Transcript Tom Allen
What Causes Recessions and Recoveries? Tom Allen To see more of our products visit our website at www.anforme.co.uk • Non-inflationary consistent expansion (NICE), was the situation the UK enjoyed for 15 years until 2008. • 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. • 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.