Economic decline Notes

What Is Economic Decline?

1. Economic decline describes a sustained weakening of economic activity in a country or region.
2. It is usually recognised through falling real output (often measured by GDP), rising unemployment, and worsening confidence among households and firms.
3. Economic decline matters because it affects living standards, job security, government finances, and, in many cases, inequality.

How Is Economic Decline Seen Through Output, Jobs, and Prices?

When an economy declines, we typically observe changes in three broad areas: output, employment, and the price level.

A common threshold used in many courses is:

In addition to output, economists look at the price level.

Changes in the price level are described using three key terms:

1. During economic decline, inflation often falls (disinflation), and in severe cases prices may fall overall (deflation).
2. This is not automatically "good" for consumers, because falling prices can reduce business revenues and wages, and can lead firms to cut jobs.

How Does Aggregate Demand Summarise Spending in the Whole Economy?

A key way to understand economic decline is to track total spending in the economy.

1. Aggregate demand can be written as:
2. $$AD = C + I + G + (X - M)$$
3. where:
   1. $C$ is consumption by households
   2. $I$ is investment by firms
   3. $G$ is government spending
   4. $X$ is exports (foreign spending on domestic goods)
   5. $M$ is imports (domestic spending on foreign goods)
4. Economic decline often starts when one or more of these components falls.
5. For example:
   1. households cut consumption because they fear unemployment
   2. firms cut investment because sales expectations worsen or borrowing becomes harder
   3. exports fall because overseas economies slow down

How Does The AD/AS Model Show How Recessions Can Happen?

The aggregate demand and aggregate supply ($AD$/$AS$) model explains how the overall price level and output are determined.

1. In many recession stories, the key event is a fall in aggregate demand.
2. When $AD$ shifts inward (left), equilibrium output falls.
3. This is one clear mechanism for economic decline.

1. In the diagram:
   1. Aggregate demand (AD) shifts leftward from AD₁ to AD₂.
   2. Real output falls from Yp to Yrec.
   3. The price level falls from Pl₁ to Pl₂, or the rate of inflation slows.

What Was The 2008–09 Financial Crisis?

Case study

The 2008–09 Financial Crisis Shows How Decline Can Spread through Credit

• The 2008–09 crisis (often called the Great Recession) is a useful example of how economic decline can begin in one market and then spread across the entire economy.
• A simplified chain of events is:
  • Mortgage lending expanded strongly, including loans to borrowers with weak credit histories (known as subprime borrowers).
  • A very strong housing market led to rapid house price increases, with prices roughly doubling over the years leading up to the crisis.
  • When interest rates rose and many mortgages proved unsustainable, more borrowers defaulted and some were evicted.
  • Forced sales and lower demand placed downward pressure on property values.
  • Mortgage debts, along with other debts (car loans, credit card debt, student loans), had been repackaged and sold globally as financial instruments called derivatives.
  • As mortgages were not repaid and house prices fell, banks and lenders incurred losses, and the derivatives linked to these assets also fell in value.
  • The result was a severe tightening of lending, a credit crunch, which reduced borrowing for households and firms.
  • Because spending (especially consumption and investment) fell, $AD$ decreased, GDP fell, and many economies entered recession.

1. This example highlights an important idea: economic decline is often amplified by the financial sector.
2. When banks restrict credit, even firms with good business ideas may cut investment because they cannot finance it.

Why Does Unemployment Rise When Labor Demand Falls?

Economic decline is not only a story about GDP. It is also a story about the labour market.

1. In the labour market:
   1. the supply of labour comes from individuals willing and able to work at each wage
   2. the demand for labour comes from firms willing and able to hire workers at each wage
2. During a recession, firms struggle to sell enough output.
   1. To reduce costs, many firms reduce production and hire fewer workers.
   2. That means demand for labour falls, creating unemployment.

1. In the diagram:
   1. Labour demand shifts leftward from D₁ to D₂.
   2. Equilibrium employment falls from L₁ to L₂.
   3. the gap between people wanting jobs and jobs offered represents unemployment

Why Are Developing Countries Hit Harder By Global Downturns?

1. Economic decline in one part of the world can quickly affect others.
2. Developing countries are often more vulnerable to global shocks for several reasons.
3. One major channel is through falling prices of key exports.
   1. Many developing countries rely heavily on a small number of primary commodities (for example, agricultural products or minerals).
   2. When global demand weakens, commodity prices can fall.
   3. During periods of falling prices, developing economies can be hit hard, leaving them more vulnerable to additional shocks such as droughts or political instability.
4. This vulnerability matters because economic decline can reinforce existing development challenges.
5. Indicators commonly associated with lower development include:
   1. low incomes and absolute poverty
   2. lower access to medical care
   3. lower education outcomes and literacy
   4. lower life expectancy
6. When government revenues fall during a downturn, it may become harder to fund health, education, and infrastructure, which can slow longer-term development.

Why Do Government Responses Depend on Economic Thinking?

1. One influential approach before the Great Depression was classical economic theory, which tended to focus on individual markets and assumed that price changes would correct imbalances.
   1. This linked to a laissez-faire view, meaning governments should "leave it alone" and wait for the economy to self-correct.
2. In practice, many modern governments do intervene during downturns to stabilise output and employment.
3. Typical stabilisation actions include:
   1. lowering interest rates (to encourage borrowing and investment)
   2. increasing government spending or cutting taxes (to raise $AD$)
   3. supporting the financial system to restore lending