- Explain how economists calculate whether a country’s economy is in a recession.
What is recession?
Recession refers to the period between a peak and a depression which in more detailed terms refers to reduction of economic activity across an economy in duration of more than few months (Kluza 2014). It can also be referred to a period during which an economy experiences negative growth economically for more than two consecutive quarters. It is normally visible in production, real income, employment and other economic indicators like reduction in corporate profits or declining wholesale and retail sales; it consists of two or more quarters of a decline in real Gross Domestic product (GDP) (Schick 2013). GPD is the total output of goods and services that are produced by an economy in a given year.
Why recession is an economic problem?
Recession results to negative consequences in the economy both in the short term and long term, high unemployment rates, reducing incomes, declining economic activity results to economic problems such as reducing production outputs, increased government borrowings, falling of asset prices, declining share prices, economic social problems and currency exchange rate devaluation (Coenen, Straub and Trabandt 2012).
Recession reduces production capacity, which may go on for years due to less private investments or reduced entrepreneurial activity and business formation. Falling of production outputs leads to a lower real GDP and lower average incomes since wages tend to rise at a slower rate or fail to rise at all. In times of recession, there is deterioration of government finances since people contribute fewer taxes because of the existing high rates of unemployment. This deterioration in the finances of the government can lead to increased interest rate costs because the markets become worried about the government levels of borrowing. This makes recession worse and more difficult to get out of as was observed in many Euro Zone economies in 2009 recession aftermath. The exchange rate of currencies tends to be devalued in a recession. This is because there is less demand of the currency due to people’s expectations of lower interest rates in a recession (Coenen, Straub and Trabandt 2012).
There is a fall in the prices of assets during recession due to reduced demand for purchasing fixed assets such as housing or real estate properties. The reduction in real estate process can aggravate the decline of consumer spending and also increase the losses on the banking industry. The falling asset prices can particularly be reflected in the balance sheet recession just like in the year 2009 to 2010 recession. The other problem is reduction of share prices of the existing corporations. This reduction will be caused by the lower profits obtained from the operations of the businesses. Economic social problems also arise from recession, issues like rise of unemployment rate that aggravates inequality in incomes and relative poverty. This reducing the purchasing power of individuals and affects their standards of living due to poor economic well being. Finally, recession leads to rise in protectionism whereby countries may be encouraged to respond to it by coming up with protectionists measures such as increasing import duties. This may result to retaliation from other countries and a general decline in trade that has adverse effects (Coenen, Straub and Trabandt 2012).
How the depth and strength of recession be measured
To measure the depth and strength of recession, economists can use changes certain metrics in an economy that gauge how far an economy has to go to regain the right performance. These metrics include the rate of unemployment, the level of incomes, Gross Domestic product Gap as well as Consumer Price Index (Chadha and Warren 2013).
Economists can use the difference in the number of people unemployed in the current period of recession compared to the number before recession began to find out the strength of the recession. This implies that the wider the difference between the two the stronger the recession or the lesser the difference the weaker the recession. The other option for measuring unemployment rate available to economists is looking at a nations labor statistics to retrieve the employment population ratio data. It will then be possible to retrieve from this data the percentage of people employed from the start of the recession period and compare it to the percentage before the beginning of recession. This will show the trend in of employment such that if there is a huge percentage decrease in the population employed then recession is deeper and weaker if there is a lesser percentage decrease in population employed (Chadha and Warren 2013).
Economists use income levels to determine the depth of a recession by looking at the median wages of individuals or a GDP that is broken down per person to achieve a more accurate picture of the fiscal health of an economy. This will indicate how much an individual contributes to the economy on average. This metric is used to determine the rate of increase or decrease in the medium household incomes from the start of recession compared to the rate before the start of recession. The GPD per capital is also measured to find out its magnitude of change from the start of recession. The strength or depth of the recession will then be higher if any of these metrics has reduced rapidly after recession has began compared to the measurements before recession and if there is no significant reduction, then recession is not strong (Chadha and Warren 2013).
Rather than economists focusing on reported absolute GPD number of a quarter, they focus on the GDP gap, which is a more complex and ultimately a more informative statistic. They use data based on national budget office which calculates economic level of production in a country if it was running at full employment and full level of output which is then compared to the prevailing actual output. GDP gap or output gap is the difference obtained which indicates the deficiency in the economy. If there is a trending increase in this gap from the start of recession period then the economy is in strong recession period and if the gap increases at a lower rate, then the recession is not so strong (Chadha and Warren 2013).
