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Howstuffworks "How Recessions Work

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03/27/2007 10:39 PM

Main > Money > Economics

How Recessions Work
by Tom Harris

Introduction to How Recessions Work On November 26, 2001, the news media announced the United States was officially in a recession, and had been since March. To most Americans, this wasn't all that surprising: Rising unemployment and a weak stock market had been in the news for months. But the announcement did raise a lot of questions. Who decides when the economy is in recession, and on what grounds? What actually constitutes a recession anyway? In this article, we'll find out what recessions are, see why they occur, and examine the criteria economists use to identify them. We'll also look at the effects of recession as well as explore some of the ways a country can turn the economy around again. Money Makes the World Go Round A recession is a prolonged period of time when a nation's economy is slowing down, or contracting. Such a slow-down is characterized by a number of different trends, including: People buying less stuff Decrease in factory production Growing unemployment Slump in personal income An unhealthy stock market By the conventional definition, this slow-down has to continue for at least six months to be considered a recession. This definition really raises more questions than it answers. What does it mean for the economy to slow down? Why does this happen? How are all these factors related? And what exactly is "the economy"? People talk about the U.S. economy as an independent entity, but it is actually the result of millions of people's actions. Economists use all kinds of esoteric terms to describe the connection between people's actions and the economy as a whole. But you can understand the basic idea of this connection by looking at only a few basic concepts: producers, consumers, markets, supply and demand. Producers and Consumers Broadly speaking, a nation's economy is the production and consumption of goods (food, clothes, cars) and services (repairs, lawn-mowing, haircuts) in that nation. Anybody producing or consuming things in a country (and that's just about everybody) plays some role in the economy. Production and consumption are intertwined. In order for people to consume things, someone has to produce those things. And in order to produce things, you need to consume things (you need to consume natural resources and people's labor, for example). Markets In a market economy, or a modified market economy such as the U.S. economy, production and consumption are connected in various "markets." A market is simply a place where consumers can go to buy things from producers and producers can go to sell things to consumers. A grocery store is an example of a physical market. People who want to consume food go to the grocery store and buy it from producers through a series of middlemen. The store itself is one of the
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In the Great Depression of the 1930s and '40s, laid-off U.S. workers lined up daily at employment agencies.

for example). can raise the price of their product (in other words. In the stock market. The willingness of consumers to pay for products is known as demand. consumers and producers buy and sell percentages of ownership of companies (see How Stocks and the Stock Market Work for more information). but most will. What Goes Up. Even if there is constant high demand for a product (toilet paper. consumers generally want to pay as little for goods and services as they can. so the general feeling about the economy is good. you are a producer of labor.. the actions of producers and consumers determine the value of goods and services.to bring in more money than they spent producing the product. almost everybody is both a producer and a consumer acting in more than one market. economy has shown the ability to grow steadily while keeping inflation under control).S. but in the past decade the U. In a growing economy. and there are usually others along the way (distribution companies. Supply and Demand The ultimate goal of producers is to make money -. on the whole. more than it is decreasing. overall. the price of some things goes up. consumer demand is increasing. some consumers and producers will not do well. but they do so based on the behavior of consumers. Working people with higher incomes have more money to spend on other products. airlines can raise their prices to decrease demand (this could lead to high inflation if it happened across the board. producers want to increase supply. the producer knows the price is too high. For example. The labor market is a more abstract sort of market. In a market. Producers are the ones who actually set prices.Howstuffworks "How Recessions Work" 03/27/2007 10:39 PM middlemen.howstuffworks. producers must either decrease the price or decrease the supply. Consumers may want to satisfy their wants and needs by buying products. In the next couple of sections. If some consumers buy it. if there are more travelers than there are seats on airplanes. If you have a job.. which increases demand even more. or they may buy products in order to make money (by reselling the products or by using the products to produce other products). individual producers need to keep the price down or consumers will just buy it from a competitor.com/recession. Whenever you go shopping.. If nobody buys a product at a particular price. As you can see.htm/printable Page 2 of 7 . businesses who want to consume work pay people to produce labor. so the labor pool. people can get paid more for their work). for example). In a growing economy. Since there is increasing demand. including labor. In this market. you are a consumer of goods. we'll see how all these factors work in a growing economy and in a contracting economy. producers have to increase their consumption of other goods and services. http://money. This means there is greater demand for labor. but not enough to buy everything produced. In any case. To do this. If demand is high enough.

In the next section. . we'll find out what happens in this sort of economy.Must Come Down Economists say the U.eventually it will contract for a while. If the recession lasts long enough. A prolonged period of contraction is known as a recession. History has proven that an economy will not keep expanding indefinitely -.. One factor that generally plays a role in a recession. These consumers figure they will make money just by holding onto the product for a while.. that they plan to sell at a later date. If consumers stop feeling confident about their job security or the value of their investments. whether or not it is the cause. such as stock in a company. a recession might be kicked off by over-production -. http://money.howstuffworks.Howstuffworks "How Recessions Work" 03/27/2007 10:39 PM In such an economy. a lot of consumers tend to make investments: They buy things. and is particularly severe. In some cases. So why did it stop? Why couldn't it keep spiraling upward forever? There are all kinds of things that can change the course of the economy. They know that if the economy keeps going the way it has been.com/recession. In the current recession.htm/printable Page 3 of 7 .a situation in which the supply exceeds the nation's ability to consume. economy was expanding steadily from early 1991 to early 2001. it is known as a depression.S. just as there all kinds of things that can change the demand for a particular product. a lot of people who have been laid off are spending as little as possible. they won't buy as much stuff. and many people who fear they may be laid off are also saving their money. their investments will increase in value. is the confidence level of the millions of consumers and producers.

