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Saturday, August 27, 2011

The Concept of Recessions In Economics

In Economics, Recessions can be found in business cycles. Business cycles are the total ups and downs of an entire nation or possibly the entire world from time to time, over a period of more than 10 years. Recession in Economics is considered to be a decline in economic activity.

An economy operating at its potential level is said to be at full employment. At full employment, some unemployment occurs. This is consistent with the shifting of workers between jobs due to changing tastes and technology.

A recession occurs when GDP falls significantly below its full employment level. The Department of Commerce defines a recession as when real GDP declines for two consecutive quarters.

Two types of recessions occur. First, output can fall if the economy is operating at below its potential (full employment) level. Second, output can fall if the economy’s potential level of output falls.

The first type of recession occurs when output falls significantly below its full-employment level in a recession. Unemployment grows as a large number of workers cannot find work. The most dramatic recession of this type was the Great Depression, where 25 percent of the workforce was unemployed and real output fell more than 30 percent. This type of recession usually occurs when consumers and investors reduce their aggregate spending.

The second type of recession occurs when the economy’s potential output falls. For example, a nation that passed a minimum wage of $2000 will likely experience massive unemployment and a recession. Its potential output has decreased. As another example, a decline in efficiency or a decline in technological progress could cause output to fall. Even if unemployment rises, the economy may still be fully employed in the sense that employers are fully hiring all workers they can.

The difference between a decline due to full-employment output falling below its full-employment level and a decline due to full-employment output falling is crucial. The first type of decline fits recessions described by Keynesian and monetary economists, each giving different reasons for the decline in spending. The second type fits recessions described by rational expectations economists, who give different reasons for the decline in full-employment output.

Why Recessions occur

Two startling facts exist about modern capitalistic economies. The first is that they have recessions. The second is that most of the time they are not in recessions. This suggests that some cause occasionally derails the economy. Yet, over time, the economy rebounds to full employment. But how can an economy recover? The explanations are given below.

Monetary Economists: This school of classical economists observes that sudden and large decreases in the money supply or decreases in the rate of monetary growth usually precede recessions. While the economy naturally tends to be fully employed, sudden unexpected declines in the money supply will decrease total spending, decreasing the economy until people and prices can adjust to having less cash.

Keynesian Economists: John Maynard Keynes emphasized the importance of total spending and the components of total spending (consumption, investment, government spending and net exports). In particular, he felt that when people reduced consumption spending to save more, financial markets in times of uncertainty would be unwilling to spend the new savings on investments. The result would be a decrease in total spending. Keynes also believed that prices are sticky – resistant to changes. The mix of less spending and fixed prices means lower output and a recession. Keynesian today put a similar emphasis on total spending and the rigidity of prices for explaining the business cycles.

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Our other articles on Economics include Labor Economics, Inflation, Demand for Money, Balance of Payments and Balance of Payment (contd)

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