The consumer price index (CPI) measure the rate at which there are price changes in consumer goods such as food, housing, clothing, appliances, medical care, automobiles among others change. Economists use CPI to determine the strength of recession by finding out the degree of prices changes of these consumer goods on the negative side. The higher the rate of price increases during the recession period, the stronger the recession and if the rate of increase is not high it means the recession is weaker (Chadha and Warren 2013).
- Discuss how the Government can use various policy tools to either avoid or limit the negative effects of a recession.
There are several economic policy tools that the government can make use of to avoid or limit recessions and reduce its negative effects. These policies help in promoting economic growth or increase the real GDP hence avoiding or limiting recession. Demand side policies are the most appropriate during recession or economic stagnation periods (Atesoglu 2013). In recession there is negative output gap in the economy and these policies help in increasing the rate of economic growth. It is however not a guarantee that these policy tools provide a solution since it may depend with the causes of recession. For instance, if high interest rates is the cause of recession, then cutting the rates may help to avoid a recession but if a reduction in asset prices which causes balance sheet recession it will not be easy to cut the interest rates because the banks may still not lend (Heise 2012). These demand side policies that can be classified as fiscal policy, monetary policy and other monetary stimulus policies besides having some shortcomings in their application, provide certain solutions that increases aggregate demand as well as spending and investment thereby reducing or avoiding recession (Atesoglu 2013).
Fiscal policy depends on the power of the government to spend and taxation. They are both used to reduce or increase the total money supply the economy. During recession, the appropriate policy by the government is to increase its spending, reduce taxation or both. Reduced taxes increase the disposable incomes of consumers, which in turn enhances consumption leading to higher demand and an increase in economic growth. It will also create jobs and improve businesses due to higher consumer confidence. A fiscal policy that is expansionary involves a higher budget deficit where the government spends more on capital investments, which ensures money is directly injected in to the economy (Atesoglu 2013). The government can also ensure that it increases spending through domestic debt rather than public debt obtained from outside economies. This reduces the possibility of a public debt crisis that can be derived from increased government spending.
The government may also come up with a plan that will deal with long term spending commitments. It should make decisions that reduce long term entitlement spending by rising the age of retirement, evaluating the spending in health care and increase taxes after the recession period is over. The short term fiscal stimulus will assist the government in reassuring markets that it is committed to a rising GDP. The long structural changes help in reassuring markets about debt (Atesoglu 2013).
There are certain issues that affect the effectiveness of this fiscal policy that can be evaluated as follows. Reduction of some taxes will not have an effect on spending as their increase. For instance, tax reduction for the rich will only have a small effect since they have a high marginal propensity to safe. The tax cuts may also depend on the prevailing confidence levels such that if individuals are pessimistic about the future, they may safe instead of spending (Heise 2012). The national debt is also a determinant whereby the scope of expansionary fiscal policy is reduces since if the government borrows more there will be an upward pressure on interest rates, which in turn increases future payments of interest. There is the possibility of crowding out due to higher spending by the government, which reduces the investments from the private sector. This because the government borrows money from the private sector by selling bonds to them which reduces the private sectors funds which they can use for investments (Heise 2012).
In case of expansionary monetary policy, the government reduces interest rates, borrowing will be much cheaper and hence consumption and investments are encouraged. Besides boosting aggregate demand, lower interest rates it also reduces the interest payments for mortgages thereby ensuring consumers disposable income is increased. The lowered interest rates encourage both firms and individuals to spend instead of saving. The government can also decide to reduce other interest rates in the economy besides the base rates, for instance, the government can sell to the Central Bank government bonds, which lower the bonds interest rates and in turn assist in boosting spending in the economy (Atesoglu 2013).
However if people are less pessimistic the lower interest rates may fail to work. They may not want to borrow even if the borrowing is cheaper. The banks may also fail to pass on the cut of the base rates to their customers, which will not encourage them to borrow. Cutting the interest rates very low can also affect the future economic activity, for instance following the United States terrorist attack in 9/11; the U.S government cut the interest rates due to the economic uncertainty at the time. The low interest rates encouraged people to get ambitious loans and mortgages and this was the factor that contributed to decline in demand for housing in the U.S. Cutting the interest rates at the wrong time can therefore contribute to worse economic conditions, it is only appropriate when the depth of the economic crisis does not pose any danger to reduction of demand in housing (Kluza 2014).
Preventing repossession of homes
High interest payments by homeowners in times of recession could result to a risk of defaulting by majority of them, which leads to home repossessions. These would have serious economic consequences such as a decline in consumer spending since homeowners spend less due to condition of meeting high mortgage payments. This will affect economic growth negatively (Horwitz 2012). Mortgage companies will also experience losses even if they repossess the houses due to the defaults on mortgages. Banks affected by these financial losses will also tighten their credit term, which affects the average consumers negatively. The government can try to freeze mortgage rates so as to prevent repossessing of homes. This will ensure that banks do not experience losses, which will in turn affect consumer spending (Horwitz 2012).
