HOW RECESSIONS WORK
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How do recessions work?
It was very early in 2008 when the stock market
crashed, the housing market plummeted and people started whispering about a
recession. This economic plunge, which occurred mainly in the United States,
affected the global economy and just days later economic stimulus packages were
being distributed by news outlets in order to try and stop a recession from
happening. But regardless of the different strategies that were designed, a
recession occurred nonetheless, and no one was too surprised by it. This
certainly wasn’t the first recession the United States had ever seen as 2001 was
also a time of recession for the States and Canada spent almost all of the 1990s
in a recession, which was also originally started by a stock market crash in the
States in 1987.
Regardless of the cause of any recession or when it
hits, it always gets people talking and asking the same sort of questions. What
exactly is a recession and how is there any hope for recovery? How does a
recession begin and who determines that there is in fact a recession going on?
All of these are important questions and ones that need to be answered in order
to grasp a better understanding of the global economy as a whole. So what
exactly is a recession and how do they work? Although recessions certainly
happen in countries other than the United States, it is the States that is known
as an independent entity financially throughout the world and because of this,
their economy is a huge factor in determining the economy of many other
countries. For these reasons, we will focus on how a recession works in the
United States. Although other countries may vary slightly, recessions work in
generally the same way from country to country.
What is a Recession?
definition of a recession may not help in understanding what one actually is, as
it is very vague and could be interpreted many different ways. A recession is
defined as a significant period of time in which the economy of a nation is
slowing down or contracting. There are many possible reasons for such a
slow-down including a drop in people’s personal incomes, leading to them
spending less and buying less; a drop in production at factories, also partly
due to the drop in personal income and consumers buying less; a growing
unemployment rate, especially at alarming rates; and an unstable stock market.
Understanding the Economy
To understand what a recession is, you must also
understand what the economy is. The economy is made up of producers and
consumers. The producers make things for the consumers and the consumers
purchase them. Without producers, consumers would have nothing to buy and
without consumers, producers don’t have anyone to develop things for. Because of
this, every single person in a country that buys things is part of the economy.
They are buying something that a producer made, and therefore giving the
producer reason to continue producing. And this is how they say money makes the
world go round!
Understanding how markets work is also important in
understanding the economy. While many may think that this mostly pertains to
stock markets, there are actually several different markets that have a role in
the economy. It may be easiest to understand the concept of markets by thinking
of your local market. You go there when you need food and in exchange for that
food, you pay them money. They are producing the food and you are consuming it.
A labor market works much the same way, although it’s much more intangible. In a
labor market, companies and businessmen look for workers to pay for a service.
In this market, the workers are the producers, as they are producing the work,
and the companies are the consumers, as they are purchasing that work. Because
of this, a large percentage of consumers are producers and vice versa. You are a
consumer when you go to the grocery store and you are a producer when you go to
Produces and consumers also make up what is known
as supply-and-demand and each has a very important role to play within this
process. Producers create the supply for the consumers to purchase and although
they ultimately determine how much the price of their product, or supply, will
be, they do this based on what they know about consumers and what they are
willing to pay. If a producer makes a product but a very small percentage of
consumers buy it, it is not worthwhile for the producer to continue making the
product. They will then need to stop making the product or reduce the prices on
it. Reducing the prices may attract more consumers and make the product more
popular, making money for the producer while sometimes a product costs so much
to make that if the producer can’t offer it at a lower price, they will stop
making it entirely. And although producers control what the prices of their
products are and what they will continue to make, they must make it reasonable
for the consumer. If a producer makes very common items but charges too much for
them, the consumer will easily be able to find the product from another producer
at a lower price.
So what does all of this have to do with a recession? It all connects to form
what is either a growing economy, which is thriving, or a contracting economy,
which is headed towards, or already in a recession. How do these two different
kinds of economies work?
Growing Economy vs. Contracting Economy
When an economy is thriving consumers are buying
more and therefore demand is rising. This generally happens when consumers are
confident in the future of the economy and therefore, feel more secure buying
more things. In order to keep up with the growing demand, producers need to
continuously make more products for the consumers to buy. In turn, producers
need to increase their own demand from the labor market and begin to consume
more labor as well as more products and services to continue making their
product. The labor market can also increase the prices of their supply because
the demand is so strong and therefore, people begin to get paid more.
Because people are getting paid more, they have
even more money to spend on products and so the cycle continues. When a producer
runs out of supply, they can begin to charge more for their supply so that the
demand will decrease and if this happens too quickly, this is when inflation can
occur. However the case needs to be fairly severe for this to happen. When the
economy is growing although not all consumers and producers will fair well, most
will and the economic outlook will be bright. It’s also in a growing economy
that consumers will begin to invest in stock, which is the purchasing of a
product (the stock) and keeping it with the expectation that its value will grow
during that time. After the stock has grown to an amount that makes the consumer
happy, they can then sell it and make money simply by buying and selling stock.
It is impossible for any economy to constantly
experience growth. Eventually both supply and demand have to go down and this is
when the economy will begin to contract. Although this is perfectly natural, and
inevitable, for an economy to experience, it’s only when the contraction
continues for a long period of time that it is considered to be in recession.
Recessions, although it’s possible to overcome them, can hit particularly hard
and for a particularly long time. This is when the economy will move from a
recession to a depression.
While economic growth certainly spells good news
for both consumers and producers, no economic growth can continue forever and no
economy will ever see an eternal upswing. Just as there are reasons for economic
growth, there are reasons for an economic downturn, or a contracting economy,
and the steps in this process are very similar to the steps in the growth
process, but they work in reverse.
