Recession and Business Cycle in the US of 1990-91

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Table of Contents

Introduction
Causes of Recession
Fiscal Policy
Monetary Policy
The Recovery and Expansion
Conclusion
Works Cited

Introduction

In economies around the world, a number of factors affect the operations of national income and expenditure that is gauged as the economic status of a country at a particular time. Economic barometers are the preserve of policy economists in the government with the understanding of both domestic and foreign fiscal policies at play in a country at that time. The status of a country’s economy is usually determined in collection of these measures, and done in quarters of fiscal years. These quarters may indicate economic growth or turndowns. The latter indicates a state in economic problems, either in domestic economy or in foreign economic terms and refers to an economic cycle.

Economic cycle (or business cycle) is the process of fluctuations in the activities of an economy and depicts its long term growth trends. The process involves periods of growth characterized by economic recovery and prosperity or stagnation characterized by retardation or recession. The general measure of the business cycle is the gross domestic product (GDP). When the GDP experiences a negative growth in two consecutive quarters, the economy is said to be undergoing recession.

This corresponds to the contraction phase of a business cycle. NBER (www.nber.org.) defines recession as “A significant decline in economic activity….. normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales”.

In this paper, an interactive analysis of the worst recession to have hit the United States economy in its recent history is presented. The causes of the 1990-1991 recession, its effects and analysis of the fiscal and monetary policies are presented using relevant economic models. The presenter further analyses how the recession was curtailed and the factors that led to the recovery of the economy. The writer concludes the study by summarizing the market perspective of the recession in reflection of all the three parameters mentioned above, i.e. causes, effects and recovery.

The recession that according to (www.nber.org, par.3) started in July 1990 and ended in March 1991, was also the worst in the world. Its effects were not only felt in the US. Other big world economies were also affected. The turndown started in North America and the UK which saw corporate profit rates peak in late 1988 while profits declined in among other countries, Germany and Japan save for those in the US and UK. This led to a fall in new investments and a decline in GDP and investment close to 7 percent and was the biggest since 1975 (Bernanke, 112).

Causes of Recession

The causes of recession are varied but there is a general feeling that the major factors contributing to recession are market speculations, economic inflation, national debt, currency crisis and to some extent, the existence of war. These factors contribute singly or in collection to affect the determinants of demand and supply in the commodity market and create changes in GDP growth, the national rate of employment and rise or a fall in prices of goods.

Speculation contains the feeling of assumed risk that creates loss for a possible rewarding venture or investment. It involves the processes of buying and holding of goods, selling or short selling of bonds, currencies, stocks or commodities, all forms of valuable instruments to gain in their fluctuating profits. This is done in contravention of normal channels of purchase to use such as through dividends or interests.

Crisis in currency or balance-of –payments crisis usually characterizes circumstances where there is a quick change in the value of a currency. This therefore reduces its worth to be used as a medium of exchange or as a way to store the value of a product.

Government debt refers to public money owed by any department of government and becomes an indirect debt to the taxpayer. These debts can be accumulated through deficit spending by the government at the expense of the amount of taxes levied. The categories of these debts can be internal such as money owed to investors within the country or external debt from foreign borrowing.

The factors mentioned above usually affect the aggregate demand and aggregate supply with direct effects on the country’s GDP, rate of employment and inflation. In the 1990-91 recession scenarios, the biggest contributions were the oil price increase in 1990 that saw an increase in inflation, massive deficit in government budget that slowed GDP and caused high cynical unemployment. This was further aggravated by a currency crisis occasioned by a decrease in aggregate demand (Robert, 275-279).

