK National Statistics

The diagram above shows the fall in percentage of total goods and services manufactured in the UK. In the second quarter of 2008, the total output fell by more than 11%. The UK has been experiencing a drastic fall in the GDP therefore leading to recession.

Recession is not a new or unusual phenomenon in most economies today. There have been periods in the past which governments of various countries have declared recessionary periods.

Table 1; UK recession periods

Year% Fall in GDP
19741.4
19750.6
19802.1
19811.5
19911.4

 

Source: UK National Statistics

The above table shows previous years in which the UK experienced recession. GDP decreased by 0.8% in the second quarter of 2009 compared to the 2.4% of the first quarter of that same year as shown on the graph below (Statistics.gov.uk, 2009)

Figure 3; UK GDP Growth

Source: UK National Statistics

Recession is usually accompanied by high unemployment rates. In May 2009, the unemployment rate was 7.6% – up 2.4% over a year making it the highest increase since 1971 (Statistics.gov.uk, 2009).

 

Figure 4; UK Employment Rate

Source; UK National Statistics

Recession also affects a lot of companies making them struggle just to stay in business until the recession is over. Companies make losses during this period and some just want to break even. This leads to companies struggling to reduce costs and cut staff, leading to high unemployment rates.

Banks also cut down on the amount of credit offered during this period. In the UK, billions of pounds were wiped off British pension schemes after the system lost £250 billion (Guardian.co.uk, 2008). During recession, the lack of bank financing makes it difficult for first time property buyers to step in to the property market. In the UK, Mortgage lending fell by 95% in 2008 for new buyers (Guardian.co.uk, 2008). In 2008, the courts ordered more than 28,000 houses for mortgage repossession (Guardian.co.uk, 2008).

 

Government Policies during Recession

 

Fiscal Policies are part of government policy concerning public spending and taxation as tools used to stimulate the level of demand in the economy and also to reduce the level of unemployment without any trigger in the inflation rate (Economist.com, 2009). Fiscal policies are designed to stimulate demand and encourage people to buy more, therefore busting the economy (Economist.com, 2009). According to the Keynesians, recession is caused by a fall in aggregate demand and therefore aggregate demand should be increased during recession in order for the government to reach equilibrium (O’Sullivan and Sheffrin, 2003). In order to get a good understanding on fiscal policies, it would be of advantage to take a look at the how the policies came about to tackle recession using Keynesian economics. This theory was developed by John Maynard Keynes to explain and look for possible solution for The Great Depression that took place in the United States in 1929 and that was believed to be caused by supply being far greater than demand, stock market changes, changes in the supply of money, and government policies (O’Sullivan and Sheffrin, 2003). Keynes argued that during recession, people tend to spend less and therefore the government has to encourage them to spend more in order to increase demand and output (O’Sullivan and Sheffrin, 2003).

 

Government Spending

Public spending helps in increasing aggregate demand. During recession, the government can increase demand by spending on public facilities that might encourage people to buy more. In both the USA and the UK, the government carries out the activity by getting money from taxes paid or by borrowing. Money borrowed from tax payers could be used for a number of purposes to encourage increase aggregate demand. The UK and US governments have been using tax payers’ money to bail out companies and lend to banks to encourage them to stay in business. Banks in turn have to promised the government they will give out more loans to small businesses and also to individuals in order to encourage people to purchase more. This act, though not supported by many tax payers, is a good way for the government to increase aggregate demand because banks will have enough cash to loan to people. The more people start spending, the faster the money circulation in the economy.

The government can also spend on constructing new buildings, road construction, employing more teachers in education, health care and any other activity that will allow the government to employ more people. This will mean hiring people and reducing the number of unemployed workers.

Governments spend a lot of money to bail out companies because they want to keep the unemployment rate low. Companies that are bailed out are mostly those companies that have been making losses and might be kicked out of the market if nothing is done. Most of these companies have to reduce the number of employees working in the company in order to reduce costs; this leads to very high unemployment rates. On the other hand, government spending to bail out such companies could help to reduce the number of people that might be unemployed but may promote inefficiency and incompetence, and may even make companies complacent and reckless in future if they know the government will always be there to bail them out (e.g. the recent bank bail-out).