Devaluation of currency exchange rate
Aggregate demand can be boosted by a devaluation of the exchange rate. This is because exports will become cheaper while imports become expensive thereby increasing the demand for exports and reducing demand for imports. This then leads to an increase in domestic demand, which causes a higher economic growth (Schick 2013). However, if there in recession in the global economy devaluation may fail to boost the demand of exports and other countries may begin competitive devaluation. This is whereby a number of countries try to achieve competitive advantage by devaluing their currency against others. Devaluation may also lead to economic pain in the short term. The increase of import prices pushes inflation upwards and deteriorates the standards of living. It can also be taken as a sigh of a nation’s economic or political weakness. Although devaluation may be needed in Euro Zone countries, it will not be easy to devalue the currency and fail to affect the exchange rate due to the likelihood of capital flight (Schick 2013).
The government can to pursue unconventional monetary policies if the interest rates are already zero. In this case, money is created electronically by the Central Bank, which involves issuing Central Bank Reserves. It then undertakes to purchase various assets such as government and commercial bonds from banks. The bank reserves increases and it should then assist in encouraging more lending from the bank. It also reduces bonds interest rates since their prices have risen which should assist in encouraging spending and investment (Heise 2012).
Higher inflation Target
The government should focus more on making decisions that target growth rather than inflation. The presence of higher inflation rates gives more options for the Central bank. For instance, a reduction of inflation rate below the set targets reduces interest rates which are ineffective in boosting demand. A higher inflation rate than the targeted rate ensures higher nominal rates, which allows central banks to have more options and reduces reliance on huge budget deficits. This means that although the government should ensure a low inflation rate to promote the stability of the economy and growth in the long term, what that low inflation rate is should also be carefully examined and a degree of flexibility allowed to it (Atesoglu 2013).
Lending for Banks
During recession, the government can provide lines of credit to lending institutions like banks. These cash injection provide funds to consumers to take loans and encourage consequent consumer spending and investing. It can also lend money to falling institutions affected by recession so that they can be able to carry on their operations and contribute to economic growth. The government can also lend money to some central banks in foreign countries, which is then provided to those countries local banks with liquidity problems for purposes of lending to consumers and business. These loans to foreign countries central banks assist in protecting the markets that are relied on which are is in these foreign economies (Heise 2012).
Introducing rules for economic governance
Governments can come up with stronger rules on economic governance to ensure there is a tight check on public debt and deficits such that a nation does not end up spending beyond its means. An economy that is debt fuelled may not be sustainable and a government should ensure there are limits applied to both debt and deficits to ensure the national budget does not hurt the economy.
A government ought to step up supervision on financial institutions like banks to make sure that they have enough capital, are responsible in all their dealings and have the capability to lend funds to households and businesses. This ensures that people’s deposits are also well protected and the government does not have to use taxpayer’s money to redeem falling institutions. This eliminates the possibility of a declining economy and recession.
Implementing structural reforms that create employment
This can be possible by targeted investments utilizing the available government funds to come up with research and development initiatives, spread innovation and newest technologies that improves transportation, and brings high speed internets. This enables improvement of job potential among citizens’ thereby boosting productivity and competitiveness, which promotes economic growth.
Centralized derivative markets
A centralized system will allow the government to easily access information on the risk of exposures experienced by different individual institutions. This would help to reduce uncertainties that may happen in case some of the institutions collapse and ensure investors understand better the derivative markets evolution. This make sure that investor’s confidence remains such that they can increase their investments and promote the growth of the economy.
In conclusion, to limit recession a government should limit an antecedent boom and after the start of recession the government can use various policy tools to mitigate it effects and bring it to an end as soon as possible. The main objective should be to encourage the restoration of economic confidence climate in which business can thrive and carry out profitable activities. The government should not only concentrate on building short term economic confidence but also long term confidence (Salin 2013). For instance, the inevitable increase of the net government spending in a recession should not be seen to be financed by significant increase in future taxation or high future rates of taxation since present and future business investments will be discouraged due to the high taxes that will be paid to the government. It is possible to avoid the scenario of funding current government expenditures though higher future rates of taxation by doing away with unnecessary government expenditure in the future. To restore long term confidence in businesses as well as in individual savers and investors, the government should come up with appropriate policies that provide direction and adhere to them in their efforts to limit and avoid recession (Salin 2013). The government policy tools despite some of their shortcoming in their application provide solutions that can assist in eliminating recession.
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Salin, P 2013, ‘Choosing the best policy mix to cure Europe’s stagnation’, The Cato Journal, 2, p. 253.
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