Recession Explained

Quick Definition: A recession is a period of time in which a country’s economic activity declines causing unemployment to rise and incomes to fall.

What is a recession?

A recession is often defined as two successive quarters of falling GDP (gross domestic product). Although this definition is widely used, a recession can be more simply defined as a decline in economic activity in a country.

A recession is one of the four phases in the business cycle. It is caused by a fall in aggregate demand (the total demand in the economy from consumers, businesses and the government) and subsequently the economy will begin to decline. What this means is that the economy’s output (the total value of all goods and services produced, a.k.a GDP) will begin to fall. As a result of the fall in output, the economy will suffer from many repercussions which will be described in the following section.

What are the effects of it?
  • The major effect of a recession on an economy is unemployment. As a result of the lower aggregate demand in the economy, consumers will buy fewer goods and services. This will put pressure on firms to cut costs in order to stay profitable and consequently businesses will lay off workers.
  • Another effect of a recession will be on average incomes. Due to businesses having lower sales wages and salaries will need to be reduced in order to decrease costs and stay profitable.
  • A recession can also cause something called a negative multiplier in the economy. A recession is caused by a drop in aggregate demand which results in higher unemployment and lower wages. As a result of higher unemployment and reduced wages, people’s disposable income will be lower and they will spend less on goods and services. This causes a further reduction in aggregate demand thus forcing more firms to cut jobs and wages due to lower sales.
  • A recession usually results in disinflation (inflation rising at a slower rate) in the economy. Lower aggregate demand in the economy means that people are buying fewer goods and services. This drop in demand will create a downward pressure on prices as firms try to attract people to buy their products. Therefore there will be a fall in the general rise in prices.
  • Another effect of a recession will be lower interest rates in the economy. Due to the lower aggregate demand and the subsequent fall in spending, the government or central bank who is in charge of the economy’s money supply will lower the main interest rate. A lower interest rate will make it more beneficial for people to take out loans and spend and will make it less attractive for people to save money. The aim of this policy is to encourage people to spend more money on goods and services so that jobs will be created and the output of the economy will rise.
Key terms
  • Aggregate demand – This refers to the total of all the demand in an economy. The equation for aggregate demand is: Consumption (C) + Government Spending (G) + Investment (I) + (Exports (X) – Imports (M)).
  • Business/Economic cycle – This is when economic activity fluctuates between its target growth rate. The four stages of the economic cycle are known as: upswing, boom, downturn and recession.
  • Gross domestic product – This is the total value of all goods and services produced in an economy during a set period of time
  • Inflation – When the general level of prices of goods and services in an economy is increasing.
  • Interest rate – This is the cost of borrowing and the reward for saving. Also referred to as the price of money.
  • Unemployment – This is a situation in an economy where there are people who are willing and able to work but do not have a job.