Why An Economy May Enter A Recession

Why may an economy enter a recession? Discuss how a government might use fiscal policy to combat recession, and what difficulties it might face in doing so.

A recession can be caused firstly by a negative demand shock. Here, fall in Aggregate Demand reduces Price and reduces Y below Y*. Such a shock could arise from a drop in consumer confidence, for example. This pessimism reduces demand for all goods at all prices, shifting AD leftward to AD1. The nation's output falls below its productive potential Y* to Y1 and the general price level drops. The falling level of output, lower sales and production means firms will reduce employment. If a long and deep recession occurs, and unemployment rises above the natural rate by the time the recovery happens, the natural rate will rise

A more adverse cause of a recession, and the worst scenario for a government is a negative aggregate supply shock. This can happen due to an increase in production costs from a rise in prices, of oil or crops for example. At an increased production cost, firms are less willing to supply goods and services at any given price level. The result is that the supply curve shifts to the left from AS to AS1. AD moves along its curve to meet AS at a new equilibrium. The output falls from Y* to Y1, and P increases. These higher prices are passed on to consumers (i.e. inflation occurs). Again, the reduced level of output, sales and production leads to firms reducing their employment. This combination of unemployment and inflation is known as stagflation.