Managers need to know:
How to anticipate recessions because the business might depend on it, especially if the business is sensitive to the up and downs in the overall economy. How the overall economy affects their financial decisions. The causes of recessions and downturns. The signals of impending recessions and downturns. *What signals are given off by an economy nearing recession -
| Causes of Recessions | How it works | Associated Recessions |
|---|---|---|
| monetary policy | The Fed can slow the economy by tightening monetary policy, which decreases the money supply and/or raises interest rates. Higher interests reduce economic activity by increasing financing costs. | all recessions? The most famous may be the 1980 recession following the Fed under the then chairman Paul Volcker dramatically raised interest rates to fight inflation |
| supply shocks | A sudden increase in an essential commodity can tip the economy into recession. A good example is the oil crisis of the 1970s. | the 1973-75 recession following an oil embargo |
| credit crunches | Banks play a critical role in the economy by funding business operations and production and individuals for their purchases of big-ticket items like houses or cars. When loans become unavailable (credit crunches), the economy can fall into recession. | the Great Recession of 2007-2008 following the burst of the U.S. housing market bubble |
| waves of optimism and pessimism | Listen to the everyday business managers to gauge the level of uncertainty in the economy. When they start sounding gloomy, a recession may be around the corner. | the 2001 recession following the September 11 attack |
| consumer confidence | In some economies, consumer spending plays a critical role. The United States is a good example. A sudden and wide swing in consumer confidence can influence the economy. | the 1990-1991 recession in the buildup of troops prior to the first Persian Gulf War |
| fiscal policy | Increased government spending, such as new highways and aircraft carriers, can stimulate the economy. The government can also use taxes to influence the economy. For example, a tax reduction would leave more money for consumers to spend and vice versa. | the 1970 recession following the end of Vietnam War, |
| foreign business cycles | A recession in an essential trading country can influence the domestic economy. For example, a Canadian recession can negatively affect the economy in the northern border regions of the United States that heavily rely on trade with Canada. | |
| trade wars | Restrictions on foreign trade reduce our exports to the foreign country and thus can be recessionary. The Great Depression is a good example. | the Great Depression following the Smoot-Hawley tariff |
| speculative mania | An asset price bubble and the following crash can contribute to a recession. When asset prices crash, consumers feel less wealthy and decrease spending. | Japan’s depression in the 1990s following a real estate boom, the 2001 recession following the American high-tech stock market bubble, the great tulip craze of Holland in 1636-1637 |
Q1. -Monetary policy affects the economic activity through a decline or a rise in real interest rates. When interest rates decline, financial institutions can procure funds at low interest rates. This enables them to reduce their lending rates on loans to firms and households. This may increase spending, especially by smaller borrowers who have few sources of credit other than banks. Lower real rates also make common stocks and other such investments more attractive than bonds and other debt instruments, as a result, common stock prices tend to rise. -Lower real interest rates in the US also tend to reduce the foreign exchange value of the dollar, which lowers the prices of the US-produced goods we sell abroad and raises the prices we pay for foreign-produced goods. This leads to higher aggregate spending on goods and services produced in the US. This increase in aggregate demand for the economy’s output through these different channels leads firms to raise production and employment, which increases business spending on capital goods even more. -Error in monetary policy is the most common cause of recession.
Q2. What do you need to watch to gauge changes in this? -Reserve requirements, the discount rate and open market operations. You also need to watch out for signs of inflation, or if the Fed anticipates inflation.
Q1. A positive supply shock will increase output which will then cause prices to decrease, while a negative supply shock will decrease output which will then cause prices to increase. Supply shocks are a secondary cause of recession, adding difficulty when the economy is otherwise weak.
Q2. What do you need to watch to gauge changes in this? -Supply shocks can be created by any unexpected event that constrains output or disrupts the supply chain, such as natural disasters or geopolitical events. You need to control monetary policy, fiscal policy, devaluation, and supply-side policies in order to control economic supply shocks. Supply shocks are a secondary cause of recession, so watch out for this. Also, watch out for oil prices, as supply shocks usually consist of oil-price increase.
Q1. A credit crunch can do a lot of damage to economy by suffocating economic growth through decreased capital liquidity and the reduced ability to borrow. The biggest consequence of a credit crunch is a recession. Higher borrowing costs which are caused by an increased interest rate, lower people’ ability to buy goods, and it also slows down the economy.
Q2. What do you need to watch to gauge changes in this? -Dramatic change in the environment which prevents banks or other lenders from doing business as they previously had. -Business managers should be aware of the possibility of changes in regulations that suddenly limit lenders’ ability to meet the credit needs of their usual customers.
Q1. Waves of optimism and pessimism affect the economy a lot, and there are some psychological factors that are important causes behind recessions. More optimism in the economy leads to many new projects, while a bit more pessimism leads to a large reduction in capital spending. Waves of optimism and pessimism create so-called business cycles, where sales are going good in one period and then in the next they are not so good.
Q2. What do you need to watch to gauge changes in this? -You need to watch out for what other businesses are doing and keep up with the current trends that are in the business. Even without knowledge of the probability of new revenue or cost, managers follow the crowd. -Listen to the everyday business managers, both mid-level and senior level executives. When those who had once been optimistic start sounding gloomy, it is time to get nervous. Don’t just listen to farmers and retail merchants.
Q1. Consumer confidence affects the economy because the increase in consumer spending naturally helps the economy sustain its expansion. If for some reason consumer confidence declines, consumers become less certain about their financial prospects, and they begin to spend less money. This in turn affects businesses as they begin to experience a decrease in sales. People have high confidence when they are employed and when inflation is low.
