In this essay, the main cause of great recession in USA is discussed by applying economic theories. For answering this question, the concept of recession is discussed to understand and to relate it to the USA economy. A discussion over the caused, which are considered as the reasons of the great recession in the USA economy, is also included in this essay to cover the different views on the topic. At last, the key reason and its role in creating conditions of great recession in the economy of this country is discussed to answer the question with proper justification.
Recession can be regarded as a phase of economic cycle in which the business activities including trade, etc. are less than the usual conditions. This condition indicates that the size of a country’s economy is shrinking. The key measures of economic activity include income, Gross Domestic Product (GDP), employment, production level and demand of goods (Kotila, 2010). Generally, these measures are used by economists to access the condition of an economy. Decline in these measures in two consecutive quarters is determined as the economic recession. In USA, the condition of recession is when “a significant decline in economic activity across the economy, lasting more than a few months” (Seefeldt and Graham 2013). Thus, the recession means the poor conditions of an economy in terms of generating production, income and employment opportunities.
In 2008, the phase of great recession occurred in the economy of the USA. The reasons of this recession have been a considerable topic of discussion due to the difference in views and opinion regarding this aspect. In accordance to Farmer (2010), collapse in housing price caused the crash of stock market and it leaded the situation of great economic crisis in the economy of US. The decline in stock market is closely associated with the unemployment rate. By depicting Keynesian economics, the relationship between stock market and employment rate is shown. In accordance to this theory, decline in investment affects the level of GDP and consequently demand of job that caused unemployment in a country. It creates conditions of economic recession.
According to (), housing bubble was the main cause of recession in USA. The prices of houses in this country was at peak in early 2006 and after this, it started to decline that caused increase in number of loan defaulters. It affected the functioning of the whole financial system, which originated economic recession. In oppose to this, Brandl (2016) stated that deregulation in the financial system is one of the key causes of depression as due to which financial institutions lent large sum of money to the individuals without evaluating their credit worthiness. Due to this, the financial system in US failed to prevent the financial crisis as the system was broken. The rules and regulations for regulating the banks in this country are quite complex, which cause difficulties in keeping strict, watch over the functions of regulatory system of banks.
On the other hand, Schularick and Taylor (2012) stated that government policies including monetary policy are key cause of financial crisis. In modern economies, financial system itself causes instability, recession and consequently crisis in the economy due to the ill-regulated credit system supported by the monetary policies of the government. From above discussed causes, it is considered that below is the main cause of great recession in USA:
In the formulation of monetary policy of a government, the role of credit was overlooked by the policy makers. In accordance to the pre-crisis Keynesian consensus, inflation and output gap were the key important factor to set the monetary policy and thus the role of credit or monetary aggregates and money both were ignored. The great recession in USA challenged this view and thus arguments for the importance of information in relation to money and credit in decisions of policy makers has aroused (Verick and Islam, 2010).
Monetary policy is used by a tool by the financial authorities of a country to control money supply in the market by targeting interest or inflation rate. There are two forms of monetary policies such as expansionary and contractionary employed to control money supply. In expansionary policy, money supply is increased by different ways such as decreasing interest rate and reducing reserve ratio or repo rates (Montiel, 2011). In contrast to this, contractionary policy is adopted to decrease the money supply.
In the first six years of the 21st century, the household debt was accumulated unequally and thus causes sharp decline in the consumption that caused rescission in the USA. The Dotcom Bubble and the terrorist attack at the end of 20th century and at the beginning of 21st century respectively were slumped the US economy into recession. The policy makers used monetary policy to rescue the economy from the conditions of recession. The expansionary monitory policy has adopted by policy makers and this caused significant decline in the interest rate from 1999 to 2004 (Van Alfen, 2014). The below chart depicts the interest rate during this period:
(World Bank, 2016)
The above chart indicates that the interest rate was declined from 6.8% in 2000 to 1.5% in 2004. This has caused the other financial bubble and consequently recession. The lower interest rate encouraged consumers to lend and spend more than they could have afforded (Carbaugh, 2013). The influence of low interest rate on the major factors of economy is depicted in below graph:
(Openstax, 2017)
The above graph indicates that lower interest rate cause shift in the aggregate demand (AD) to the right from AD0 to AD1. The output level will also increase in this condition as businesses can get loan easily at the lower interest rates to satisfy the increased AD. An increase in demand causes shortage of supply in short-run, which ups the price levels. In US, lower interest rate caused rise in the demand of houses. Due to loose monetary policy, banks borrowed money to the individuals without checking their credit worthiness and this caused housing bubble (Sexton, 2015). The below graph indicates the volume of subprime borrowers:
(BBC News, 2017)
The above graph indicates that the amount of loan in US rose quickly after the year 2002 and the annual volume of subprime also increased. It indicates the high risk of loan defaulter. The prices of houses were also rose in US till 2006 constantly due to the availability of cheap loans (See below graph).
