During a recession, monetary policy aims to boost aggregate demand by expanding the money supply. According to the liquidity preference theory, increasing the money supply lowers interest rates. Lower interest rates induce increased investment spending which enhances aggregate demand.
In a recession, does the money supply shrink?
- Interest rates serve as a vital link in the economy between savers and investors, as well as between finance and real-world activities.
- Liquid credit markets operate similarly to other forms of markets, following the rules of supply and demand.
- When an economy enters a recession, demand for liquidity rises while credit supply falls, leading to an increase in interest rates.
- A central bank can employ monetary policy to cut interest rates by counteracting the usual forces of supply and demand, which is why interest rates fall during recessions.
In a recession, what happens to supply?
Supply-side strategies aim to boost the economy’s competitiveness and efficiency. Tax reduction, privatization, education investment, and more flexible labor markets are examples of such policies. Supply-side strategies are often long-term initiatives aimed at increasing productivity and the long-run trend rate of growth.
Demand-side interventions, like as monetary and fiscal policy, have traditionally been used to combat recessions.
However, supply-side strategies are seen to play a role in helping an economy recover from a recession, particularly if:
- When conventional monetary policy fails to enhance economic development, we find ourselves in a liquidity trap.
Supply Side Recession
When an economy is forced into recession by a supply side shock, it is known as a supply side recession. A sharp increase in the price of oil, for example, would raise the cost of production and shift the aggregate supply curve to the left in the near run.
Supply Side Recession (Supply Side Shock)
Higher (cost-push) inflation results from the increase in raw material costs, as well as a shift in the Aggregate Demand curve. Increased manufacturing costs and rising living costs result in decreased consumer expenditure and slower economic growth.
In theory, supply-side interventions can help move AS to the right, lowering cost-push inflation and boosting growth.
Supply-side measures, on the other hand, are ill-equipped to deal with a sharp increase in oil prices. They can only work to increase production over time.
Lack of Competitiveness and Recession
A fundamental cause for sluggish economic development in Euro countries such as Greece, Spain, Italy, and Portugal is that they have become comparatively uncompetitive. This is attributable to factors on the supply side, such as:
These supply-side considerations become increasingly relevant when nations in the Eurozone are unable to lower their currencies in order to regain competitiveness.
There is a decrease in exports and an increase in imports as they become uncompetitive. This causes a drop in domestic demand, which leads to slower economic development and the possibility of a recession.
If the United Kingdom becomes uncompetitive, the pound will fall, restoring competitiveness and increasing export demand.
Supply Side Policies and Recovery from Recession
How effective are supply-side strategies in assisting an economy’s recovery from a downturn?
In the cases of Spain, Greece, and Italy, supply-side policies that aid in the restoration of competitiveness could be crucial in assisting the economy’s recovery.
could all aid in increasing labor productivity and lowering costs. This should boost export demand while also helping local demand.
Role of Aggregate Demand
The issue with supply-side strategies, however, is that they might take a long time to take impact. In addition, pay cuts and less labor market flexibility are frequently met with opposition. Furthermore, there is no certainty that government supply-side initiatives will boost competitiveness. If you rely solely on supply-side policies to restore competitiveness and aid the economy’s recovery, it may require several years of deflation and poor growth.
There is a basic lack of aggregate demand in countries with a big negative output gap. As a result, methods to enhance domestic demand (expansionary monetary policy/expansionary fiscal policy) must be considered.
If the economy is at Y1, the most immediate need is to increase AD; raising productive capacity (moving AS to the right) would have little effect on economic growth.
Wage Cuts and Impact on Demand
Another difficulty is that, while supply-side measures may boost competitiveness, they may also result in lower consumer spending. Workers will have less disposable money and lose faith in their economic prospects if their nominal wage is reduced. As a result, pay cuts to encourage economic development could backfire.
Supply Side Policies and Liquidity Trap
Supply-side initiatives, it is suggested, can assist enhance long-term expectations in a liquidity trap. This rise in expectations may help to boost investment and consumption. In a liquidity trap, even interest rate reductions are ineffectual at increasing consumption and investment. This is due to a lack of investment by both businesses and consumers. However, if they observe significant supply-side gains, they may be more optimistic about the economy’s future. Effective labor market reform in Spain, for example, may stimulate more international investment.
Supply-side strategies can aid in the recovery of an economy. However, relying solely on supply-side strategies is a mistake.