Q2. What do you need to watch to gauge changes in this? -You need to watch how your consumers’ income and confidence is at all times, and possibly also see how the overall population is doing when it comes to their financial situation. -Watch out for major non economic events that impact confidence, but also take into consideration what kind of business you are in these situations.
Q1. Fiscal policy can affect the economy if the government adjusts their level of spending and tax revenue. The government can then affect the economy by either increasing or decreasing economic activity in the short term. Fiscal policy is an important tool for managing the economy because of its ability to affect the total amount of gross domestic product produced.
Q2. What do you need to watch to gauge changes in this? -Fiscal policy is very easily seen. New aircraft carriers are built, highways are constructed, federal buildings are opened. -You also have to watch out for the “unseen” offsets. If taxes are used to finance the spending, then taxpayers have less disposable income. Their spending will be lower than it otherwise would have been. -Look carefully at changes in government spending.
Q1. International events can be contributing factors to domestic recession. First, global recessions can always hit the US or any other country. The world is becoming more synchronized, with greater cash flows, so the foreign business cycle certainly affects the US. The countries of the world are more economically connected than ever before.
Q2. What do you need to watch to gauge changes in this? -Watch out for international recessions, and keep an eye on the international market and if there are any recessions in countries that your country does business with.
Q1. Trade wars affect the economy because having to pay more for raw materials hurts the manufacturers’ profit margins. Because of this, trade wars can lead to price increases, with manufactured goods in particular becoming more expensive, which leads to a sparking increase in the local economy overall.
Q2. What do you need to watch to gauge changes in this? -Watch out for restrictions on foreign trade, because they can be recessionary, like the Great Depression as an example. -Dramatic increase in the tariff.
Q1. Speculative mania certainly affects the economy. Because speculative demand fuels the inflated prices, the investment bubble eventually pops, and massive sell-offs cause prices to decline, often quite dramatically.
Q2. What do you need to watch to gauge changes in this? -Watch how people spend their money and what they invest in, especially when prices in the popular areas, because this might be a sign that the bubble might pop.
Explan each of the following terms in your own words. The author explains the terms in the textbook. If necessary, you may also Google the term on the Web. Good resources include:
Explain the terms in your own words briefly.
Classical economics refers to the school of thought of economics that originated in the late 18th and early 19th centuries. It focused on economic growth and economic freedom, advocating ideas and belief in free competition.
Keynesians believe that, because prices are somewhat rigid, fluctuations in any component of spending-consumption, investment, or government expenditures-cause output to change. If government spending increases, and all other spending components remain constant, then output will increase.
Milton Friedman was an American economist and statistician and he was awarded the Nobel Prize for Economic Science in 1976. He was best known for explaining the role of money supply in economic and inflation fluctuations.
The Federal Reserve System, often referred to as “the Fed”, is the central bank of the United States. It was created by the Congress to provide the nation with a safer, more flexible, and more stable monetary and financial system. The Federal Reserve Banks provide key financial services to the nation’s payment system including distributing the nation’s cash and coin to banks and clearing checks.
Monetary policy is a set of actions to control a nation’s overall money supply and achieve economic growth. Monetary policy strategies include revising interest rates and changing bank reserve requirements. It is often classified as either expansionary or contractionary.
The federal funds rate is set by the Federal Open Market Committee of the Federal Reserve. It can be defined as the interest rate charged to various lending institutions such as banks on unsecured loans that are borrowed overnight.
A time lag in economy is a delay between an economic action and a consequence. An impact of time lags is that the effect of policy may be more difficult to quantify because it takes a period of time to actually occur.
The real interest rates measures the percentage increase in purchasing power the lender receives when the borrower repays the loan with interest.
A yield curve is a line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates. The slope of the yield curve gives us an indication of future interest rate changes and economic activity.
Fiscal policy is the use of government spending and taxation to influence the economy. Governments typically use fiscal policy to promote strong and sustainable growth and reduce poverty.
A recession is a significant decline in economic activity that is spread across the economy and that lasts more than a few months.
A leading indicator is a piece of economic data that corresponds with a future movement or change is some phenomenon of interest. Economic leading indicators can help predict and forecast future events and trends in business, markets, and the economy.
Describe the characteristics of the following events briefly.
The 1990-91 recession was a milder recession than the typical postwar recession, but it happened because of several external factors such as the Persian Gulf crisis, the savings and loan collapse, and continued job cutbacks as a result of lower defense spending. The US economy slowed down and dipped in 1991, but it slowly starting recovering again in 1992.
The 2001 recession came after a long period of growth. However, a drop in the manufacturing across sectors also contributed. Companies stopped investing and jobs of all kinds were lost. More than two-thirds of those who lost their jobs in 2001 considered their layoff to be permanent. total employment fell down by more than 1.3 million in 2001, and the downturn affected workers in a wide range of occupations.
The recession of 1973-75 in the US came about because of rocketing gas prices caused by OPEC’s raising oil prices as well as embargoing oil exports to the US. Other major factors included heavy government spending on the Vietnam war, and a Wall Street crash in 1973-74. Some effects of this were high budget deficits, low interest rates, and the collapse of managed currency rates were among the main causes of the stagnation that happened.
The Smoot-Hawley tariff seriously backfired as furious European countries imposed a tax on american goods making them too expensive to buy in Europe, and restricting trade which contributed to the economic crisis of the Great Depression. It was an act to provide revenue, to regulate commerce with foreign countries, to encourage the industries of the US, to protect American labor and for other purposes.
Tulip mania reached its peak during the winter of 1636-37, when contracts were changing hands five times. No deliveries were ever made to fulfill any of these contracts, because in February 1637, tulip bulb contract prices collapsed abruptly and the trade of tulips ground to a halt.