Problem of Economic Recession - Term Paper Example

Economic Recession: In the present time, the word recession is being widely used by almost every body to describe the ongoing global economic scenario, which has been experiencing a huge down turn since 2008. All the media across the world is talking about recession every day. Whether it is a news paper, on a news channel on television, or some news bulletin on radio, everywhere people are talking about recession, the methods to recover from the recessionary situation and so on. In short, the economic phenomenon ‘recession’ has been gathering huge attention of people across the world since quite a long time. Recession is actually a macroeconomic phenomenon. The present paper will look into the issue of recession. It will first make an attempt to provide some general ideas about recession and then it will discuss the issue of current economic recession. Definition of recession: Technically speaking, the word ‘recession’ refers to decline in gross domestic product or GDP of a country over a period of two successive quarters. This kind of definition, is, however, not capable enough of providing a clear idea regarding recession. To understand recession, first one need to have a clear idea regarding what is actually meant by G.D.P or gross domestic product. Gross domestic product of a particular year can be defined as the value of all the final goods are services that are produced in that given year. In the calculation of G.D.P. only final goods and services are taken into account. Final goods and services actually refer to those goods and services that are never transformed into some other products in later periods. During the calculation of G.D.P, these final goods and services are evaluated at their market price. Now the technical definition of ‘recession’ can be illustrated as follows: in an economy, in a given year if the total market value of all the final goods and services produced in that country declines for two successive quarters, then the economic state of that country will be referred to as a state of recession. In a simple way it can be described as a period of declined economic activity. Recession is visible through fall in real growth in GDP, fall in real personal income, fall in employment, reduction in industrial production as well as wholesale retail sales. (Froyen) According to the surveys of National Bureau of Economic Research, the economy of the most dominating and powerful country U.S.A. has experienced many recessionary phases since 1945. From 1945 to 2007, most of the recessions lasted around 10 months on average. Average expansion of the recessionary phases, however, lasted around 57 months. During the period of 1945-2007, the recession of the shortest length took place in 1980 and lasted six months only, from the month of January to June. On the other hand, during this period the two longest recessions took place during 1973 and 1981 and both of those two recessions lasted sixteen months. In the case of first one, the phase of recession started in the month of November, 1973 and lasted up to the month of March of 1975, while in case of the second recession started in July, 1981 and ended in November, 1982. The current economic recession that the U.S. economy is going though, however, appears to become the longest one since 1945. ( Amadeo) Important Symptoms of economic recession: Major symptoms, which indicate that the economy has entered into a recessionary phase, are as follows: 1. The extent of job cut becomes very alarming. 2. Many business houses across all the sectors of the economy experience a huge decline in their sales and their profits start to shrink in an alarming way. 3. Prices of essential commodities jump up. 4. Financial system breaks down, particularly the banking system as borrowers becomes incapable of repaying their loans. (Wright; Sommers) Causes of Economic recession: There are a number of causes, which push an economy into recession. Some of these causes are very simple, while some are complex. The major causes of recession may be explained as follows: Among the simple causes, the most important one is inflation. As the rate of inflation rises, the purchasing power of people declines if income does not rise. Inflation can be caused by increase in costs of production, higher costs of energy, or increased national debt. When prices of goods rise, people tend to reduce their overall spending. Under inflationary situation, people have a tendency of reducing their spending on luxurious commodities and try to confine themselves only to the consumption of essential goods. As a result demand declines by a large extent and consequently G.D.P falls, which makes companies to suffer huge losses and therefore prompts them to cut production costs by cutting down jobs. Apart form this, not so well performance of financial sector, which ultimately results in reduced confidence of the people in the financial system, can also cause recession. (Ozaki 30-60; Siegel 50-70; West) There are some complex causes also. For example, at some point of time consumers may lose their interest in purchasing products. This can be happened after a period of over production that causes supply to surpass demand. Under such condition companied may increase their prices for earning profits, which in turn causes consumers to lose their confidence, and thereby they make the decision of spending less. Some also point towards some events that produce large effects on the working of economy. There may occur certain incidents which may causes severe harm to some particular industries or sectors like what is happening to the banking sectors of the recession hit countries of the present time. Under these circumstances, economy may go into recession. Sometimes over consumption in some period may also induce a recession as