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The Definition and Nature of Economy

Question:

Discuss About The Journal Of Economic Dynamics And Control?

By the term “economy”, the overall condition of a geographical area, in terms of the production and consumption of goods and services within a particular span of time, is meant, with the productive activities being measured mostly in monetary terms. The economy of a country is inherently supposed to be dynamic, with the dynamism being created by the interaction of the supply and demand forces and other crucial economic indicators, which in turn causes short term as well as long term fluctuations in the economy of the country (Mian and Sufi 2015). The mutual interactions of these economic indicators and their fluctuations, often leads to deviations from the economic equilibrium, thereby giving rise to abnormal situations in the economy which can be short spanned or continue to persist for long, depending upon the nature and magnitude of the fluctuation. One of the most significant of such situations is recession, which means an overall decline and stagnating of the productive and economic activities of a country for considerable period, thereby having considerable implications on the economy of the concerned country. The essay tries to discuss the occurrence of one such phenomenon, the Great Recession, which had its initiation in 2007-08, in the USA and left a long-term impression on the economy of the country as well as the global economy as a whole. The main objective of the essay is to find out and analyze the primary causes of this Great Recession of the USA and its impact on the economy, providing explanations of these causes, in terms of economic concepts (Giuliano and Spilimbergo 2013).

As discussed above, the temporary slowdown of an economy, in terms of its production activities, trade dynamics, industrial conditions and a lessened confidence of the people over the monetary and stock markets of the economy, can be termed as a recession. The slowing down of the overall economic growth of the country can be seen from the poor performances of the same in different economic indicators, especially Real GDP and Real GDP per-capita growth rates, which decline strikingly during that period (Gabisch and Lorenz 2013). An economy, by its inherent dynamic nature, undergoes continuous changes, the rough pattern of which can be explained with the help of the concept of the Business Cycle, which is discussed as follows:

Figure 1: Business Cycle in an Economy

The Downturn of an Economy: Recession

(Source: As created by author)

In a business cycle, there are four phases, namely expansion, peak, contracting time and trough, which occurs in succession. In the contractionary period, when the economy hits the lowest of the lows, it signals the occurrence of a recession, which graphically is signaled by a trough, as shown in the above figure. Recession, apart from reducing the GDP statistics, also reduces the employment generation, increases the unemployment and poverty issues, decreases the aggregate demand and supply of the country and thereby, cumulatively reduces the overall well being of the residents of the concerned economy. The cyclical nature of recession often creates a vicious cycle of suffering in the economy, by continually aggravating the negative performances of the economy, thereby leaving long term implications on the economic healthcare of the country, which takes a considerable amount of time to wither out (Sherman 2014).

Among the various factors, which cause the advent of a recessionary situation in the economy, few of the most significant ones are elaborated in the following section:

  1. a) Fluctuations in interest rates- A faulty monetary and fiscal policy framework can lead to adverse fluctuations in the interest rate prevailing in an economy, thereby hampering the business and investment activities of the economy significantly, often leading to recession.
  2. b) Stock market shocks- The stock market being one of the backbones of the monetary framework of any economy, huge fluctuations in the stock market can lead to loss of confidence on part of the investors and can make them skeptic about the profitability of investing, thereby leading to a crash in the stock market. This may mark the beginning of recession in that concerned country (Ehrenberg and Smith 2016).
  3. c) Irregularities in residential and other asset markets- Housing increasingly becoming one of the primary arena of investment, a fall in prices of the residential assets, may also trigger a recession. With the fall in the prices, the market sees immense number of foreclosures, the problem becoming more severe in the high-developed regions, where residential investments form a significant share of the total investment activities.

Apart from the above factors, there can be many other causes of recessionary pressure in the economy, which varies according to the nature of the economy and other endogenous characteristics of the country (Farmer 2012).

The United States of America is the one of the strongest global economies, for the last few decades and enjoys significant power and influence on the global economic scenario. The monetary and fiscal policies of the country not only have implications on the domestic economy itself, but also have the capacity to influence the health of the global economy. The economy of the USA, though is one of the most robust economies in the world, has experienced its share of fluctuations over time, the two most significant of them being the Great Depression of the 1930s and that of the Great Recession, the latter leading to a Global Economic Crisis. The latter approximately continued to persist in the global economy for the period 2007-2009, with the recovery starting from early 2010 (Rabie 2013).  