Aggregate demand is the demand for goods and services (Y) at a time and at a given level of price or simply the demand for GDP at stable inventory levels. It shows the various amounts of real domestic output that domestic and foreign buyers desire to purchase at each possible price level and an inverse relationship between price level and domestic output. An inverse relationship is not the same in the explanation for demand for a single product, which centers on substitution and income effects (Bade et al, 1810-1811). AD measures real GDP on the horizontal axis. AD curve sums all curves for different sectors of the economy. Thus,

Yd = C + I + G + (X- M)

Where C= Consumption = a_c + b_c*(Y – T), I = Investment, G = Government spending and X-M is the difference in total exports (X) and imports (M).

The model can also help determine the extent to which increases in aggregate demand lead to increases in real output or instead to increases in prices. An increase in any of the components of AD shifts the AD curve to the right. This increases both the level of real production (Y) and the average price level (P). If price rises, aggregate expenditures will fall because purchasing power of wealth falls, interest rates may rise, and net exports fall. If price rises further, real asset balance value falls, interest rates rise again and net exports fall. The equilibrium level of output determines the equilibrium level of employment in the model. Bringing in other considerations may imply this correspondence, though (Campbell, 27).

According to Broaddus (pg 13, par 6), when price levels fell, the purchasing power of existing financial balances rose. This increased spending. This state is referred to as the real balances effect. Also a decline in price level meant lower interest rates which increased levels of certain types of spending.

Similarly the foreign purchase was affected since other things being equal, U.S. prices fell relative to foreign prices, which increased spending on U.S. exports and decreased import spending in favor of U.S. products that compete with imports. Dollar depreciation discouraged importation into the country with serious effects on the exchange markets. The dollar could not be exchanged for as much money for different foreign currencies. These realignments affected the aggregate expenditure for given price levels during the time.

Fiscal Policy

When the government is involved in funding a deficit through the use of bonds, there occurs an increase in interest rates in the money market. This is as a result of government borrowing which creates a deficit, causing the aggregate demand to be high since disposable income starts to disappear in contravention to the objectives of deficit in budget. This concept is referred to as crowding out. In another related instance, through funding big projects such as construction or infrastructure development, government may increase its spending. This can also cause crowding out since opportunities are lost by private investors in undertaking the same project.

Another problem is the time taken between actual implementation of the policy and realizing what is affecting the economy. An approach to expansionary fiscal policy that is characterized by a decrease in taxes or an increase in government spending is normally enforced to increase in the aggregate demand for the fiscal period. However, if this spiraling in aggregate demand is not checked, it may easily lead to inflation. This therefore justifies the role of government in checking the effects of AD (Borio, 28).

When an economy experiences a slide into recession, it causes a decreased price level and a lowered GDP. This further affects the full employment which is calculated as a percentage of the GDP. The effect is an increasing negative GDP. If the government regulating agency decides to take an expansionary fiscal policy which shifts the aggregate demand curve to the right, the economy will respond by registering a full employment output free of the effects of inflation (Bootle, 113).

An increase in government spending also has the potential of creating an expansionary effect. This can also be registered with a decrease in taxes or a combination of the two effects. This can be used to eliminate the negative GDP gap created by recession. This approach can be used to restore full employment as a real measure of GDP.

While fiscal policy may be instrumental in increasing the aggregate demand, it does not act in total exclusion. Borrowing to finance deficit spending occasioned by the fiscal policy measures has a potential to increase interest rates that further crowds out investment spending. This can weaken the original idea of expansionary fiscal policy and even render it ineffective.

In the 1990-91 recession scenarios, the government increased its borrowing to fund domestic debts. This spiraled into a decreased aggregate demand that affected the economy. The government attempted to use specific discretionary policies to focus on long run issues of reforming tax and the state of social security. However, owing to the failures occasioned by these policies earlier, they were rejected by the congress on the basis that they were countercyclical and not able to stimulate growth from the recession.