over spending may result in increasing amount of debt that in turn negatively affects savings and thereby disposable income. Fall in saving actually decreases future demand and therefore contributes to a fall in production and induces recession. (Ozaki, 30-60) Effects of economic Recession: Recession brings with itself a number of consequences, which adversely affect the economy. One of the main effects of recession is inflation. It has already been noted that inflation itself is a major cause of recession, but it also triggers inflation further. It implies that due to recession prices of commodities reach a very high level, which compels people to cut down their spending. Recession also contributes to lower income of people as under recession people reduce their demand, which ultimately reduces income. Recession can also be held responsible for increasing the value of mortgage rate as lenders try to cover up their losses by imposing higher mortgage rates. Stock markets also suffer badly from recession. Stock market indices use to come down at very lower levels. And finally one of the major consequences is realized in the labour market. Recession brings down average wage rate and a huge loss in employment is taken place. (Sommers; “Causes of Economic Recession”) Measures to get out of the recession: To bring back the economy on the stable path, appropriate strategies have to be undertaken. However, there exists differing opining regarding which strategies should be appropriate. Actually, strategies for bringing economy again on a stable path of growth very much vary on which economic school of thought the policy makers are following. It is generally found that the Keynesians prescribe huge involvement by the Government and spending a lot for deficit financing to augment economic growth, while some supply side economists advocate tax cut for promoting business investment. However, the policy makers, who follow the classical school of thought, suggest no intervention by government. How a tax cut or increase in government spending can increase output can be presented by applying a simple economic model known to be as Simple Keynesian Model. For the convenience of the analysis, two cases are being considered. In the first case, the effect of a cut in tax will be examined and the second case will show the effect of increase in government spending (which may occur for providing tax rebates to individuals and businesses). (Tatom, 2-8; Sommers) Let us consider an open economy with government sector. In such an economy aggregate demand can be given as follows: Ad= c(Yd) + I + G + (X-M), where, AD stands for aggregate demand, c(Yd) represents consumption as a function of disposable income Yd, I is the autonomous investment, G is the autonomous government spending and (X-M) represents net exports. Here Yd, is equal to (Y – T + TR), where Y stands for total income or total output, T represents total taxes, and TR stands for transfer payment. For the simplicity of analysis, let us consider TR to be equal to zero here. In equilibrium, total output produced should be equal to total demand. The equilibrium condition of the economy can therefore be given as follows: Y= c(Yd) + I + G + (X-M) …………………………………………………..(i) Solving equation (i) equilibrium level of output can be obtained. Let us now discuss, how equilibrium Y will be changed in the three cases under consideration. Case 1: effect of cut in income tax: In this case, the equilibrium condition can be given as follows: Y= c(Y – T)) + I + G + (X-M)………………………………………………..(ii) Let us first derive the equilibrium level of income in this case, From equation (ii) we get, Y – cY = I +G + (X – M) – c(T) => Y [1 – c] = I +G + (X – M) – c(T); => Y* = (I +G + (X – M) – c(T) / [1 – c])…………………………………(iii) It would be now interesting to see the effect of a fall in tax, T. From (iii), it can be found that lower is the value of T, higher would be the value of Y*, as with fall in T numerator get increased, other things being unchanged, and so Y* would increase. By differentiating Y* with respect to T we get, (dY*/ dT ) = - [c/ (1-c)]…………………………………(iv) Equation (iv) represents a negative relationship between output and taxes, which simply implies that with fall in taxes output of the economy will increase. The logical explanation of this can be that as tax falls, disposable income rises. As disposable income rises consumer will want spend more in the present period. As consumer attempts to spend more, demand for output increases. As output demands expands, to equilibrate the market, economy will automatically move towards the new equilibrium value of output, which is higher than the previous value. Case 2: effect of increase in government spending: In this case also, the equilibrium condition can be given as follows: Y= c(Y – T)) + I + G + (X-M)………………………………………………..(ii) Equilibrium level of output can be given by as follows: Y* = (I +G + (X – M) – c(T) / [1 – c])…………………………………(iii) It would be now interesting to see the effect of a fall in tax, T. From (iii), it can be found that higher is the value of G, higher would be the value of Y*, as with rise in T numerator get increased, other things being unchanged, and so Y* would also increase. By differentiating Y* with respect to G we get, (dY*/ dT ) = 1/ (1-c) Equation (iv) represents a negative relationship between output and taxes, which simply implies that with fall in taxes output of the economy will increase. The logical explanation of this can be that as government spending rises, demand for output will increase directly by the amount of increase in government spending. As output demands expands, to equilibrate the market, economy will automatically move towards the new equilibrium value of output, which is higher than the previous value. (Froyen) Current Economic Recession: At present, most of the economies