In other words. theme parks and other popular tourist destinations. contributing to cutbacks in other industries and setting off similar spirals. this meant reducing ticket prices as well as cutting back on the number of flights. To deal with this turn of events. the contracting of the airline industry affected a number of other industries. they had to lay off a lot of their workers. Reducing supply and price meant that the travel producers did not need to consume as much labor. there was reduced demand for in-flight meals.howstuffworks. The employees who were not laid off were afraid they would be laid off. and others decided not to go on any big trips. travel producers had to reduce both the price and supply of their product. In a healthy economy. including big cities. Consequently.htm/printable Page 4 of 7 . In the airline industry. The plane hijackings shook a lot of people's confidence in air travel. http://money. for example. airplane equipment and room-andboard for their traveling crews. they also cut back on spending. A huge number of travelers immediately cancelled their flights. had way too many empty seats on its flights. travel agents and dozens of other travel-related services also shrank considerably overnight. problems with the airline industry probably wouldn't affect as many companies or workers. the laid-off airline workers had to reduce their spending. further reducing demand in hundreds of markets. and most of the workers it did affect would be able to move on to other industries. With a much smaller income. They saw the struggling airlines as evidence that the economy was heading downhill in general. The travel producers reduced demand for the products they need. It also made people extremely wary of densely populated areas. things tend to snowball in a contracting economy. This reduced the demand for other products. The airline industry. the demand for air travel plummeted. for example.Howstuffworks "How Recessions Work" 03/27/2007 10:39 PM Just as in an expanding economy. shaking the confidence of millions of workers who had nothing to do with the airline industry. There are thousands of different elements in this downward spiral. All of this was played out on the news. Post 9/11 Let's look at what happened to the travel industry after the September 11 terrorist attacks.com/recession. In this way. Travel service producers were faced with a supply that far outweighed demand. Afraid they would lose their jobs in the near future. you can see the snowballing effect in any number of specific situations. But with enough similar problems in different markets. In the airline industry. so they also reduced their spending. these workers felt like they didn't have anywhere to go. In the next section we'll examine the effects of September 11th on the economy. The demand for hotel rooms.

typically six months or more. They give more weight to personal income.S. Different people consider different factors when making the assessment. and the economy as a whole may periodically contract. There is no strict definition for recession. and consumers are free to buy goods and services or to not buy goods and services. producers are usually free to charge what they want for goods and services. In other words. we'll see how economists make this determination. The forces of supply. This non-profit. and industrial production.S. But this freedom has a price -. NBER economists keep track of the nation's business cycles -. Spotting a Recession In the United States. the GDP is a pretty good indicator of the overall state of the economy. Economists don't know if the economy is in recession until they can gather data over an extended period of time -. the economy follows a somewhat regular pattern of expansion and contraction. we'll look at the common remedies employed by the U. The point where the recession begins is known as a peak. When the nation is in the early part of a recession. If this is the case. The GDP is the value of all the reported goods and services produced by people and institutions operating in a country.it puts the economy beyond the control of any single entity. just as in an expanding economy. non-partisan organization employs hundreds of economy experts (university professors. economy. The great thing about this system is that it provides consumers and producers with a high level of freedom. But the economists who officially designate a recession in the United States do not rely on the GDP alone. sales in manufacturing and trade. mostly) to analyze and report on the U. There are two kinds of policies the government might institute to get the country out of recession: fiscal policies and monetary policies. The GDP is not the most important factor to the NBER economists. government in times of recession. everybody is guessing what everybody else will do. An overall decrease in the value of goods and services indicates that demand has decreased in most markets. nobody knows for sure if it is actually a recession or not.only the actions of millions of consumers and producers can turn the economy around. it's a good bet that companies have laid people off. In general. In a shrinking economy. which would mean the contraction was just a temporary decrease in activity along a mostly upward track. The Fix Is In The United States is basically a market economy. they believe things will get worse in other industries in the immediate future. The economy will typically expand steadily for six to 10 years and then enter a recession for six months to two years. Since it is unhealthy for a nation to be in recession. Usually the stock market is also in bad shape when overall value is decreasing. In a market economy. Some economists and journalists define a recession as two consecutive quarters (three-month financial periods in the year) in which the gross domestic product (GDP) decreases. the economy expands again toward another peak. Following the trough. it is a private organization that works to further understanding of the economy. But the U. The NBER is not a government agency. By general agreement. the national employment rate. In the next section. the government influences the economy by changing how it (the government) http://money. so unemployment is up. The Business Cycle Dating Committee decides whether or not the economy is in recession based on several monthly indicators.htm/printable Page 5 of 7 . governments will generally take action to get the economy expanding again. government does have some ways to influence the actions of consumers and producers. the government cannot automatically set things right when things go wrong -. Fiscal Policy With fiscal policies. They stop consuming and producing as much.com/recession. In the next section.the courses of expansion and contraction in the economy. Among other things.S. The economy might turn around the next day. the official determination of recession is left to the Business Cycle Dating Committee at the National Bureau of Economic Research (NBER). which causes things to get worse on a larger scale. But economists only declare a recession when the economy is contracting as a whole for an extended period of time. Different sectors of the economy are contracting all the time.howstuffworks. demand and competition determine how the economy will behave. and the point where it ends as known as a trough. too.Howstuffworks "How Recessions Work" 03/27/2007 10:39 PM When producers and consumers see negative things happening in several different industries. Economists call the period of time between two peaks a business cycle.

