Understanding Why Recessions Happen
AD 0 SRAS
AD1 P
Y1 Y0 Y
P0
In the short run, it makes sense to think of the firm as having more control over its production levels than its prices, which leads to modelling the SRAS curve as horizontal. In the long run, potential output is capped at a level given by a number of underlying long-run factors. In between, we have a number of models of various degrees of elaborateness explaining what hap- pens. Generally at some point, these models all agree: the SRAS first becomes upward sloping (implying that prices and output rise together) and then vertical. What we’re going to do here is to skip the middle bit in the name of simplicity. Of course, in reality economies don’t just jump from a horizontal SRAS to a vertical LRAS, from growth to recession, or from one price level to another. However, the model is simpler to understand, without losing the essential features of the analysis, if we pretend for the moment that this does happen to economies. If you’re okay with making that a deal, we’re going to use only the initial horizontal curve and the final vertical curve, calling the former the SRAS and the latter the LRAS.
Figure 6-4 also has two aggregate demand curves, ADo and AD1, which again show what happens when aggregate demand is reduced as the result of a negative demand shock. The initial level of output that firms produce, Yo, is determined by the intersection of the original aggregate demand curve, ADo, with the SRAS curve. In other words, at price level Po, people demand output level Yo, and firms respond by supplying it.
When the negative demand shock strikes, it shifts aggregate demand left- ward to AD1. Reduced demand means that at the fixed price level, customers are willing to buy less output. Because firms can’t change prices, their only recourse is to reduce production down to match the decrease in demand;
this reduced level of output (Y1) appears on the graph where the SRAS curve intersects AD1. Because lower output means that firms need fewer workers, you end up with a recession: output falls and unemployment rises.
If you compare Figures 6-3 and 6-4, you can see that the leftward shift in aggregate demand has very different effects in the short run and the long run:
✓ In the short run when prices are fixed, output falls and unemployment rises.
✓ In the long run, prices fall and output returns to the full-employment level.
Supermarkets and Y *
The two most recent recessions in the United States, in 1991 and 2001, have been very mild – much milder than most previous recessions – and the early 1990s recession in particular was felt more strongly in other developed countries, such as the UK and Japan. The exact reason for this is not totally clear, but a number of economists have an interesting answer: inventory manage- ment. A combination of competitive pressure and technological progress enabled managers to manage prices more effectively than they did in the past. Inventory management means that stores typically carry very much less stock than they used to, order more flexibly and price more appropriately, meaning that stuff doesn’t tend to hang about unsold for as long as it used to. Stocks in stores used to be counted by hand and priced by hand, usually once a month or so. Now, with the application of computerised systems, manag- ers can adjust the prices of unsold stocks much faster. One of the poster boys for this revolution
is Wal-Mart, the US low-cost retailer and parent of UK supermarket chain ASDA, which has been the subject of countless business-school case studies on the subject. Wal-Mart has devel- oped inventory management systems that are often acclaimed as the most sophisticated in the industry. With these computerised systems, Wal- Mart managers can tell minute by minute what’s selling and what’s not. As a result, the prices of slow-moving items are cut very quickly so that products don’t go unsold for weeks or months. Of course, Wal-Mart’s competitors quickly followed suit, and now these systems are commonplace within retail management.
As a result of such innovations, prices can adjust quickly to equate supply and demand.
Prices can now fall much more rapidly to get the economy back to producing at full-employ- ment output (Y*). That means shorter, milder recessions.
Why the huge difference between the short run and the long run? Firms aren’t forever stuck with their original catalogue prices. Eventually, they print new catalogues with lower prices. The lower prices entice customers to purchase more, and soon the economy can return to producing at the full- employment output level, Y*.
Putting together the long and short of it
If you’ve got the previous sections tucked under your belt, you’re now an expert in both long-run and short-run responses to an economic shock.
(Congratulations! You’ve earned the right to pontificate at your next dinner party!) We now drive this subject home by putting the two very different responses together into one big picture.
Figure 6-5 lets you see how an economy adapts to a negative demand shock both in the short run and in the long run. The economy begins at point A, where the original aggregate demand curve, ADo, intersects both the LRAS and the SRAS curves. At point A, the economy is in equilibrium because at price level Po, the aggregate demand for output equals the full-employment level of output, Y*. Neither a surplus nor a shortage exists that may cause prices to change.
The SRAS curve is horizontal at price Po to reflect the fact that after the econ- omy reaches its equilibrium (where ADo intersects the LRAS at output level Y*), the prices that are determined at that level are fixed in the short run; they can’t change immediately even if a demand shock happens to come along.
Figure 6-5:
Short- run and long-run responses to a nega- tive demand
shock.
P0 A SRAS
AD1 AD0
LRAS
B
C P
For example, suppose that the aggregate demand curve shifts left from ADo to AD1 because of a negative demand shock of some sort. Because prices are fixed in the short run at Po, the economy’s first response is to move from point A to point B. In other words, because prices are fixed, production falls from Y* down to YLow as firms respond to decreased demand by cutting pro- duction. (Small arrows indicate the movement of the economy from point A to point B.)