throughout the world are going through a critical phase of recession and among all the economies. The situation has been so critical that the most power economies in the world also have not been able to escape this economic crisis. Economies of U.S., Japan, China, U.K. etc are all suffering from severe demand crunch and consequently fall in production and employment. U.S. is the Worst hit country by the current recession. The ongoing economic crisis through out the whole world owes it origin in U.S. following a huge credit crisis in the home loan market. Since early 2008, the U.S. economy has been looming under recession. Many economists are even of the opinion that this recession has started during the last quarter of 2007 itself. The effect of recession has not been confined to U.S. economy only. In late 2007 and even early 2008, most of the stock market indices across the world were touching the sky. Under such scenario, corporate houses were showing over enthusiasm and in several of countries money was flowing in huge amount. There was signal of the greed of making more and more profit all over. All these incidents, however, were also providing some signals that in near future over exuberance and greed would ultimately put a halt in the dream run of the economies. In early 2008, these signals ultimately came to life with the prediction of IMF regarding deteriorating growth of economy. (Foldvary, 24-40; Recession, 2008) U.S.A has always been a dominant economic power in the world and it accounts for approximately 21 percent of the world economy. The changing economic scenario, particularly since early 2008, had pointed towards a recession in U.S. economy. U.S. economic recession was held responsible for the global economic downturn as U.S. economy always influences economies of other countries in a major way. A number of countries, particularly the developing countries of the world are hugely dependent on U.S.A. and hence, economic slowdown in America brought about bad fate for the economies of these countries also. Since the early 2008, the demand of consumers in U.S.A. have started to reduce drastically as a result of which demand for imported items have also declined significantly which in turn have negatively affected the economies of those countries whose economies are largely dependent on the exports of the goods and services to America. (“Recession” 2008) The major factors that have caused this huge economic downturn in U.S.A. and other countries include soaring oil prices and a huge credit crisis. It is a common knowledge that the oil, specially the fuel is an indispensable thing for each and every country in this age of civilization. Without the fuel the pace of the tempo of the development of any country will be hampered drastically. Since the beginning of twentieth century the prices of oil have started to increase, but these prices have started to touch the sky and break all the records since the beginning of 2008. The prices of oil reached all time high in the year of 2008. The prices broke every record in this year reaching to a level of $147 per barrel from a level of $80 per barrel within a period of only 6-7 months. This increasing price of fuel has caused severe global inflation. Apart from this soaring fuel price, the year of 2008 also witnessed a dangerous credit crisis in a large number of countries which is now increasing held responsible for the closure of a number of investment banks across the world. This credit crisis actually originated from the U.S. home loan market. With the starting of the year of 2008, U.S. sub prime-mortgage market started to encounter several problems, which appeared to be difficult to deal with. These resulted in an application of huge correction in this market, which had great implications for making credits more costly across the world. With the implementation of this correction, a large number of banks of the America, European countries as well as of Asia had been forced to write down billions of dollars in their holdings. More shocking thing was that a number of well-established and reputed banks like Lehman Brothers had to file for bankruptcy (Sorkin). The bankruptcy of Lehman Brothers is considered to be the biggest eve case of bankruptcy in the history of U.S. Since 2008, more than 80 firms in U.S.A. only have filed for bankruptcy and a large number of firms have appealed to the government for financial support. The situation is not quite different in other nations too. Most of the companies across the world are suffering huge losses, which are directly affecting the G.D.P and employment scenario of the countries. (Hunnicutt, 2009; Foldvary, 24-40; Recession 2008) The effect of recession is being largely felt in most of the major and supposedly strong economies in the world. The economies of U.S., Japan, and a number of European countries are suffering the most. Most of the economic sectors are facing excessive domestic as well as international demand crunch. There has been huge fall in domestic demand as well as in exports. Under this recessionary situation, the level of employment has decreased to a large extent all over the world. The fall in employment has easily been translated into a fall in real income thereby causing fall in demand for consumption goods. In U.S.A around 1,57,000 job were lost in 2008. Jobs cut has become common in other countries too as most of companies have been adopting the process of cost cutting for surviving in this critical economic situation. A number of developed as well as developing countries are suffering from very low G.D.P and declining growth of economy. The whole world has also been experiencing severe credit crunch. (Foldvary, 24-40; Tatom, 2-8) Measures taken to rescue economy: Since 2008, all the recession hit countries have been adopting several measures to fight this