Question

Discuss thoroughly and nuanced for the reasons why a recession may occur.

Answer 1

In economics, a recession is a business cycle contraction which results in a general slowdown in economic activity. Macroeconomic indicators such as GDP (gross domestic product), investment spending, capacity utilization, household income, business profits, and inflation fall, while bankruptcies and the unemployment rate rise. In the United Kingdom, it is defined as a negative economic growth for two consecutive quarters.

Recessions generally occur when there is a widespread drop in spending (an adverse demand shock). This may be triggered by various events, such as a financial crisis, an external trade shock, an adverse supply shock or the bursting of an economic bubble. Governments usually respond to recessions by adopting expansionary macroeconomic policies, such as increasing money supply, increasing government spending and decreasing taxation.

Here are some important causes of recession:

High-interest rates. When rates rise, they limit liquidity, or the amount of money available to invest. The biggest culprit was the Federal Reserve, which often raised interest rates to protect the value of the dollar. The Fed raised rates to battle stagflation, causing the 1980 recession. It did the same thing to protect the dollar/gold relationship, worsening the Great Depression.

A stock market crash. The sudden loss of confidence in investing can create a subsequent bear market, draining capital out of businesses. Here's how a stock market crash can cause a recession.
Falling housing prices and sales. As homeowners lose equity, it forces a cutback in spending as they can no longer take out second mortgages. Over time, it will cause foreclosures. This was the initial trigger that set off the Great Recession, but for different reasons. Banks that lost money on the complicated derivatives based on underlying home values.

A slowdown in manufacturing orders. Orders for durable goods started falling in October 2006, before the 2008 recession actually hit.
Massive swindles. The Savings and Loans Crisis caused the 1990 recession. More than 1,000 banks (total assets of $500 billion) failed as a result of land flips, questionable loans, and illegal activities.
Deregulation. The seeds of the S&L crisis were planted in 1982 when the Garn-St. Germain Depository Institutions Act was passed. This removed restrictions on loan-to-value ratios for these banks.
Wage-price controls. Fortunately, this only happened once, when President Nixon kept prices too high, cutting demand. Employers laid off workers because they weren't allowed to lower wages.
Slow down after a war. This caused both the 1953 recession, following the Korean War, and the 1945 recession, following World War II.
Credit crunch. This occurred when Bear Stearns announced losses thanks to the collapse of two hedge funds it owned. The funds were heavily invested in collateralized debt obligations. When Moody's downgraded its debt, it, banks who were in a similar over-invested condition panicked. They stopped lending to each other, creating a massive credit crunch.

Asset bubbles: This is when the prices of internet companies, stocks or houses become inflated beyond their sustainable value. The bubble itself sets the stage for a recession to occur when it bursts.

Deflation, which encourages people to wait until prices are lower. This aggravated the Great Depression.

The type and shape of recessions are distinctive. In the US, V-shaped, or short-and-sharp contractions followed by rapid and sustained recovery, occurred in 1954 and 1990–91; U-shaped (prolonged slump) in 1974–75, and W-shaped, or double-dip recessions in 1949 and 1980–82. Japan’s 1993–94 recession was U-shaped and its 8-out-of-9 quarters of contraction in 1997–99 can be described as L-shaped. Korea, Hong Kong and South-east Asia experienced U-shaped recessions in 1997–98, although Thailand’s eight consecutive quarters of decline should be termed L-shaped.

A recession implies a fall in real GDP. An official definition of a recession is a period of negative economic growth for two consecutive quarters. Recessions are primarily caused by a fall in aggregate demand (AD). This demand-side shock could be due to several factors, such as

A financial crisis. If banks have a shortage of liquidity, they reduce lending – this reduces investment
A rise in interest rates – increases the cost of borrowing and reduces demand
Fall in asset prices. – negative wealth effect leads to less spending
Fall in consumer/business confidence also exacerbated by negative multiplier effect.
Appreciation in exchange rate – exports less competitive
Fiscal austerity – when government cuts spending

Recessions can also be caused by

Supply-side shock, e.g. rise in oil prices cause inflation and lower spending power.

the major cause is inflation. Inflation refers to a general rise in the prices of goods and services over a period of time. The higher the rate of inflation, the smaller the percentage of goods and services that can be purchased with the same amount of money. Inflation can happen for reasons as varied as increased production costs, higher energy costs and national debt.
In an inflationary environment, people tend to cut out leisure spending, reduce overall spending and begin to save more. But as individuals and businesses curtail expenditures in an effort to trim costs, this causes GDP to decline. Unemployment rates rise because companies lay off workers to cut costs. It is these combined factors that cause the economy to fall into a recession.