Photo courtesy NARA Workers build a government storage facility as part of the Works Progress Administration (WPA). Banks are not allowed to have too little in reserves. and they don't want to have an excess in reserves (this money isn't earning any interest.com/recession. Automatic fiscal policies. Lower the discount rate (the rate on federal loans) . The most common fiscal policy actions in a recession are: Tax cuts for businesses or for individuals . The Fed mandates that all national banks keep a certain percentage of their assets in one of the Federal Reserve banks. http://money. (Check out How the Fed Works for more information. This might lead them to offer more attractive loans to their customers.This frees up more money for banks. which kick in right away . a bank that suddenly has too little reserves can get an immediate. so they need to quickly adjust their reserves on a regular basis. Franklin Roosevelt set up the WPA and other programs during the Great Depression in the hopes that the new jobs would help turn the economy around. at a set rate called the federal funds rate. and it is the main regulating body that oversees bank operations. which can lower the unemployment rate.This frees up money for banks that are borrowing money from the Fed. Lower the federal funds rate . This system provides an income for people who are out of work.This gives people and corporations more money. Again. they have more accessible money. monetary policy is conducted by the Federal Reserve System. which increases demand.One of the most important automatic fiscal policies is unemployment insurance.This increases demand for labor. Fiscal policies are dictated by congress and the president. short-term loan from a bank that has an excess.htm/printable Page 6 of 7 . it is the bank for the government itself.Howstuffworks "How Recessions Work" 03/27/2007 10:39 PM spends and collects money. after all). Increased spending to establish new government jobs . as well as for national commercial banks. A bank's assets constantly fluctuate. The Fed is the nation's central banking institution. these savings may be passed on to the bank's customers.howstuffworks. where those assets will earn no interest. In order to keep things balanced.If banks don't have to keep as high a percentage of their assets in reserves. and the set percentage is called the reserve ratio. commonly called the Fed. There are four major things the Fed can do to curb a recession: Reduce the reserve ratio . allowing them to offer more attractive loans. which may make them more likely to buy things. which can help boost economic growth.) The Fed has several tools at its disposal for manipulating the economy. The Fed is also in charge of issuing currency. In the United States. Monetary Policy Monetary policy involves manipulating the available money supply in the country. This money is known as reserves. The lending banks charge interest on these loans.

But in the United States. The Fed has to be extremely careful in its actions in order to avoid economic catastrophe. how can the NY Stock Exchange have stocks valued at $15 trillion? How does the social security system work? More Great Links Board of Governors of the Federal Reserve System National Bureau of Economic Research Bureau of Economic Analysis Recession 411: What it is and How it Should Affect Your Investment Decisions Brooks Jackson: A primer on recession What is "the economy"? About. time has proven that attitudes and economic factors shift. it can also make things a lot worse. Inc. The Fed's power is a double-edged sword.Buying bonds translates to income for the U. government. Anything influenced by so many people is beyond the control of any one person or group -. things turn around and an upward spiral is reestablished. Eventually.com/recession. the course of a nation's recession is controlled by the actions of everybody living in the country. and every recession is a temporary recession.it seems to have a mind of its own. While it can be used to nudge the economy out of recession (or otherwise influence its course). http://money.howstuffworks.com: Economics How the Fed affects the stock market HSW Brazil | Home | Company Info | Advertise With Us | Newsletter | Careers | Privacy | Contact Us | Help | Terms & Conditions RSS ©1998-2007 HowStuffWorks. which puts more money into the economy. In the end. where does that check go? How does it end up in my bank statement? How much money is "all the money in the world"? If all the money in the U. Lots More Information Related HowStuffWorks Articles How the Fed Works How Banks Work How Stocks and the Stock Market Work How Income Taxes Work How Pawnshops Work How Credit Cards Work How Affiliate Programs Work How Franchising Works How Customs Works When I pay for my groceries by check. For lots more information about recessions.S. only totals $6 trillion. check out the links on the next page.Howstuffworks "How Recessions Work" 03/27/2007 10:39 PM Use its own reserve money to buy government bonds .htm/printable Page 7 of 7 .S. the Federal Reserve System and the world of economics.