 

Taxation

Taxes are used to raise money for the government to use for activities that will improve the economy of a country. In order to encourage people to spend more, the government can subsidise taxes on goods and services. This money can be raised from tax payers’ money. In this case where the tax payer’s tax burden has been reduced, the government will receive less than what they used to receive – especially if there are fewer taxpayers due to unemployment and less company tax due to business failure. Just like individuals, the government can borrow from other sources like central and commercial banks, or even the IMF, in order to finance such activities. In 2008, the UK government cut VAT by 2.5% from 17.5% aimed at getting customers to start spending again (BBC.co.uk, 2008), though many commentators think this has been a pointless and ineffective policy. The taxation policy allows individuals with enough income to be able to purchase more goods and services. A reduction in taxes will therefore increase aggregate demand and improve economic conditions, in theory at least.

 

 

 

 

 

Figure 5; Aggregate Demand Curve

E=Y

Expenditure

(E)                                                                                                       A1

A2

T2

T1

 

 

Y2          Y1             Real National Income (Y)

Source; BPP, 2006

An increase in tax from T1 to T2 will lead to a reduction in aggregate expenditure from A1 to A2 causing money value to fall from Y1 to Y2 (BPP, 2006)

Fiscal Policies are concerned with injections (government spending) and withdrawals (taxation) Y2 (BPP, 2006). The government should always look for a way to balance these two during periods of inflation, and should always look for a way to balance these two during periods of recession. Increasing expenditure will mean more injection of cash into the economy causing national income to increase.

 

Monetary Policies

Fiscal Policies are not the only policies a country can use during periods of recession. Monetary policies are also very important tools for governments to implement during recessionary times. This is when the government comes together with the central banks to control the supply of money in the economy and interest rates (Economist.com, 2009). Central banks, such as the Bank of England, supply money to commercial banks at a lower interest rate in order to encourage them to give out more loans so as to increase demand (BPP, 2006). The treasury in the UK and US offer bonds to commercial banks as a form of investment which are later bought by the central bank during recession, therefore increasing the supply of money in commercial banks (BPP, 2006). These monetary policies allow central banks to act as monopolies during recession by giving them power to control money supply and interest rate (BPP, 2006)

The Keynesian theory on money policy identified three reasons why people hold money: transactions motive (house hold needs), precautionary motive (unforeseen circumstances), and speculation motives (future advantages) (BPP, 2006). The demand for money will be high when interest rates are low because people expect high returns on their investments in the future (BPP, 2006). The impact of increase in money supply in the economy will greatly depend on the interest rate. The Bank of England acts as a primary source for the supply for money in the UK while the Federal Reserve plays the same role in the US.

Liquidity preference is when people tend to hold money in hand rather than invest in something that might give them some return (BPP, 2006). Monetary policy is aimed at encouraging people to spend more by investing as well. This policy helps to control the rate of inflation in the economy.

The recession today has caused many countries to implement both policies. Recession has led to bank crises – or, perhaps, the banks cause the crisis, in part at least; but certainly the banks find it difficult to recover mortgages owed by their customers and have made substantial losses. Some companies are now beginning to experience profits, which is arguably a good indicator showing that aggregate demand is beginning to rise due to some of these policies being implemented.

 

 

 

 

 

 

 

References

 

 

 

 

 

 

 

 

 

 

 

 

Appendices

 

Figure 1; Index of Production in the Manufacturing Sector

Source; UK National Statistics

 

Figure 2; GDP Growth

Source; UK National Statistics

 

Figure 3; Employment

Source; UK National Statistics

 

 

E=Y

Expenditure

(E)                                                                                                       A1

A2

T2

T1

 

 

Y2          Y1             Real National Income (Y)

Source; BPP, 2006

 

Year% Fall in GDP
19741.4
19750.6
19802.1
19811.5
19911.4