At point B, the economy is operating below full employment, implying that there are a lot of unemployed workers. This high level of unemployment causes wages to fall. As wages fall, firms’ costs also fall, allowing them to cut prices in order to attract more customers.
Falling prices cause increased aggregate demand for goods and services, which eventually moves the economy all the way from point B to point C.
(This movement is indicated by arrows on the graph.) When the economy reaches point C, it is once again producing at full employment, Y*.
The short-run and long-run effects of a negative demand shock are basically total opposites of each other:
In the short run, prices are fixed while output decreases.
✓ In the long run, prices decrease while output returns to Y*.
If prices don’t stay fixed for very long, the economy can quickly move from A to B to C. But if prices are slow to adjust to the negative aggregate demand shock, the economy can take a very long time to get from A to B to C. In such cases, a long-lasting recession results during which output remains below Y* and many people are unemployed.
For these reasons, we need to figure out what affects the ability of prices to change quickly. The most important culprit is sticky prices, or more pre- cisely, sticky wages.
Heading toward Recession: Getting Stuck with Sticky Prices
When the economy encounters a negative demand shock like the one depicted in Figure 6-5, price flexibility (or lack of flexibility) determines both the severity and length of any recession that may result. If prices are infi- nitely flexible – if they can change within seconds or minutes after a shock – the economy immediately moves from point A to point C, and all is right with the world. But if prices are fixed for any period of time, the economy goes
into a recession as it moves from point A to point B, before prices eventually fall and bring it back to full-employment output at point C.
In the real world, prices are indeed somewhat slow to change, or, as econo- mists like to say, prices are sticky. Interestingly, they tend to be stickier when going downward than upward, meaning that prices appear to have a harder time falling than rising.
The major culprit seems to be one particular price: wages. Wages are the price employers must pay workers for their labour. Unlike other prices in the economy, people are particularly emotionally attached to wages and how they change over time.
In particular, employees don’t like to see their wages cut. They have a very strong sense of fairness when it comes to their wages and, as a result, usually retaliate against any wage cut by working less hard. (Not to mention that EU employment law has some pretty stern rules against firms cutting wages when workers have contracts!) As a result, managers typically find it counterproduc- tive to lower wages even if a firm is losing money and needs to cut costs.
Cutting wages or cutting workers
Suppose that a negative demand shock hits an economy and greatly reduces sales at a particular company. The firm is losing money, so managers need to figure out a way to cut costs. About 70 per cent of this company’s total costs are labour costs (wages and salaries). Naturally, labour costs are an obvious target for cuts.
But the managers of the firm realise that if they cut wages, employees will get angry and work less hard. In fact, their productivity may fall off so much that cutting wages may make the firm’s profit situation worse: output may fall so much that sales revenues decrease by more than the reduction in labour costs. Therefore, cutting wages isn’t really a good option.
So, instead, the managers lay off a large chunk of their workforce in order to reduce labour costs. For example, if sales are down 40 per cent, the firm may lay off 40 per cent of the workforce. However, any workers who remain employed get to keep their old wages so that they aren’t angry and their pro- ductivity doesn’t fall.
For the reasons we’re showing you here, what you see during a recession is a large increase in unemployment but little decrease in wage rates. The fact that managers are unwilling to cut wages, however, has a nasty side effect: as we discuss in the next section, not cutting wages makes it very hard for firms to cut the prices of the goods and services they sell.
Adding up the costs of wages and profits
Obviously, firms need to turn a profit in order to stay in business. And that means making sure that the price per unit that they charge for their products exceeds the cost per unit of making them.
During a recession, lower aggregate demand means that firms reduce produc- tion and sell fewer units. As we discuss in the previous sections, wages are the largest component of most firms’ costs – in fact, they’re a full 70 per cent of the average firm’s costs. If a firm can’t cut wages for fear of causing worker productivity to drop, it also can’t reduce its per-unit production costs very much. In turn, the firm can’t cut its prices very much because prices have to stay above production costs if firms are to make a profit and stay in business.
What does all this mean? When demand drops off, prices are typically sticky.
They stay high despite the fact that less demand exists for output in the economy. That’s an underlying reason for the economy moving horizontally from point A to point B in Figure 6-5 after the negative demand shock. With prices sticky because firms can’t cut wages, the negative demand shock results in a recession with output falling and unemployment rising because so many workers get fired.
Worse yet, unless prices can somehow begin to fall, the economy isn’t able to move from B to C to get back to producing at the full-employment output level (Y*). Prices do eventually fall, but this process can take a long time, meaning that the negative demand shock can cause a long-lasting recession.
Returning to Y * with and without government intervention
In Chapter 7, we explain how the government can use monetary and fiscal stimuli to get around the sticky prices problem by boosting aggregate demand. Here, we want to give you a preview of how that process works.
