What it is: An economic recovery is the initial part of the expansion, where the economy gained strength returned to growth after the recession. Economic growth is showing signs of strengthening. Consumer spending is starting to increase, especially for durable goods. This, in turn, encourages businesses to intensify production.
Other terms for economic recovery are an economic upturn, an economic revival, and an initial expansion.
What’s happening: During this period, economic and business activity is improving. Typically, it is characterized by positive economic growth, improved income, and employment prospects.
At which stage: In a business cycle, the ups and downs of economic activity follow four phases, respectively peak, contraction, trough, and expansion.
Types of economic recovery
V-shaped recovery: real GDP fell sharply and soon reached the trough. But, the economic stimulus prompted a speedy recovery and soon achieved expansion.
U-shaped recovery: Economic growth fell drastically and into the trough, but slowly. Furthermore, the recovery takes some time before heading towards expansion, longer than the V-shaped one.
W-shaped recovery: The sharp decline in real GDP boost the economy immediately reached the trough. The economic stimulus stimulated economic recovery, but it was not strong enough to move the economy towards expansion. Finally, the economy fell again and headed for another trough. A second economic stimulus may prevent the economy from a deeper recession and regain momentum for a recovery towards expansion.
L-shaped recovery: The economy fell and immediately reached the phase of the trough. But, the economy is still stagnant and will not recover soon, even when the government has launched an economic stimulus. The “lost decade” in Japan is the most common example of restoring an L-shaped recovery.
Economic recovery signals
Real GDP growth is the main indicator of economic recovery. When it comes out of recession, real GDP grows positively. And, if it lasts for two consecutive quarters, it is a signal of recovery. Of course, the hope is that it will lead to expansion, not fall as in a W-shaped recovery.
You can observe other signals of economic recovery from indicators such as interest rates, consumer spending, business spending, industrial production, unemployment rate, inflation rates, and working hours.
Low-interest rates usually initiate a recovery. Policymakers start implementing expansionary policies when the economy is slowing down or contracting. That’s to prevent a recession.
One option is to lower policy rates. A cut in interest rates increases the money supply in the economy and decreases interest rates on financial markets. Lower interest rates drive consumers and businesses to increase demand for goods and services, especially those financed by loans.
Consumer demand is starting to increase, especially for durable goods and housing. Consumers benefit from the lower costs of the new loan. They also saw an increase in overtime pay as the company attempted to intensify production.
The recovery pace depends partly on how quickly consumer spending starts to pick up after the economic downturn. When spending is increasing fast and robust, it will encourage businesses to increase output.
Household consumption plays a vital role in stimulating the economy. Understandably, it accounts for more than half of the gross domestic product (GDP) in most countries.
Businesses are starting to order light equipment to increase efficiencies, such as technology software, systems, and hardware. They see an improvement in income and free cash flow due to an improving economy.
But, in the early stages of recovery, the business has not ordered heavy machinery to increase capacity. They are unconfident enough to do so, fearing that the recovery will be temporary or of a weak scale.
Manufacturing output rose from its lowest level. Still, the increase is at a slow pace. Businesses want to confirm that the recession has really ended.
Also, after downsizing during a recession, it will take time for businesses to recover production to normal levels. Only when it comes to the expansion phase, where consumer demand is getting stronger, companies will start adding new workers.
At the initial phase of recovery, employment conditions improved despite the high unemployment rate. Layoffs are slowing down. However, new recruits had not yet occurred. Businesses prefer to increase overtime and use temporary workers to meet the increasing demand for products.
That way, their profitability will be better. Businesses will recruit new workers if they are more confident that recovery is underway to expand, and available resources are fully utilized. Only when the recovery is strong will the unemployment rate slowly fall.
Companies are more intensively using the existing employee. They will increase overtime to meet the increasing demand.
Businesses will fully utilize their resources before deciding to add a new worker. That is to maintain operating expenses and anticipate the possibility of temporary recovery.
The inflation rate remains moderate and may continue to fall in the early parts of the recovery. And, it slowly rises as the demand grows strong.
Durable goods may see a rise in prices. Their demand outlook improves as the recovery is underway. Previously, consumers tended to put off purchasing durable products during a recession. And, because interest rates are still low during this period, consumers will buy durable goods, anticipating a possible increase in interest rates when the economy is headed for expansion.
How to recover the economy
Expansionary economic policies are one way of moving the economy out of recession. It can take the form:
- Expansionary fiscal policies with options to lower taxes and increase government spending
- Expansionary monetary policies by cutting policy rates policy, purchasing government securities, and reducing the reserve requirement ratio.
Both policies seek to stimulate the economy by increasing aggregate demand.
But, if the recession is caused by the supply-side shocks, policies to increase aggregate demand are ineffective. Take the case of stagflation.
Stagflation occurs due to increased costs, for example, due to a surge in oil prices. That results in an increase in the production cost and can result in a shrinking of economic output and a sharp spike in inflation.
Expansionary economic policies will only increase inflation. Aggregate demand rises, and it will only cause inflation to increase further.
On the other hand, a contractionary policy will result in a shrinking economy. Aggregate demand weakens and forces businesses to cut output.
Why are both policies ineffective. That’s because the problem’s source is from the cost side (aggregate supply), not from the demand side. And, both fiscal and monetary policy, they are both demand-side policies.