Economic downturn refers to a period of decline in economic activity, characterized by negative real GDP growth. In a business cycle, it takes place after the economy reaches its peak. During this period, the inflation rate decreases. Unemployment is higher as labor demand shrinks.
Causes of the economic downturn
The economic downturn occurs due to shocks from the supply side and from the demand side. Some factors contributing to the economic downturn include:
- Contractionary monetary policy. Central banks raised rates to control inflation during the economic boom. When they increase it too aggressively, it can actually decrease economic growth, not slowing down its pace.
- Contractionary fiscal policy. An increase in tax rates decreases the disposable income of households, leading them to reduce the consumption of goods and services.
- Global recession. It reduces the demand for domestic products and services, thereby decreasing exports.
- A sharp decline in household wealth. The bursting of the asset bubble or the collapse of the stock market could cause it, making consumers reduce household consumption.
- A sharp appreciation of the exchange rate. It makes the price of domestic goods more expensive for foreigners, thereby reducing exports. Conversely, imports become cheaper, encouraging imports. As a result, net exports fell.
- Oil price shocks. It surges production costs of various industries, prompting producers to cut output. It also pushed the inflation rate up. This condition is what we call stagflation (stagnant growth and high inflation).
Increase in interest rates
During the boom, the economy is overheating. To control inflation, the central bank raises policy rates.
An increase in interest rates makes new loans more expensive. Households reduce spending on goods and services financed through loans. On the other hand, businesses reduce investment because rising borrowing costs make investment returns unprofitable. As a result, aggregate demand is down.
Lower demand causes the company to end up with excess inventory. To rationalize operating costs, they decided to reduce production. As a result, workers no longer receive overtime payments, and the company does not use physical capital at full capacity.
If workers choose to reduce consumption, it leads to a further decline in aggregate demand. Lower aggregate demand will drag down the price level (deflation) and lower economic output.
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