Unfortunately, this is the prescription for many of the Eurozone’s recession-stricken countries. (Eurozone alternatives)
During a recession, what does the Fed do with the money supply?
- Congress has given the Federal Reserve a dual mandate to maintain full employment and price stability in the US economy.
- During recessions, the Fed uses a variety of monetary policy tools to assist lower unemployment and re-inflate prices.
- Open market asset purchases, reserve regulation, discount lending, and forward guidance to manage market expectations are some of these tools.
- The majority of these measures have previously been used extensively in response to the economic hardship created by current public health limitations.
What effect does the money supply have on aggregate supply?
Expansionary monetary policy expands an economy’s money supply. An rise in the money supply is accompanied by an equal increase in nominal output, or GDP (GDP). Furthermore, the expansion of the money supply will result in increased consumer expenditure. The aggregate demand curve will move to the right as a result of this rise.
Furthermore, a rise in the money supply would cause a shift up the aggregate supply curve. This would result in higher prices and more real output potential.
How does the government boost the amount of money available?
- To increase or decrease the amount of money in the economy, central banks use a variety of strategies known as monetary policy.
- The Federal Reserve can expand the money supply by decreasing bank reserve requirements, allowing them to lend more money.
- The Fed, on the other hand, can reduce the quantity of the money supply by boosting bank reserve requirements.
- Short-term interest rates can also be influenced by the Fed lowering (or raising) the discount rate that banks pay on short-term Fed loans.
What effect does the recession have on supply and demand?
With this in mind, the question of whether a recession lowers or raises demand arises. A recession will reduce demand for most things, referred to as “normal goods.” Recessions, or periods of economic contraction, lower income, and consumers spend less when they have less money in their pockets. A recession shifts the demand curve to the left for ordinary items. During a recession, however, some products actually see an increase in demand as individuals replace them for more expensive items. Because they have less money in their pockets, they buy more of this item. (An example would be ramen noodles.) Such things are referred to as “inferior goods” by economists. A recession pushes the demand curve to the right for lesser items.
During a recession, what happens to the price level?
A recession is a time in which the economy grows at a negative rate. In a recession, real GDP falls, average incomes decline, and unemployment rises.
This graph depicts the growth of the US economy from 2001 to 2016. The profound recession of 2008-09 may be seen in the significant drop in real GDP.
Other things we are likely to see in a recession
1. Joblessness
In a downturn, businesses will produce less and, as a result, employ fewer people. In addition, during a recession, some businesses will go out of business, resulting in employment losses. For example, many people in the finance business lost their jobs as a result of the credit crunch in 2008/09. When demand for cars fell, car companies began to lay off staff as well.
2. Improvement in the saving ratio
- People tend to preserve money during a recession because their confidence is low. When people expect to be laid off (or are afraid of being laid off), they are less likely to spend and borrow, and saving becomes more appealing.
- Keynes observed that during the Great Depression, there was a paradox of thrift: when individuals saved more and consumed less, the recession worsened because consumption fell even more. Individually, individuals are doing the right thing, but because many people are saving more, consumer spending is being reduced even more, worsening the recession.
3. A lower rate of inflation
Inflation in the United States was high in 2008 due to rising oil prices. However, the recession of 2009 resulted in a substantial decline in inflation, and prices fell for a time (deflation)
Prices are under pressure due to a drop in aggregate demand and slower economic development. During a recession, stores are more inclined to offer discounts to clear out unsold inventory. As a result, we have a reduced inflation rate. Deflation occurred during the Great Depression of the 1930s, when prices plummeted.
4. Interest rates are falling.
- Interest rates tend to fall during recessions. Because inflation is low, central banks are attempting to stimulate the economy. In theory, lower interest rates should aid the economy’s recovery. Lower interest rates lower borrowing costs, which should boost investment and consumer expenditure.
5. Increases in government borrowing
In a recession, government borrowing will increase. This is due to two factors:
- Stabilizers that work automatically. The government will have to pay more on jobless compensation if unemployment rises. Because fewer individuals are working, however, they will pay less income tax. In addition, as business profitability declines, so do corporate tax receipts.
- Second, the government may try to utilize fiscal policy that is more expansionary. This entails lower tax rates and higher government spending. The objective is to repurpose unemployed resources by utilizing surplus private sector funds. Take, for example, Obama’s 2009 stimulus program. Look at Obama’s economics.