The advent of the recessionary conditions started in the economy of the USA, from the last quarter of the year 2007, as can be seen from the data of the National Bureau of Economic Research with the simultaneous occurrence of several striking phenomena in the investment and stock markets of the country. As seen from the data provided by them, there was a 51% contraction in the GDP of the country and huge negative repercussions on the overall employment and aggregate consumption expenditures of the economy, the overall condition of the country had similarity to that which prevailed at the time of the 1930’s Great Depression (Rabie 2013).

The Business Cycle

Figure 2: GDP Growth Rate of the USA

(Data.worldbank.org, 2017)

As can be seen from Figure 2, the GDP growth rate of the country plunged steeply to a high negative value, during that period, thereby providing evidences of the recessionary conditions of the country, which decreased the economic activities of the same drastically. The decrease in the overall productive activities of the country had immense implications on the employment scenario of the country.

Figure 3: Employment Population Ratio: USA (1900-2016)

(Source: Bls.gov, 2017)

Figure 3 shows the drastic fall in the employment population ratio of the country during that period, the sheer magnitude of which had a long term effect on the overall economy of the country as the ratio of the country since then had not still now came up to match the pre-recession levels. There was a loss of almost 7.5 million jobs in the country itself, which had tremendous repercussions in the economy as a whole (Enelow 2016).

Figure 4: Changes in Personal Consumption Expenses in the USA

(Source: Bls.gov, 2017)

The shocking decrease in the employment numbers had direct implication on the aggregate demand statistics of the country, which can be seen from the decline in the personal consumption expenditures of the country during that period. The fall in the aggregate demand in its turn reduced the supply side activities of the country significantly thereby, increasing the recessionary pressure and marking the initiation of the Great Recession in the economy and the Global Financial Crisis in the global economic scene (Fairlie 2013).

The Great Recession, which started in the economy of the USA, in 2007 and had immense implications on the economic health of the country as well as on the global economy, effecting almost all the leading countries adversely and creating a huge financial crisis all over the world. The causes of this phenomenon had always been an issue of huge debates among the economists and policy-makers of the world. However, almost all the economists unanimously agree on the contribution of several key factors to the initiation of the recession. These factors are discussed below:

One of the primary and probably the most important reasons for the occurrence of the Great Recession in the USA was the bursting of the huge bubble in the residential investment sector of the country. Post Great Depression (1930s), the economy of the USA had recovered and started prospering impressively, soon acquiring the position of the global leader in an overall framework. The huge increase in the GDP as well as the population of the country gave rise to a booming housing sector with a continually increasing demand for housings. The housings were no more just facilities for accommodation, but with continuous increase in their value, they were also treated as an alternative form of asset building for the households. The prevailing notion regarding the stability in the price increase, attracted both commercial investors as well as households to venture in the residential market, during this time (Jagannathan, Kapoor and Schaumburg 2013).

The Great Recession of the USA

The interest rates prevailing in the economy, were also low and were to some extent deliberately kept at low levels to facilitate the inflow of investments in all the market, including the residential market. The banks and financial organizations, including the insurance companies started venturing in this market, facilitating easy borrowing of money for the investors and households, to invest in the residential sector. The lucrative mortgage facilities, very low initial down payments and interest-only loan structures introduced by them, induced the households to buy those housing assets, which were otherwise unaffordable by them. A section of entrepreneurs started buying these housings and selling them at even higher prices, thereby prospering immensely. All of these, cumulatively contributed in creating the housing market bubble, which much to the shock of the speculators and investors, did burst in due course of time (Jagannathan, Kapoor and Schaumburg 2013).

Figure 5: The creation and bursting of the housing market bubble in the USA

(Tradingeconomics.com, 2017)

The bubble burst occurred with a sudden drastic fall in the prices of the housing market of the country, after which the prices went on seeing a continuous decline. This fall in the prices, led to the loss of confidence of both the households and the investors from the housing market and its future profitability, which in turn led to a huge foreclosure in the residential market with a lot of its potential and existing investors withdrawing from the market. The commercial banks and the insurance companies were the worst hit with the bailing out of nearly 700 billion USD from the residential market.

The housing sector bubble burst had a direct relation with the astonishing crash in the stock market of the country, which led to immense negative implications on the monetary health of the country. This led to bankruptcy of many prominent investment banks and financial institutions of the country, thereby making the scenario even worse for the country and for the global investment statistics (Farmer 2012).

Figure 6: Fall in the Net Worth of Household

(Imf.org, 2017)

The household market lost nearly 16 trillions of dollars, which affected the stock market massively.

