A country is said to be in a recession when the GDP growth declines continuously for about four months. Closure of industries, increased unemployment, loss recorded by businesses and general uncertainty are some of the common characteristics of a recession. The 2008 US recession resulted from bad investment decisions in the financial sector which had spill over effects to other sectors . Political economists has asserted that the crisis started in wall street and ended in main street. High oil prices and the financial turmoil have led to inflationary pressures in the economy.
Crude oil prices have the effect of increasing the cost of production and thus said to be a supply side factor. Any significant changes in the international oil prices have severe implications across many sectors in the economy. The high oil prices in turn makes producers to raise their prices for goods, this in turn forces consumers cut the spending on luxuries and other non-essential commodities like holidays. The financial meltdown started when the financial institutions and sub prime mortgage companies lent monies to borrowers who could not afford to pay back the loan obligation.
The speculative lending results in institutions accumulating toxic loans that are loans that could not generate income to pay back the loaned funds. By June 2007, unemployment rate hit 6. 2% in America. A housing bubble results from insatiable demand for housing that is not backed by market fundamentals . This housing bubble which started in 2006 precipitated the financial crisis in America. The imminent recession saw a reduction in output due to the reduced economic activity. The financial crisis resulted in freeze on lending.
This meant that banks were not willing to lead to each other and to the potential investors. The credit crunch denies consumers the purchasing power for domestic commodities like shopping, gas and personal health care. The unavailability of credit makes industry lay off workers; reduce the amount of purchases and accumulation of unsold inventories. High inflation means that the investors who borrow monies repay at a higher interest rates. The transmission mechanism works through the aggregate demand (AD) and Aggregate supply (AS) relationship.
At high price from inflation, consumers reduce their purchase of goods. To stimulate the economy the monetary authorities have to cut the interest rate. Inflation is correlated to interest rate that is a rise in price results in a rise in interest rates charged on lending. The high interest rates charged by financial institutions help them to cushion from loss in value of the monies. (Leonhardt 1) The Federal Reserve has had to reduce the rate of interest to cushion the economy from the heating effect of a shift in the Aggregate demand curve.