A recession, sometimes called a contraction, is a period of economic slowdown and is often marked by high rates of unemployment, plunging stock prices, lower corporate profitability, and consumer anxiety. It is actually a normal part of the cycle of business in a market economy, which tends to move regularly through booms and busts, expansion and contraction, recovery and recession.
A recession is frequently defined by economists and the media as occurring when the economy experiences two consecutive quarters of negative GDP growth. It falls to the National Bureau of Economic Research (NBER), however, to officially call a recession, and the NBER does not actually follow such a simple rule. They take many more economic indicators besides GDP into account as well, considering unemployment, consumer confidence, real income levels, sales, and industrial production data. What the NBER is looking for in order to declare a recession, according to their website, is "a significant decline in economic activity that is spread broadly across the economy, lasting for more than a few months…"
Often a recession is caused by inflation after a period of economic expansion, the booming part of the business cycle. When things are going well and the economy is growing, there is generally more demand for goods and services than the actual amount of goods and services that are being produced. Over time this leads to higher prices across the entire economy; eventually a tipping point is reached where consumers decide that they are not going to buy at that price. Suddenly there is more supply than demand, and companies begin to struggle to cut back on their production and reduce their inventories; employees are laid off, prices are slashed, profits and stock prices drop. Consumers become frightened, stop buying things and start hiding their money in their mattresses – and the cycle snowballs as all of this cutting back further reduces demand for goods and services across most sectors of the economy.
Recession can also be caused by any number of other large precipitating events that shake consumer confidence; the bottom line is that if demand for goods and services decreases significantly for more than a few months in a row, the overall economy will probably move into a period of recession. If this persists for more than three years, or the real GDP declines more than ten percent, then the period may end up being categorized as a depression.
Although temporary, recessions can be extremely difficult to turn around into another period of expansion and economic growth.
The federal government can stimulate the economy directly through tax cuts and unemployment insurance checks, and it can even create jobs by hiring new government employees and funding large public works projects.
The Federal Reserve (the Fed) controls the actual money supply in the United States, and it uses less direct methods to stimulate economic growth. During a recession businesses and consumers are afraid to spend, so the Fed puts incentives in place to encourage large-scale consumption. The main thing the Fed does is to make money cheap for banks to lend out to both consumers and businesses, who are then able to spend more on goods and services thereby increasing overall demand. Snowballing demand is what signals the end of a recessionary period. We will talk more about the Federal Reserve next week.
This article is intended to provide general information and should not be considered legal, tax or financial advice. It's always a good idea to consult a tax or financial advisor for specific information on how certain laws apply to your situation and about your individual financial situation.