The largest bankruptcy in the history of the economy of the USA happened during this period (2008), with the filing of bankruptcy of the Lehman Brothers, one of the largest investment banks in the country, with a significant global business. The bank participated in the housing bubble hugely, by creating mortgage originations. The bursting of the housing bubble immediately affected the bank so adversely that the company with over $600 billion asset holding, had to file for bankruptcy, thereby decreasing the Dow Jones by 500 points and significantly affecting the global stock market (Hansen 2015).

Causes of The Great Recession

The activity of exporting a good or service by a company or country to some other country at a price lower than that is prevailing in the domestic market of the importing country is known as dumping and this activity has severe significance on the international trade. The Great Recession, which occurred in the USA, also had as one of the causing factors, the dumping activities of another global economic giant, China, who at that point of time was experiencing economies of scale in its industrial sector. The overall slowdown of the supply side dynamics coupled with the dumping activities of China, had a huge adverse effect on the productive activities of the economy of the USA (Mäler 2013).

Conclusion

From the above discussion, it can be concluded that one of the greatest economic disasters, which occurred in the economy of the USA and had severe implications in the global economy was the Great Recession of 2007-2008, which was coupled with the Global Financial Crisis, affecting almost all the prominent economies in the world. The primary reason for the occurrence of this recession being the burst of the bubble created in the housing market, there were other factors affecting the economy too. The huge stock market crash, bankruptcy of big investment banks like the Lehman Brothers and the dumping activities of other leading economies like China also had implications on the supply side dynamics of the USA, thereby aggravating the recessionary pressure.

References

Bls.gov (2017). [online] Available at: https://www.bls.gov/web/empsit/cps_charts.pdf [Accessed 7 Sep. 2017].

Data.worldbank.org (2017). GDP (current US$) | Data. [online] Data.worldbank.org. Available at: https://data.worldbank.org/indicator/NY.GDP.MKTP.CD [Accessed 16 Sep. 2017].

Ehrenberg, R.G. and Smith, R.S., 2016. Modern labor economics: Theory and public policy. Routledge.

Enelow, S., 2016. THE GREAT RECESSION. Film Comment, 52(5), p.56.

Fairlie, R.W., 2013. Entrepreneurship, economic conditions, and the great recession. Journal of Economics & Management Strategy, 22(2), pp.207-231.

Farmer, R.E., 2012. The stock marketing crash of 2008 caused the Great Recession: Theory and evidence. Journal of Economic Dynamics and Control, 36(5), pp.693-707.

Farmer, R.E., 2012. The stock market crash of 2008 caused the Great Recession: Theory and evidence. Journal of Economic Dynamics and Control, 36(5), pp.693-707.

Gabisch, G. and Lorenz, H.W., 2013. Business cycle theory: a survey of methods and concepts. Springer Science & Business Media.

Giuliano, P. and Spilimbergo, A., 2013. Growing up in a Recession. Review of Economic Studies , 81(2), pp.787-817.

Hansen, P.H., 2015. Hall of mirrors: the great depression, the great recession, and the uses—and Misuses—of History. Business History Review, 89(3), pp.557-569.

Imf.org (2017). IMF Data. [online] IMF. Available at: https://www.imf.org/en/Data [Accessed 16 Sep. 2017].

Jagannathan, R., Kapoor, M. and Schaumburg, E., 2013. Causes of the great recession of 2007–2009: The financial crisis was the symptom not the disease!. Journal of Financial Intermediation, 22(1), pp.4-29.

Mäler, K.G., 2013. Environmental economics: a theoretical inquiry (Vol. 7). Routledge.

Mian, A. and Sufi, A., 2015. House of debt: How they (and you) caused the Great Recession, and how we can prevent it from happening again. University of Chicago Press.

Rabie, M., 2013. The Great Recession. In Saving Capitalism and Democracy(pp. 103-115). Palgrave Macmillan US.

Rabie, M., 2013. The Great Recession. In Saving Capitalism and Democracy(pp. 103-115). Palgrave Macmillan US.

Sherman, H.J., 2014. The business cycle: growth and crisis under capitalism. Princeton University Press.

Tradingeconomics.com (2017). United States GDP Growth Rate | 1947-2017 | Data | Chart | Calendar. [online] Tradingeconomics.com. Available at: https://tradingeconomics.com/united-states/gdp-growth [Accessed 16 Sep. 2017].

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