situation. The efforts made by the U.S. government are the most significant one. U.S. government is playing a very active role in overcoming this recession. Various stimulus packages have been designed to provide a boost to the economy. In 2008, U.S. government had passed the Economic Stimulus Act whose main focus was on providing huge tax rebates to the taxpayers. Even the very recent economic stimulus package provided by the Osama’s Government has placed its major emphasis on tax cut. A huge sum of money is being spent to allow significant tax cut. Economic Stimulus Act of 2008 in U.S. created huge tax rebates by law. During 2008, most of the individual taxpayers having the income below the limit set by the government received a rebate of at least $300 (approximate) per person, while the married couples received a rebate of approximately $600. The taxpayers who were eligible for getting tax rebates additionally obtained around $300 per children under the age of 17 along with the individual tax rebates. The payment was set in such a way that it was equal to the taxpayer’s net income tax liability. But point to be noted here is that in no occasion tax rebates exceed 4600 for a single person. Another interesting thing regarding this stimulus act was that people having no tax liability also became eligible for getting the rebates. However, for the persons, whose earnings were greater than 75000, tax rebates were phased out. (Broda and Parker, Tatom, 2-8) As far as the present economic stimulus package is concerned, it can be found the in the case also prime focus has been put on tax related issues. Of the $787 billion total stimulus package, which has been designed to provide some life into the waning economy of U.S., 40 percent has been reserved to spending in tax cut. This tax cut is applicable to individuals as well as businesses. The tax cut which has been reported is bigger than what was expected, and it now being expected by the policy makers that this huge tax exemption could provide a great support to the ailing economy. The package includes tax cuts of around $500 to $1000 for individuals and couples who fall under the middle class status and around more than $100 billion for businesses and officials. Not only that, along with these measures, the package also includes a one year tax credits which amounts to $40 to $50 billion for those companies which are supposed to hire new workers. (Longley) This policy of huge spending on tax cut or tax rebates have generated differing opinions. According some people, this policy of tax cutting or providing tax rebates is not capable enough for stimulating demand in the economy. Many people have been skeptical about its effect on increasing gross output production and therefore on employment. Actually, providing stimulus to the economy through increasing government spending is not being considered to be justifiable by many. The reason for opposing this policy by some is that increasing government spending would simply raise the level of national debt, which already at the level of 65% of G.D.P. Apart from it, some economists are in favor of monetary policy. According them to a fall in interest rate is a very direct way of increasing invests and it is also more effective. References: 1. Longley, Robert. The Economic Stimulus Package - How It Could Affect You. Retrieved from on 7th March, 2009. 2. Broda, Christian. and Parker, Jonathan A. 2008. The impact of the 2008 rebate. Voxeu. Retrieved on March 23, 2009 from: http://faculty.chicagobooth.edu/christian.broda/website/research/unrestricted/Stimulus%20Payments%20and%20Spending.pdf 3. “Obama: Tax cuts will be felt by April 1”. 2009, retrieved from http://blog.al.com/businessnews/2009/02/obamatax_cuts_will_be_felt_by.html on 7th March, 2009. 4. Froyen, Richard T. Macroeconomics Theories and Policies. Singapore: Addison Wesley Longman. 2001 7. Foldvary, Fred E. The Depression of 2008. The Gutenberg Press. 2007, retrieved on march 23, 2009 from: http://www.foldvary.net/works/dep08.pdf 5. Collyns, Charles "The Crisis through the Lens of History". Finance and Development 45 (4), 2008. retrieved on March 24 2009 from: http://www.imf.org/external/pubs/ft/fandd/2008/12/collyns.htm 6. Tatom, John. The Superlative Recession and economic policies, MPRA Paper No. 13115,2009. retrieved on march 23, 2009 from: http://mpra.ub.uni-muenchen.de/13115/1/MPRA_paper_13115.pdf   7. Hunnicutt, Susan. The American housing crisis. Farmington Hills, MI : Greenhaven Press, 2009 8. Siegel, Jeremy J. Stocks for the Long Run: The Definitive Guide to Financial Market Returns and Long-Term Investment Strategies, 3rd, New York: McGraw-Hill, 2002. 9. Sommers, Albert T. Answers to Inflation and Recession: Economic Policies for a Modern. So ciety, New York: The Conference Board. Inc. 1975 10. Ozaki, Robert S. Inflation, Recession - and All That.New York: Holt, Rinehart and Winston. 1972. 12. Sorkin, Andrew R. 2008.Lehman Files for Bankruptcy; Merrill Is Sold. Available at http://www.nytimes.com/2008/09/15/business/15lehman.html?pagewanted=all. [Accessed on 24th March, 2009] 13. Mumbai Space. Recession 2008. Available at http://www.mumbaispace.com/economics/recession-2008.htm[Accessed on 24th March, 2009] 14. West, A. C. There are complex reasons in addition to simple causes as to why economic recessions occur. Available at http://ezinearticles.com/?Economic-Recession---Recession-Definition-and-Causes-of-Economic-Recession&id=1602436. [Accessed on 24th March, 2009] 15. Econguru Economics Guide. Causes of Economic recession. Available at http://www.econguru.com/causes-of-economic-recession/ [Accessed on 24th March, 2009] 16. Amadeo, Imberly. 2009,The History of Recessions in the United States. Available at http://useconomy.about.com/od/grossdomesticproduct/a/recession_histo.htm. [Accessed on 24th March, 2009] Read More