Monetary Policy

The Fed’s job in creating stability of outputs in the shorts run and promoting stability in prices stability in the long run involves several steps. The Fed initially estimates how the economy is currently performing and how it’s likely to do in the near future. It then compares these estimates to its goals for the state of the economy and inflation. If a gap exists between the goals and the realized estimates, then Fed then has to decide how forcefully and how swiftly to act to close that gap. The lags in policy can complicate this process. But so do a host of other things. These include variables like employment, growth, productivity, and so on which reflect conditions in the past, not conditions today (Broaddus, 18).

Fed initially finds out what the most pertinent economic developments are such as taxing policies and policies on spending, important economic developments outside the country, foreign and domestic financial conditions, and the use of new technologies that promote productivity. The developments assumed in this process are then integrated into an economic model to observe how the economy is likely to develop over time. It’s hard to be sure about any approximation, in part because it’s hard to be sure that the model or meter the estimate is based on is the functional and right. There’s another important impediment in estimating the rate of highest sustainable growth; the fact that it can shift with time.

The experience of the 1990s provided a good example of the policy problems caused by such a shift. During this period, output and productivity surged at the same time that rapid innovation was transforming the information technology industry. In the early stages, there was no way for the Fed to tell why output was growing so fast.

The contributions of the Gulf war partly due to its costs and the uncertainty that accompanied it. The effects was to last a whole eight months of recession. This was followed by the oil prices spiking up from around $15 to over $35 per barrel which lasted up to early 1991. The result was an apparent postponement of household spending awaiting the outcome of the war. The economic activity contracted up to march 1991.

Monetary policy became less influential in averting the effects of the war because of the lag associated with policy implementations. At this time, the Fed was struggling from a credibility crisis that followed their handling of inflation. CPI inflation recorded a rise of up to 5.3 percent with a risk in inflation scare in the bond market if it responded by cutting the funds sharply. The reaction of the Fed was to bring the rates down to 6% at the close of the recession. The measures taken prior to the war and the happenings during the recession saw a recess in inflation with core CPI inflation decreasing to 4.4% by the end of the period.

The recovery was equally slow owing to the severity of the recession. Unemployment rose to about one percent during the period from the lower 5.5% at the start of the recession. The unemployment rate climbed marginally and peaked at 7.8 % by June 2002 in the wake of the GDP snapping back to 4% from 0.8 % between the periods March 1991 and June 1992. The monetary policy reaction saw the federal funds rate reduced from 6% in July 1991 to 4% by December 1991 and to 3% by October 1992. Inflation also fell with 3% by 1992.

The stance taken by the Fed was caused by the high rate of rising unemployment, the less capital in the banking system, expensive banking loans, the reduction in inflation and the gains against inflation that increased the credibility of the Fed so as to move to a minimal federal funds rate to stimulate AD and growth in jobs.

The move was very crucial because of the tendency of the policies to react differently relative to the exact reason of the economy’s faster growth. If it was assumed to react to new technology spread which improved worker and capital productivity, indicating that the trend growth rate was higher, then the economy could swell faster without causing inflationary pressures. In that case, monetary policy could stand touch. But if it was just the economy encountering a more ordinary business cycle growth, then price increases (inflation) could heat up. In that case, monetary policy would need to tighten up. The latter scenario was the case as the inflation heated up.

The Fed’s job became intricate because of the fact that statistical theories did not find sufficient evidence to suggest a change in the trend growth rate. But the Fed considered a range of indicators, which included the profit data from firms, as well as at unofficial evidences, such as anecdotes, to come to a conclusion that the majority of the verifications were consistent with an increase in the trend growth rate. On that foundation, the Fed did not tighten economic policies as much as it would have otherwise.

The turndown was characterized by fiscal effects reflected in interest rates and expectations of profit. High business taxes and a change in government spending that declined marginally. There was also a decreased net exporting that had no relation to price levels. The latter were as a result of low incomes abroad and low exchange rates for the dollar.

