Business owners and consumers alike dread the word “recession.” Recessions are periods in which many sectors of society face economic decline and many businesses struggle to stay afloat. These periods of economic decline touch nearly all sectors, and small businesses often see the biggest negative impact. In the U.S., under one widely used standard, a recession is in effect when negative GDP growth occurs in two consecutive calendar quarters. But what causes a recession?
This article covers the three primary causes of a recession:
Cause #1: Monetary Policy
One of the most common causes of a recession is monetary policy. Monetary policy is the actions taken by a nation’s central bank to influence the money supply and interest rates in order to affect economic activity.
The two main tools of monetary policy are open market operations and reserve requirements. Open market operations refer to the buying and selling of government securities in the open market by the Federal Reserve. The purpose of these operations is to influence the level of reserves banks have, which then affects the amount of money banks can lend.
Reserve requirements are the percentage of deposits commercial banks must hold in reserve and not lend out. By changing these requirements, central banks can influence how much money is available for lending and, as a result, how much spending occurs in the economy.
When monetary policy is too tight, it can lead to a recession. This happens when central banks raise interest rates or increase reserve requirements in order to slow down the economy and fight inflation. While this may be successful in combating inflation, it can also lead to a decrease in spending and investment, which can lead to a recession.
Cause #2: Fiscal Policy
Another cause of a recession is fiscal policy. This particular type of policy relates to the tax and spending decisions made by a federal, state, or local government. These decisions can influence the level of economic activity in the economy.
If the government cuts spending, it can lead to a decrease in demand for goods and services, which can lead to a recession. Likewise, if the government raises taxes, it can also lead to a decrease in demand as consumers will have less disposable income.
Fiscal policy can also be expansionary or contractionary. Expansionary fiscal policy occurs when the government reduces taxes or increases spending in order to stimulate the economy. Contractionary fiscal policy is when the government does the opposite in order to slow down the economy.
Cause #03: Private Sector Decisions
The third cause of a recession is private sector decisions. This refers to the spending and investment decisions made by households and businesses.
For example, if households decide to save more and spend less, this can lead to a decrease in demand for goods and services. Similarly, if businesses decide to invest less, this can also lead to a decrease in demand.
Private sector decisions are often influenced by confidence. If households and businesses are confident about the future, they are more likely to spend and invest. However, if they are not confident, they are more likely to save and hoard cash, which can lead to a recession.
No two recessions are alike, but there are certain trends that can be seen. By understanding the causes of a recession, we can be better prepared for when one hits. This article has covered the three primary causes of a recession: monetary policy, fiscal policy, and private sector decisions.