A recession is a period (lasting longer than a few months) of temporary economic decline during which trade and industrial activity contract, generally identified by negative GDP for two consecutive quarters.
Looking at the aggregate supply (AS), aggregate demand (AD) model, we can analyze what happens in a recession and how the Federal Reserve responds. It is critical that traders and investors understand where we are at in the business cycle so as to be in on the right side of the trade. Timing Bull/Bear cycles and sector rotation is a critical skill for traders.
Stage 1: The economy is at full employment, Q1 where AS1 (aggregate supply) intersects AD1 (aggregate demand) at a price of P1.
Stage 2: The Great Recession hit causing a demand shock, shifting the aggregate demand back to AD2. Consumers reduce their spending and businesses reduce their investment. The new equilibrium is a recessionary output of Q2 at a price of P1. And the result is a recessionary gap equal to Q1 minus Q2.
The Great Recession had a wicked negative feedback loop or multiplier effect.
In the graph above, phase one is an aggregate demand shock, which leads to $100 billion in unsold goods from a reduction in aggregate demand. In phase two, this leads to a cutback in employment and wages. While in phase three, this leads to a reduction in income. Now assuming a marginal propensity to consume of 0.75, we see a reduction in consumption of $75 billion in phase four. This triggers a cutback in sales and further cutbacks in employment, and the process continues to go around in a negative feedback loop.
Stage 3: Wages, prices, and interest rates fall, as a result of the recession. This causes aggregate demand (AD) to move downward, along the aggregate demand (AD) curve.
At the same time, the supply curve (AS) shifts out to AS2, as firms hire more workers, and expand output. Together, these price and wage adjustments drive the economy back to full employment at Q1 and close the recessionary gap, but at a new and lower price of P2.
The Federal Reserve intervenes to increase AD.
The figure above shows how an expansion of the supply of money causes a rightward shift of the aggregate demand curve from AD to AD prime. Note that in the range of this shift; the aggregate supply curve is relatively flat. This Keynesian range reflects the presence of unemployed resources and recessionary forces. In this region, we get a very small increase in the price level from the Federal Reserve’s expansionary monetary policy and a large increase in real GDP as equilibrium moves from E to E prime. This is exactly what we saw with the larger increases in GDP in 2010 through 2012.
If the Federal Reserve tries to push the aggregate demand out even more to E double prime, this is well past the economies level of potential output or potential GDP. Here, the slope of the aggregate supply curve turns steeply upward. In this fully employed economy, the higher money stock would be chasing the same amount of output so that the major impact of the Fed’s expansionary policy would be to significantly raise the price level, with little increase in real GDP and this is where we are currently at in the economy.
The next stage is that the Federal Reserve wants to see the price level (CPI, PPI) rise which would indicate the time to raise interest rates. The process of the Fed raising interest rates is as follows.
The Fed reduces reserves R, through open market operations which causes the money supply M to contract, and interest rates I, to rise. In the GDP formula (GDP = C + I + G + (Exports – Imports), this interest rate rise, not only reduces investment I, but it also reduces consumption expenditure C and net exports. The cumulative effects of a fall in I, C and exports are to push aggregate expenditures or aggregate demand down in doing so real GDP and inflation likewise go down, thereby achieving the desired policy goal.<< Back to Glossary Index