The Recovery and Expansion

By the end of the quarter, the Fed had to balance its policies over the uncharacterized inflation and recovered from the operational lags in implementing its fiscal policies. It undertook increasingly controlled expansionary monetary and fiscal policies. The policies on government’s taxing and spending as well as economic developments abroad had to be marginally reduced. Financial conditions at home and abroad had to be restructured to slow down spending through deficit spending techniques (Robert, 260).

The expansionary policies saw a downward trend of 4.7 % of the GDP on actual budget deficit and 2.9% of the GDP of full employment budget deficit in 1990 to lower to less than 3% of GDP in budget deficit in April 1993. This saw the expansion of aggregate demand and a rise in employment rates with minimal inflation. The government reduced its deficit in primary budget that resulted in reduced spending by the government. This also saw an increase in tax revenue although at low rates to supplement private growth. The duration of this fiscal adjustment was very short and the cuts in expenditure were substantial to see a largely positive proportional gain in taxes.

To finance the requirements of supply on capital formation, the Fed continually utilized controlled budgeting. This approach was to maintain public employment at the expense of consumption and capital transfers. The responses were, to a great extent, fiscal and avoided uneven ideology in dealing with uncontrolled expansion. The tax curve was flattened to correspond to the effects experienced on different tax brackets during the period. The full employment budget deficits were projected to show growth as the economy recovered from the recession.

The large actual and full employment rates threatened to result in high interest rates as it approached 1993. There was a threat of low investment and slowed economic growth. However, the Clinton administration increased personal income and corporate income tax rates to prevent these outcomes escalating into another recession. This counterbalance saw full employment budget deficit shrinking for the next couple of years with the country recording a surplus in 1999 (Robert, 264).

The real short rate was to be until 1994 February. This saw an increased employment rate of about 1.2 percent for the eighteen months following the monetary policy adjustments. The inflation rate also followed to fall slightly while the bond rate also fell to about 6 % in 1993. This was attributed to a weak expansion in the economy and a slow progression against the budget deficit during the time of recession. Another explanation of the fall in long bond rates was the acquisition of credible stance for low inflation that was attributed the Fed for the deflationary policy actions that had bogged them since 1988.

Conclusion

The challenges of recession in the US economy have been varied. These included rising inflation, restricted monetary policy, preemptive actions in the monetary policies, and the wars in Iraq and the war on terrorism among other policy imbalances and lag in reaction due to political ideologies. The Fed has grown more transparent in telling about the federal fund rates and shifting monetary policy to adapt to their credibility sustenance.

The 1990-91 was one of the periods that registered long cynical expansions in the economy of the United States. Much of the curious solutions that were adopted and promised did not work out. It turned out to be as difficult to manage just as the previous recessions prior to 1987 were. However, the fiscal and monetary reactions associated with transparent and focused regulatory framework enabled recovery from the recess.

Works Cited

Bade, Robin and Parkin, Michael. Foundations of Macroeconomics. 3^rd Ed, 2007.

Miguel A. Kiguel, “Stagflation” Journal of Economic Literature, Vol. 23, No. 4. 1985, pp. 1810-1811.

Bernanke, Ben, and Mark Gertler. “Monetary Policy and Asset Price Volatility.” In New Challenges for Monetary Policy. Kansas: Federal Reserve Bank of Kansas City, 1999, 77–128.

Bootle, Roger. 1996. The Death of Inflation. London: Nicholas Brealey.

Borio, Claudio, and Philip Lowe.. “Fiscal, Asset and Monetary Stability: Exploring the Nexus.” Bank for International Settlements. 2001.

Broaddus, Alfred. “Transparency in the Practice of Monetary Policy.” Federal Reserve Bank of Richmond Economic Quarterly. 2001.

Campbell, McConnell, and Brue, Stanley. Economics: Principles, Problems, and Policies McGraw-Hill, 2004.

NBER. List of US Business Cycles. 2008. Web.

Robert, Hall. Macro Theory and the Recession of 1990-1991. The American Economic Review, Vol. 83, No. 2, 275-279. 1993.

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