Just as it does during a time of growth,
contracting economies generally begin with consumers and their lack of
confidence in the future of the economy. Because of this, consumers don’t feel
as though the national economy is very good and so they become insecure about
their own financial situation and they stop buying products. Producers in turn,
have no consumers to produce their products for and so, they no longer have the
need or the ability to consume from the labor market and so they begin to lay
off their workers. These workers will now contribute to the unemployment problem
and they will not have extra money to buy things from producers. Investors will
also become uncomfortable investing in new stock and new companies because of
the overall outlook of the economy and the stock market will in turn, fall or
Recognizing a Recession
Although there is no one person or one factor alone
that determines a country is in a recession, there are general patterns that can
be looked at to determine if a nation is headed towards, or already in, a
recession. The United States for example, sees a very typical pattern of
economic growth and economic contractions. The economy here will typically grow
for 6 – 10 years when it will then see a contraction lasting for approximately 6
months to 2 years. The time at which the recession or contraction begins is
known as the peak and when it is over it is known as the trough. Once the trough
is over, the economy will begin rebuilding and growing again, leading up to
another cyclical contraction. This period of time between 2 different peaks in 2
different cycles is what economists call the business cycle.
Once a nation begins to head towards a recession,
it cannot really be determined if the country is actually in a recession. This
is because not all downturns point to a recession. The stock market could be
drastically down one day, or the interest rate for the housing market could
skyrocket, causing for a brief downturn. It could then all come back a few days
or a week later and so, this would not qualify as a recession, it’s just a
slight bump in the road. Economists will need at least 6 months to gather
economic and financial data to determine whether a country has a recession in
its near future and even then, they use different definitions to qualify that a
recession is about to take place.
Many economists look at the consecutive financial
quarters, with each quarter making up 3 months of the year. When two consecutive
quarters show a significant fall in Gross Domestic Product (GDP), this is when
they declare that the country is in a recession. The GDP is determined by
totaling the value of the goods and services the people of the country have
produced during that time. When the GDP shows a steady decrease, it suggests
that consumers have decreased demand in several different markets. The GDP is
also an indicator that the stock market is down because people are no longer
investing and that the labor market is also seeing a decrease because producers
don’t have the money to invest in the labor market. Overall the GDP is a good
measuring stick of the shape of the economy.
The economists however that keep a close eye on the
GDP are not those who claim that a recession is in place although they are great
studiers of the economy and provide valued input. The people who claim that a
recession is happening within the United States make up the Business Cycle
Dating Committee at the National Bureau of Economic Research (NBER). This
committee is made up mostly of university professors who are also experts on the
economy and while they do take into consideration what the GDP is doing, this is
not the only, or even the most important factor, that they look at. The NBER
documents the nation’s business cycle and they pass this information on to the
Business Cycle Dating Committee. This committee will then take into
consideration factors such as consumers’ income, national unemployment rate,
production sales and the GDP before determining whether or not the country is in
a recession. Although the NBER is not part of the government itself, they are a
private, non-profit company that the government hires to study the state of the
economy. Once the committee has determined that the country is in a recession,
they will report this to the government who will quickly take action to get the
country out of the recession.
Turning it All Around
Because economies are cyclical and see typical
patterns of growth and downturns, it’s reasonable to assume that once a
recession hits, it’s likely the country will come out of it to see a time of
growth again. While it’s true that it’s entirely possible and countries do
generally come out of recessions, it’s not done by simply waiting for the
economy to turn itself around. The economy will change only once the choices and
actions of the millions of people that make up that country’s population change.
However, the government does have a lot of say in how the economy changes and
while they can certainly help to turn the economy around, it is something that
takes time. In the United States the government has two different kinds of
policies that it will use during a time of recession. These are known as fiscal
policies and monetary policies.
Fiscal policies are when the government decides to change the way the government
itself spends its money. These types of policies may include tax cuts and breaks
for companies and individuals, which will give them more money to spend in the
economy; creation of government jobs which places more demand on the labor
market and lowers unemployment rates; and automatic fiscal policies such as
unemployment insurance which is effect immediately after an individual loses
their job and provides a source of income while they are not working. It is the
President and Congress that determine fiscal policies.
Monetary policies however, deal with guiding the money already available within
the country to work in certain ways. In the United States it’s the Federal
Reserve System, otherwise known as The Fed that controls monetary policies. The
Fed is the national center of banking. It is the bank that the government itself
uses and it is the bank for every national commercial bank. The Fed oversees the
operations within the banks themselves and it is also responsible for issuing
It’s a requirement of The Fed that all national
banks keep a percentage of their money in a national reserve, where it will not
earn any interest. These national reserves are kept in one of many banks owned
by The Fed. The money held in these banks is known as reserves and the
percentage the bank is required to keep within the reserve is called the reserve
ratio. The reserve ratio is determined upon a percentage of the bank’s assets
and because this amount is always changing, the banks are constantly adjusting
their reserve amount.
How much are in the reserves is critical because
while banks are required to keep a certain amount in them, they also don’t want
to overstock their reserves, as the money could be earning interest elsewhere.
Because of this, banks often work together to ensure that their reserves are
properly filled. One bank may find a shortage in their reserve and so they will
take out a loan with another bank that is in excess in their reserve. The
lending bank will charge interest for this loan and the interest rate will be
determined according to the federal funds rate.
All of this is key to understanding how The Fed
works to control the funds within the economy already. There are 4 main steps
The Fed can take to help curb a recession. These are to reduce the reserve
ratio, which will give banks more of their money to spend and put back into the
economy; lower the federal funds rate, which will also give banks more money to
put back into the economy; lower the rate on federal loans, also known as the
discount rate; and use the money The Fed has in reserves to buy bonds, which
would give the government more money to put back into the economy.
While The Fed has a lot of power in deciding how
the economy works, it also needs to be very careful. Too much manipulating of
funds and the economy could face financial disaster.
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