"What Causes Recessions?If you watch the "talking heads" on financial news networks, you'll sometimes hear them say that an expansion is getting a little "long in the tooth," or that we are in the late stages of expansion. While they might have reasons for expecting the expansion to end, the phrasing can make it seem that expansions have a lifespan—that they end simply because they've been around for a while (like watching fruit start to go bad in your fridge and knowing you've got to throw it out soon).That's not how economic expansions work, though. In fact, economic theory suggests there is no reason for economic cycles to occur at all, as the economy's natural state is expansion—positive growth.1 The economy gets knocked off its natural growth trend only when an economic shock knocks it off track. And, as the word suggests, a shock is an unexpected event.These shocks can be positive (booms) or negative (recessions), and they come from a variety of sources. Economists suggest that shocks that cause recessions might include financial market disruptions, international disturbances, technology shocks, energy price shocks, and actions taken by monetary policymakers to restrain inflation.2 Of course, we'd like to avoid recessions; they are costly because unemployed workers (and resources) lose income and economic opportunities, and the economy loses output that cannot be regained."
"What Do Recessions Look Like?While they all start with a shock, every recession is a little different, which makes us think that Mark Twain's quote that "history doesn't repeat itself, but it often rhymes" also refers to recessions.
So, what does a "typical" recession look like? Recessions usually include the following characteristics:A. A negative shock such as a financial crisis occurs.
B. Firms reduce investment spending on machinery, equipment, new factories, and new office buildings (physical capital). In fact, typical recessions begin with reduced business investment spending, which is the most volatile component of GDP because businesses can postpone this type of spending.
C. As business investment falls, affecting employment and demand for inputs, consumers reduce spending on new houses and durable goods such as furniture, appliances, and automobiles.
D. As spending declines, firms that produce these products see declining sales and increasing inventories. They decide to cut production levels and lay off some workers.
E. Rising unemployment and falling profits lead to further declines in spending.
F. Eventually, the declines will end as consumers and businesses reduce debt and increase their ability to spend and as producers lower their prices to reduce inventory.
G. Lower interest rates and resource prices make investment and spending more attractive.
H. Firms take advantage of low interest rates and resource prices by increasing investment spending on capital goods as they anticipate the next expansion.
I. Consumers take advantage of low interest rates by borrowing to spend on new houses and durable goods.
J. The increased demand for products and services increases employment and income, and consumer spending levels rise.
K. As consumer spending increases, businesses increase production and employment.
L. Recession ends, beginning the next expansion."
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