Imagine that after the negative demand shock depicted in Figure 6-5 moves aggregate demand leftward from ADo to AD1, the government doesn’t hang around waiting for prices to eventually fall. Instead, it stimulates aggregated demand so that the aggregate demand curve shifts back rightward and returns to where it started, at ADo. Taking this action returns the economy to produc- ing at full employment without having to wait for prices to fall.
What if the government doesn’t act to stimulate aggregate demand in that fashion? What if the economy is at point B and the government doesn’t inter- vene? In such cases, prices do eventually fall because firms’ production costs eventually fall.
As we see in the previous sections, labour costs are very slow to fall because managers don’t want to risk alienating workers by cutting their wages. But because there are so many unemployed workers when the economy is at point B, wages eventually decline. Some firms hire unemployed people at lower wages, which reduces their costs, meaning that they can undersell firms that keep wages high. Eventually, such competitive pressures mean that all firms end up cutting wages.
Other costs also decline, because during a recession, with output so much diminished, a significant portion of the economy’s productive capacity is unused: unused factories, unused trucks, unused train cars and unused ships, as well as large amounts of unused lumber, iron, oil and other produc- tive inputs.
The owners of these unused inputs lower their prices in order to try to sell them. As their prices fall, firm costs also fall, thereby allowing firms to reduce the selling prices of their output. And as these selling prices fall, the economy moves from point B to point C in Figure 6-5, restoring the economy to produc- ing at the full-employment output level (Y*). See how nicely it all (eventually) works out?
Achieving Equilibrium with Sticky Prices: The Keynesian Model
Even if this book is the first on economics you’ve ever laid your hands on, you may have heard the name Keynes before. Who is this guy, and why do economists like him so much?
John Maynard Keynes was the most influential economist of the 20th century.
He was the first economist to realise that sticky prices (caused by sticky wages) are the culprit behind recessions. If you read the previous section, you may not have thought the ideas contained there were revolutionary, but trust us: Keynes’s insight changed the way people studied economies.
What inspired Keynes to have this insight? He was led to the idea by the horrible state that the economy reached during the Great Depression of the 1930s. Just the name itself – Great Depression – gives you some idea how bad things got. Normal economic downturns are called recessions. Really bad
recessions are called depressions. (Yes, technical definitions apply to the two words – see the ‘What makes a recession a recession?’ sidebar, later in this chapter.) But what happened in the 1930s was so bad that people started calling it the Great Depression to indicate just how severe it was.
The Great Depression started with a lingering recession from 1929 to 1933.
This recession is most usually described as beginning with the infamous stock market crash of 1929 (the Wall Street Crash). The United States, for example, didn’t see its output return to its 1929 level until after entering the Second World War in 1941, and the results for the UK were hardly better, although the recession of 1921 was actually the more severe. To put the Great Depression in perspective, look at Table 6-1, which gives data for each of the seven recessions that the United States has experienced since 1960, plus (on the first line) the same data for the Great Depression. We use US data because its consistency over time makes seeing a clear picture a little easier: you can also plot a similar picture for the UK or many other countries.
Table 6-1 The Great Depression and US Recessions since 1960
Start End Duration
(Months)
Highest Unemployment Rate
Change in Real GDP (%)
8/1929 3/1933 43 24.9 –28.8
4/1960 2/1961 10 6.7 2.3
12/1969 11/1970 11 5.9 0.1
11/1973 3/1975 16 8.5 1.1
1/1980 7/1980 6 7.6 –0.3
6/1981 11/1982 16 9.7 –2.1
6/1990 3/1991 8 7.5 –0.9
3/2001 11/2001 8 6.0 0.5
Source: NBER, Economic Report of the President, Bureau of Labor Statistics
As you can see, the Great Depression was far, far worse than any normal recession. Nearly 25 per cent of the labour force was unemployed, and the initial downturn lasted about four times longer than the 10.7-month average duration of post-1960 recessions.
Total economic output as measured by real GDP (which we discuss in Chapter 5) also fell much more than in a normal recession. Because real GDP adjusts for inflation, it captures changes in the physical quantity of output
In comparison, the misery of the Great Depression reached a peak in the UK in 1932. The rate of unemployment topped out at 22 per cent, although output measured by GDP fell by only about 5 per cent over the preceding years. The next worst recessions, in the early 1980s and 1990s, by contrast, were characterised by persistent high unemployment, peaking at 10 per cent, but falls in GDP of only 3 per cent and 1.5 per cent each.
As a witness to the Great Depression, Keynes obviously wanted to figure out what caused such a drastic economic downturn – and what may prevent such devastation from happening again.
Adjusting inventories instead of prices
Not only did Keynes figure out that sticky prices cause recessions, but he also developed a hugely influential model that’s still presented in many macroeconomics textbooks. This model is a small part of a larger approach to managing the macroeconomy that came to be called Keynesianism – an