6. The stock market plummets
- Stock markets may collapse as a result of lower profit margins. There’s also the risk of companies going out of business.
- If stock markets foresaw a downturn, it’s possible that it’s already factored into share prices. In a recession, stock prices do not always fall.
- However, if the recession comes as a surprise, profit projections will be lowered, and stock values will decrease.
7. House prices are dropping.
In this scenario, property values in the United States decreased prior to the recession. The recession was triggered by a drop in house prices. It took them until the end of 2012 to get back on their feet.
In a recession, when unemployment is high, many people may be unable to pay their mortgages, resulting in property repossessions. This will result in a rise in housing supply and a decrease in demand. Because of the prior property boom, US house values plummeted dramatically during the 2008 recession. In truth, the housing/mortgage bubble bust in 2005/06 was a contributing reason to the recession.
8. Make an investment. As companies reduce risk-taking and uncertainty, investment will decline. Borrowing may also be more difficult if banks are low on cash (e.g. credit crunch of 2008). Due to variables such as the accelerator principle, investment is frequently more volatile than economic growth.
A simple AD/AS framework depicting the impact of a decrease in AD on real GDP and price levels.
Other possible effects
The effect of hysteresis. This means that a momentary increase in unemployment could lead to a long-term increase in structural unemployment. Manufacturing workers, for example, required longer to locate new positions in the service sector after losing their jobs during the 1981 recession. See the hysteresis effect for more information.
Exchange rate depreciation is number ten. Depreciation could result from a recession that hits one country more than others. Because interest rates decline, there is less demand for the currency (worse return)
Because of the credit crisis, the UK economy, which is heavily reliant on the finance industry, witnessed a severe fall in the value of the pound in 2008/09.
The Pound, on the other hand, was robust throughout the 1981 recession. In fact, the Pound’s strength contributed to the slump.
11. New businesses and creative destruction Some economists are more optimistic about recessions, claiming that they can force inefficient businesses out of business, allowing more inventive and efficient businesses to emerge.
- In a recession, however, good companies can go out of business owing to transient circumstances rather than a long-term lack of competitiveness.
12. Current account with a positive balance. If a country’s domestic consumption falls sharply, the current account deficit may improve. This is due to a decrease in import spending.
The UK’s current account improved through the recessions of 1981 and 1991. However, the recovery in the current account in 2009 was just temporary.
- It depends on what caused the recession in the first place. High oil prices, for example, contributed to the recession in the mid-1970s. As a result, in a recession, inflation was higher than usual.
- The high value of the Pound hurt the manufacturing (export) sector during the 1981 recession. Because the recession was driven by unusually high interest rates, which made mortgages expensive, homeowners carried a greater burden during the 1991/92 recession. The finance and banking sectors were the hardest hit during the 2008 financial crisis.
- It all depends on whether the recession is global or country-specific. The recession in the United Kingdom was worse than everywhere else in the globe between 1981 and 1991.
- It all relies on how governments and the central bank react. For example, in 1931, the United Kingdom attempted to balance its budget, which resulted in additional declines in aggregate demand.
What causes a downturn?
Most recessions, on the other hand, are brought on by a complex combination of circumstances, such as high interest rates, poor consumer confidence, and stagnant or lower real wages in the job market. Bank runs and asset bubbles are two further instances of recession causes (see below for an explanation of these terms).
In 2021, how much money has the Fed printed?
In the last 22 months, 80 percent of all US dollars have been created (from $4 trillion in January 2020 to $20 trillion in October 2021) – Tech Startups.
What would happen if a country produced an excessive amount of money supply inside its economy?
The activities taken by the Fed to alter financial circumstances in order to achieve its objectives are referred to as monetary policy.
The Fed’s major lever of control is the ability to raise and lower short-term interest rates. The Fed can indirectly impact demand, which in turn influences the economy, by doing so. If interest rates are dropped, for example, borrowing money to make purchases becomes less expensive, and consumers are more likely to spend since they may get a better loan deal. Spending money boosts economic growth, which is exactly what the Fed is attempting in this case. People spend more money when there is too much money in the economy, and demand rises faster than supply can keep up. Because of the scarcity of products, prices rise too quickly, resulting in inflation. People do not have excess spending money if there is too little money in the economy, and economic growth is limited.