Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Reading about Recessions

In case you hadn’t realised, recessions aren’t good: they reduce people’s living standards and usually lead to an increase in unemployment (a problem we discuss in the later ‘Uncovering Unemployment: Causes and Responses’ section).

Identifying a recession


A recession refers to a fall in real Gross Domestic Product (GDP), which basically measures the value of all the goods and services an economy produces in one year (check out Chapter 2 for more on GDP). The norm is for real GDP to increase over time, which is why living standards now are much higher than those of a few generations ago. Economies are just better at producing things now than they used to be. In Figure 3-1, you can see that, on average, real GDP has increased over time. This increase is a persistent phenomenon – since the Industrial Revolution of the late eighteenth and early nineteenth centuries! You can also see, however, that real GDP fell quite significantly during 2008

– the fallout from the global financial crisis – and it took several years to recover its previous peak.

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Figure 3-1: UK real GDP increase – with one significant ‘blip’.

People’s incomes must ultimately come from the production of goods and services (where else could they come from?), so a recession reduces average income in a country or real GDP per capita. Indeed, as of 2015, real GDP per capita in the UK still hasn’t recovered its pre-crisis peak.

Recessions occur for two main reasons:


A fall in aggregate demand for goods and services: For whatever reason, if consumers, firms or the government demand fewer goods and services, this behaviour can cause a recession.


An adverse supply shock: If something happens that makes it more difficult for firms to produce goods and services – for example, a large increase in energy prices – the result is likely to be a recession.

Recessions also tend to increase unemployment, because when fewer goods and services are being produced, firms no longer need as many workers as before. Unsurprisingly, therefore, recessions are big deals politically as well as economically. Voters often attribute a recession to bad economic policy making, which can hurt the incumbent in the next election.

Addressing recessions with fiscal or monetary policies

Policy makers have a few tools they can use to combat a recession. Here we introduce a couple of policies that affect the demand side of the economy (see Chapters 10–11), although we also discuss many ways of stimulating the supply-side of the economy (check out Chapter 6):

Expansionary fiscal policy: Increasing government spending on goods and services and/or reducing taxes for consumers and firms. Both these actions increase the aggregate demand for goods and services, the former directly and the latter indirectly: households have greater disposable income to use to increase consumption, and investment looks attractive to firms because they get to keep more of the profits.


Expansionary monetary policy: Cutting the official interest rate – the rate at which commercial banks can borrow from the central bank. The hope is that this action reduces interest rates throughout the economy and encourages consumers to spend and firms to invest.


Here’s a small catch, though: when the official interest rate is at (or close to) zero, not much more can be achieved by conventional monetary policy. You may have noticed that, for many years now, interest rates in many developed countries – including the UK and US – have been close to zero. This situation led to some unconventional monetary policies, including most prominently quantitative easing: the flooding of the financial system with liquidity, or in other words, creating lots of new money (ease over to Chapter 10 for more).


Macroeconomists tend to favour expansionary monetary policy over fiscal policy for stimulating the economy. The reason is that the latter usually results in a fiscal deficit (the government spending more money than it earns in taxation), which requires it to borrow. This borrowing has to be paid back at some point and adds to the nation’s indebtedness. Expansionary monetary policy, on the other hand, has a similar impact but without increasing government debt.

Getting Hyper about High Inflation

No one likes inflation (well, actually that’s not true; economists like a little bit of inflation, but more on that in Chapter 5). Inflation means that on average the prices of things in an economy are rising. Whereas small amounts of inflation can be a mild inconvenience, very high inflation or hyperinflation is seriously bad news and threatens the very fabric of society.