Recessions

Question 1

A recession

Answer 1

A recession is defined as a period of time when the economy contracts (negative economic growth) for two consecutive quarters. A recession is characterised by:

1. Lower output
2. Higher unemployment
3. Lower inflation
4. Decline in consumer confidence
5. Fall in value of assets such as houses and shares

Question 2

Causes of recessions

Answer 2

A demand side shock could be caused by factors which cause a fall in aggregate demand (AD). For example:
• Higher interest rates. In 1991, increased interest rates made mortgages expensive, leading to a decline in consumer spending and a fall in house prices
• Credit crunch and fall in bank lending. In 2008, bank losses, led to a fall in bank lending which caused lower investment and consumer spending.
• Global recession. A world-wide recession will lead to lower exports and lower confidence.
• Stronger exchange rate. A rapid appreciation in the exchange rate will make exports less competitive.
• Fall in house prices. Falling house prices cause a negative wealth effect, leading to lower spending.
• Tightening of fiscal policy. Policies to cut government spending and increase taxes will cause lower aggregate demand.

Question 3

Supply Side Shock

Answer 3

• A rise in oil prices could cause a recession. Higher oil prices would cause the SRAS to shift to the left, causing both inflation and lower GDP.
A supply shock causes a dilemma for policy makers. Interest rates could be increased to reduce inflation or they could be cut to boost economic growth. However, you can’t do both at once. Therefore a supply side shock leads to a worse trade off – both higher inflation and higher unemployment

Question 4

Supply side shock examples

Answer 4

1. Wage levels, which affect firms’ unit labour costs.
2. Other costs of production, such as commodity prices, or which changes in oil prices are significant.
3. Indirect taxes, such as VAT.
4. Subsidies.
5. Productivity of factors, especially labour.
6. Changes in the use of technology and production methods.
7. Direct taxes, such as income tax, via an incentive or disincentive effect.
8. Labour migration.