What cause recession are a complex and an intricate question, which in the words of John Maynard Keynes ( Kaza, n. p) is an animal spirit that runs, include pessimism, uncertainty, and lack of confidence. Thus, proper understanding of economic recession will remain limited and for the sake of objectivity, the paper will focus on the more prominent culprits namely monetary policies and fiscal policies. These policies affect demand and destabilize it , which in turn affects consumer spending.
The first five months of 2006, witnessed measure decline in consumer spending, averaging between 0. 6 percent and 2. 4 percent in the first quarter. This sudden weakness in US consumer spending has an obvious reason. The population has been used to, to borrowing money before returning it back at the right time has started making some serious decisive considerations before doing so today. Expenditure on durables like autos and housing durables is going bust. More remarkably, this has been off set by some record credit growth well before the housing bubble has burst away.
Errors sparked by flawed policies include those that go unheeded when adequate measures are not taken following a change in demand. A decline in aggregate demand has triggered most recessions; a situation in which economy produces more than what is consumed. The impending recession in this case can be alleviated by adjusting the prices accordingly. In most cases, prices are not adjusted as quickly leading to a decline in production and output. This is where policy comes into play; policy makers can use the monetary and fiscal policies to offset recession.
The decision, however they make is in most cases variable, unpredictable, and bleak . Effective measures at this point lie in scrutinizing the “erroneous” policies and bringing the economy back in shape. These policy errors come into shape for two reasons. First, the accelerating economy sparked by flawed policies. In this bid to prevent inflation and a myriad of other economic imbalances, the errors are reversed. In the midst of this reversal, economy in most cases reciprocates by “overshooting” or entering its recession phase. Second, is the lax attitude displayed on the part of our policy makers?
In most cases, the stimulus to recession comes in to play after it has started, bringing in a lag in policy effectiveness. The errors come into play because of unavailability of data and information needed to act accordingly. Another prominent cause of economic recession is the change in supply or “supply shocks” as most economists put it. It is not just the aggregate demand that affects economy but changes in supply can also trigger off recession. Productive capabilities of economies can be severely impeded by natural disasters at times; for example hurricane, tornadoes, cyclones, floods, and earthquake.
Business activities come to a halt, factories, industrial units and major machinery may be destroyed in the process. Moreover, events taking place across the globe can also cause problems at home. The recession Finland experienced following Soviet’s collapse is an example. However, this is generally when dependence on international trade is big. United States has another story to tell. It is too large with very little reliance on international trade to be affected to the extent of a recession. For the United States, oil shocks basically have been on the front line.
Most of the recessions, the nation has undergone have been a result of soaring oil prices (Shawn, n. p). We first look into how demand affects oil prices. Energy prices affect both consumers and producers. When oil prices rise, the consumers are at the receiving end on the perverse side. They increase their spending on energy while producers are at the winning end. Since producers are also consumers, they act to adjust their demand of energy according to their incomes. Aggregate demand thus falls. This may be also a result of an increase in oil prices, which is void of decline in other prices.
The real value and purchasing power of the money in consumer’s hand decrease triggering a decline in demand as well. Rise in energy prices may even give way to uncertainty and cause buyers to defer their purchases away. However, the relative magnitude of each of these effects will remain short and temporary, if the rise in prices is of short duration. There are a myriad of effects on the supply side. First, the aggregate output witnesses a fall because increase in oil prices is offset by increases in the cost to produce output. This decline in productivity paves way for unemployment.
Secondly, since the amount of oil used in most commodities is variable, price changes will vary across most goods and services. Consumer loyalty will shift towards good and services, that have been less affected in the process. This will cause a shift of labor and capital from the contacting industries to the expanding industries. The proportion of these industries will not only vary heavily but will also be not rightly proportioned. As a result, unemployment will increase. Thus, on the supply side, an increase in oil prices leaves labor unemployed.