(BBC News, 2017)
The above graph shows that lower interest rate in USA encougred people to buy more homes ad this caused rise in the prices, which caused housing bubble. The policies have played great role in pushing the lender to lend money to almost all individuals without considering creditworthiness. Government guaranteed the loans and due to this buyer did not care to purchase expensive homes (Besanko and Braeutigam, 2010). Banks in USA made the riskier loans and packaged them to sell others. The loans were sold to government enterprises such as Fannie Mae and Freddie Mac, who converted those loans mortgage-backed security (MBS) through securitization. MBS was rated highest by the rating agencies as banks were paid them to rate better the securities and thus it encougred others to buy them. The demand of these securities kept the prices quite high and due to this the prices of houses were rising till 2006 (Mankiw, 2016).
In 2006, government adopted the contractionary monetary policy that caused considerable rise in the interest rates. Below graph indicates change in interest rate in USA:
(World Bank, 2016)
The blow chart shows rise in interest rate and due to this, people become disabled to take new loans and to pay the old ones. The prices of the houses started to decline and this made the MBS quite worthless. The investors refused to purchase MBS and this caused difficulties for big investment banks such as Lehman Brothers to get any new loans. This also caused collapse of Lehman Brothers, AIG, Fannie Mae and Freddie Mac (Gwartney et al., 2016). The major financial institutions were not able to loan money to the businesses and each other and this caused the recession in the country. But, the government bailed out of around more than $7 billion to the major companies and banks for stimulating the economic activities with the borrowed money. In 2008, the interest was also lowered to encourage people to lend money. In 2009, around $1 trillion was pumped in the economy of USA (). The bailout decisions of the government caused considerable and constant increase in the debt of the nation. Below chart shows central government debt of USA in percent of GDP:
(World Bank, 2016)
In 2008-2009, the consumption decline significantly and this caused decline in the aggregate demand that caused a considerable decrease in the real output. The excessive accumulation of debt by the federal government failed to stimulate consumption in the economy and thus consumption level fell down from 4.1 to 2.9 in 2008. It caused increase in the inventory levels of businesses that caused the job cut and consequently unemployment (Hetzel, 2012). The below graph indicates the contribution of decreasing AD in causing the recession:
In US, the decline in AD encouraged business to decline the output level and price both to reduce the inventory level. In order to response the low demand, the business slowed down production that declined jobs in the economy of USA and it further caused sharp decline in the consumption that worsened the condition of economic recession (Sexton, 2015).
Conclusion
It can be concluded that intervention of federal government from the period of 2001 was the main cause of creating great recession. Low interest policy of government of this country created housing bubble and sub-prime mortgage crisis. This decision caused moderate recession but it worsened due to the low interest and bail-out decisions of the government despite of deteriorating conditions of the economy. This caused decline in consumption, real GDP and consequently employment opportunities. Due to massive job cuts in the economy, the demand of goods declined considerably during this time and made the situation worse. In this way, government ways of intervention could have the major reason of great recession in USA.
References
BBC News (2017) The downturn in facts and figures. [Online]. Available at: https://news.bbc.co.uk/1/hi/business/7073131.stm [Accessed: 5 September 2017].
Besanko, D. and Braeutigam, R.R. (2010) Microeconomics. USA: John Wiley & Sons.
Brandl, M. (20016) Money, Banking, Financial Markets and Institutions. USA: . Cengage Learning.
Carbaugh, R.J. (2013) Contemporary economics: an applications approach. ME Sharpe.
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.
Gwartney, J., Stroup, R., Sobel, R. and Macpherson, D. (2016) Macroeconomics: Public and Private Choice. USA: Cengage Learning.
Hetzel, R.L. (2012) The great recession: market failure or policy failure?. Cambridge University Press.
Kotila, I. (2010) SURVIVE THE RECESSION: Spiritual and Practical Tips to Find a Better Financial Future. USA: iUniverse.
Latzko, D.A. (n.d.) Lecture 17: Aggregate Demand and Aggregate Supply, Part 1. [Online]. Available at: https://www.personal.psu.edu/~dxl31/econ4/Fall_2004/lecture17.html [Accessed: 5 September 2017].
Mankiw, N.G. (2016) Principles of macroeconomics. USA: Cengage Learning.
Montiel, P.J. (2011) Macroeconomics in emerging markets. UK: Cambridge University Press.
Openstax (2017) Monetary Policy and Economic Outcomes. [Online]. Available at: https://cnx.org/contents/[email protected]/Monetary-Policy-and-Economic-O [Accessed: 5 September 2017].
Schularick, M. and Taylor, A.M. (2012) Credit booms gone bust: monetary policy, leverage cycles, and financial crises, 1870–2008. The American Economic Review, 102(2), pp.1029-1061.
Seefeldt, K. and Graham, J.D. (2013) America’s Poor and the Great Recession. USA: Indiana University Press.
Sexton, R.L. (2015) Exploring economics. USA: Cengage Learning.
Van Alfen, N.K., 2014. Encyclopedia of agriculture and food systems. USA: Elsevier.
Verick, S. and Islam, I. (2010) The great recession of 2008-2009: causes, consequences and policy responses.
World Bank (2016) Central government debt, total (% of GDP). [Online]. Available at: https://data.worldbank.org/indicator/GC.DOD.TOTL.GD.ZS?end=2016&locations=US&start=2005&view=chart [Accessed: 5 September 2017].
World Bank (2016) Real interest rate (%). [Online]. Available at: https://data.worldbank.org/indicator/FR.INR.RINR?end=2010&locations=US&start=1999 [Accessed: 5 September 2017].
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