What causes recessions and depressions?

Recessions and depressions are caused by insufficient overall spending on newly produced goods and services. When there is insufficient aggregate demand (AD) for new products, stores sell fewer things, causing factories to produce less output and increasing unemployment. As workers lose their jobs, their incomes are reduced, leading to further decreases in overall spending and deepening the economic downturn.

The recession that began in December 2007 was caused by collapsing housing prices, the subprime mortgage crisis, and subsequent tightening of credit markets. In 2004 and 2005, the United States experienced unusually rapid increases in housing prices, sometimes referred to as a real estate bubble. Low interest rates and insufficiently regulated lending practices fueled these unsustainable price increases. Many people increased general purchases by borrowing against their homes (with unrealistically high values). Housing prices peaked in 2006 and the subsequent declines, sometimes called the bursting of the bubble, triggered home foreclosures, the subprime mortgage crisis and reductions in loans. Thus, real estate declines led to a decrease in the aggregate demand (AD) for newly produced goods and services.

See also "Recessions & Depressions: Questions & Answers."

Important Definitions Related to the Macroeconomic Policy Goal of Low Unemployment

Unemployment refers to adults who do not have a job, but are looking for one.

· employed – people who spent most of the previous week working at a paid job.

· unemployed – people who do not have a paid job, but are looking for one. This category includes workers who are temporarily laid off and people who have found a job and are waiting for it to begin.

· not in the labor force – people who do not have a paid job and are not looking for one, such as retirees, homemakers, and full-time students.

· Current Population Survey is a telephone survey of approximately 60,000 randomly selected adults that is used to calculate several commonly reported measures of labor market conditions.

· The labor force is the total number of workers in an economy, including both the employed and the unemployed.

· The labor force participation rate is the percentage of the adult population in the labor force.

· The unemployment rate is the percentage of the labor force that is unemployed.

The natural rate of unemployment is the normal rate of unemployment around which the unemployment rate fluctuates. The natural rate of unemployment is currently estimated to be 5.5%.

· Underemployment refers to people with jobs who are not working as much as they want or need to work.

· Discouraged workers are individuals who would like to work but have given up looking for a job.

· In markets for labor, the price of labor is often referred to as the wage rate.

· The equilibrium wage rate is the price of labor at which the quantity of labor supplied equals the quantity of labor demanded.

· The market wage rate is the price of labor paid in a labor market. It may or may not be the same as the equilibrium wage rate.

· A minimum wage law is a price floor that specifies the lowest price that employers can legally pay for labor.

· A price floor is a legal minimum price at which a product can be sold.

· Labor unions are worker associations that bargain with employers over wages and working conditions.

· Collective bargaining is the process by which unions and business firms agree on the terms of employment.

· A strike is the organized withdrawal of labor from a business firm by a union.

· Efficiency wages are above-equilibrium wages paid by firms in order to increase worker productivity.

· Frictional unemployment occurs because it takes time for workers to search for the jobs that best suit their skills and preferences.

· Job search is the process by which workers find appropriate jobs given their skills and preferences.

· Unemployment insurance is a government program that temporarily provides unemployed workers with a fraction of their previous earnings.

· Structural unemployment occurs when workers have job skills that do not match the skills required by available jobs.

· Cyclical (Keynesian) unemployment is the deviation of unemployment from its natural rate.

· The natural rate of unemployment (5.5%) is the normal rate of unemployment around which the unemployment rate fluctuates.

· The business cycle is the natural fluctuations in the economy.

· Cyclical unemployment is also called Keynesian unemployment.

· John Maynard Keynes (1883-1946) was a British economist who popularized the idea that the government should play an active role in managing the economy.

· Classical economic theory suggests there is no role for government because the economy corrects itself.

· Keynes agreed that the economy might correct itself in the long run. However, he thought a natural correction might take an extremely long time. The Great Depression motivated Keynes to say “in the long run we are all dead.” Keynes’ most famous book, published in 1936, is entitled The General Theory of Employment, Interest, and Money.

· Aggregate demand (AD) refers to total spending in the economy on newly produced goods and services.

· Expansionary monetary policy refers to an increase in the money supply. This reduces interest rates and encourages more consumption (C) and investment (I) spending.

· Expansionary fiscal policy can be achieved by either (1) reducing taxes to encourage more spending by households and businesses (C + I); or (2) increasing government purchases (G).

Cyclical (Keynesian) Unemployment

Cyclical (Keynesian) unemployment is the deviation of unemployment from its natural rate. The natural rate of unemployment (5.5%) is the normal rate of unemployment around which the unemployment rate fluctuates. Cyclical (Keynesian) unemployment is caused by downturns in the economy that are part of the business cycle. The business cycle is the natural fluctuations in the economy.

The graph below illustrates how the unemployment rate has fluctuated over the last half-century.


Source: Bureau of Labor Statistics


Cyclical unemployment is also called Keynesian unemployment. John Maynard Keynes (1883-1946) was a British economist who popularized the idea that the government should play an active role in managing the economy. This is a departure from Classical economic theory, which suggests there is no role for government because the economy corrects itself. Keynes agreed that the economy might correct itself in the long run. However, he thought a natural correction might take an extremely long time. The Great Depression motivated Keynes to say “in the long run we are all dead.” Keynes’ most famous book, published in 1936, is entitled The General Theory of Employment, Interest, and Money.

The remedy for cyclical (Keynesian) unemployment is an increase in overall spending on newly produced goods and services, which economists refer to as aggregate demand. In the U.S. economy, increased demand for American products encourages U.S. businesses to produce more output. Businesses may hire additional workers to help produce the additional output needed to satisfy the increased demand. Thus, increased aggregate demand tends to reduce unemployment.

A closer look at the components of aggregate demand make it easier to develop appropriate macroeconomic strategies. Aggregate demand (AD) refers to total spending in the economy on newly produced goods and services.

AD = C + I + G + X - M or AD = C + I + G + NE

where:
C = consumption spending (mostly by households)

I = investment spending (mostly by businesses)

G = government purchases of goods & services (It does not include transfer payments.)

X = exports of domestically produced goods & services to foreign purchasers

M = imports of foreign produced goods & services by domestic purchasers

NE = X - M = net exports


An increase in aggregate demand can be achieved using expansionary monetary or fiscal policy.

Expansionary monetary policy refers to an increase in the money supply. This reduces interest rates and encourages more consumption (C) and investment (I) spending.

Expansionary fiscal policy can be achieved by either (1) reducing taxes to encourage more spending by households and businesses (C + I); or (2) increasing government purchases (G).

Structural Unemployment

Structural unemployment occurs when workers have job skills that do not match the skills required by available jobs. If a U.S. steel mill closes, for example, the steelworkers are likely to become structurally unemployed. There may not be enough jobs in the U.S. steel industry for all of the Americans who are trained to work in the production of steel. The remedy for structural unemployment is anything to improve the ability of these workers to acquire additional education and skills training, such as improved financial aid for attending college or vocational school.

Types of Unemployment and their Remedies

Types of Unemployment and their Remedies

There are three major types of unemployment: frictional, structural, and cyclical (Keynesian).