GDP is made up by 4 components, which are government spending (G), consumption(C), investment (I) and net export (NX). (Y=G+C+I+NX)When one of the components changes in amount ,the aggregate demand curve(AD) will be affected. When it reduces, it will shift the AD towards left and this causes the real GDP is below the equilibrium point (Y1) and there is a slowdown. (Figure 1) (N. Gregory Mankiw ,2008)
Price level
AD AS
Y1 Y0 Real GDP
To deal with the slowdown, governments can execute expansionary fiscal policy which means increasing the government spending or reduces taxes. Due to the slowdown faced by China in 2008, a massive stimulus package of 4 trillion Yuan ($585 billion) had been provided by the government to defy the global slowdown. Besides, the government of China supported nine industries including steel, telecommunications and automotive by cutting taxes, offering subsidies for technological upgrades and helping smaller companies get credit to get rid of economic slowdown.( Yanping & Spears, 2008. Neate, 2009 )
By implementing the expansionary fiscal policy, the AD curve shift to the right due to an increase in government spending. In addition, due to multiplier effect, ( Y=1/(1-b)* G) the increase in government spending brings a larger change to Y and causes the new intersection point (Y2) is higher than the equilibrium point and there is a huge growth in economic (Y1 to Y2). (Figure 2) According to Keynesian Cross Model, there is also a huge shift to the left of the planned expenditure (Ep) due to an increase in G and cutting taxes by China's government and bring a huge increase in economic growth (Y0 to Y2). (Keynesian Cross Model)On the other hand, although there is an increase in Real GDP, but inflation occurs too (P0 to P1).Due to the decrease in real wages, workers will demand for a higher salary. As a result, most firms wish to cut cost and so the Aggregate Supply curve (AS) will shift to the left and worsen the inflation plus reducing the Real GDP.(Figure 2) In the long run, the matter of unemployment and inflation will arise. (N. Gregory Mankiw , 2008)
Price level LRAS E
P3 AS E=Y
P1 AD Ep=C+I+G+NX
P0 Vertical intercept
=a-bT+I+G+NX
Y1 Y0 Y2 Real GDP Y0 Y2 Y
(Figure 2) Keynesian Cross Model
Furthermore, the increase in government spending initially increases Y and the multiplier effect may amplify the shift in the AD curve(AD1 to AD2).(Figure 4) Yet, the demand for money (Md) will also increase and this in turn increases the interest rate(r).(Figure 3) When the interest rate is high, people rather do saving than investment. As a result, there is a crowding-out effect and offsets the initial increase in AD (AD2 to AD3).(Figure 4) (N. Gregory Mankiw , 2008)
r Ms P AD2
r2 AD3
Md2
r1 Md1 AD1
M
Figure 3 Figure 4 Y
In addition, central banks also can help in reducing the impact of economic slowdown by implementing expansionary monetary policy. Expansionary monetary policy means increase in money supply (Ms) or decrease in the interest rate(r).(Figure 5)This action also can help to offset the crowding-out effect because when the interest rate is low, people tends to invest more. The increase in the investment will shift the AD curve to the right back (AD3 to AD4). (Figure 6)
r Ms1 Ms2 P
AD3
r2 Md2 Figure 5 Figure 6
r3 AD4
M Y
As a prove to the effect above, China cut interest rates and allowed most banks to set aside smaller reserves so that the money supply will increase in the market as worsening credit-market turmoil and weakening export demand slowdown the economic growth. Besides, The People's Bank of China reduced the one-year lending rate to 7.20 percent from 7.47 percent, so that more people will borrow money for investment and increase in the aggregate demand. In United States, a group of 10 banks including JPMorgan Chase & Co., Goldman Sachs Group Inc. and Citigroup Inc. formed a $70 billion fund to ensure market liquidity. In turn, the money supply in market will increase and brings down the interest rate and investment is being encouraged. (Yanping &Hamlin, 2008)
For my opinion, I think that governments and central banks should respond differently towards economic slowdown and recession since people and commercial banks will have different perceptions towards economic slowdown and recession. Most commonly, people and commercial banks would have a more pessimistic thinking during recession because the economy is growing negatively and people will tighten their money spending and do more saving while commercial banks have to reduce their lending in order to maintain the acceptable loans to capital ratios. (Moseley, 2009) So, the consumer spending decreases and due to the reducing in money supply, interest rate increases and investment also reduce. (Figure 8) Exchange rate also depreciates since the interest rate is cut (Figure 7) and makes the exports goods cheaper but impact of exchange depreciation often has time lag on the current account deficit. (Economics Help, 2009) So the net exports may not be affected for some time. AD curve will shift to the left due to the decrease in C and I. When the demand is low, firms reduces supply by firing workers and shift the AS curve to the left. (Figure 6) This causes recession and unemployment rises. (N. Gregory Mankiw, 2008)
Price r Exchange Rate
AD1 AS2 Ms2 Ms1 S1 S2
AS1
AD2 Md D
Recessionary Gap Y M Qdollar
Figure 7 Figure 8 Figure 9
Recession does happen when the GDP growth is negative for 2 quarters or more. Usually, recession is felt before it started because it is followed by quarters of slowing but positive economic growth. In other words, when economic growth slows, businesses stop expanding and unemployment rises (Figure 10) ,it can be called a recession.(Amadeo, 2009)As an example, the National Bureau of Economic Research has confirmed that the U.S. has been in a recession(Bureau of Economic Analysis, 2010) since December 2007.(Isidore, 2008)
Price Inflation rate
High AD AS
Low AD
Philips Curve
Real GDP Unemployment rate(%)
Figure 10
Source: Bureau of Economic Analysis, 2010
In order to rescue the economy from recession, the government should implement expansionary fiscal policy as what they have done during economic slowdown. Yet, government has to be more aggressive and vigorous by executing few expansionary fiscal policies to tame the recession. For an example, Congress approved the$168 billion Bush Economic Stimulus Package in 2008 to solve the recession. The stimulus package may trigger the $14trillion economy by lifting consumer spending and creating job opportunities by reducing the business tax to motivate companies to expand. (Amadeo, nd)By the way, recession is still a threat to U.S. although they have executed the Bush Economic Stimulus Package. In order to mild the recession faced by U.S., Obama's second economic stimulus package worth $787 billion was approved by Congress in February 2009. The purpose was to jumpstart economic growth and save between 900000 - 2.3 million jobs. (Amadeo, 2010)Due to multiplier effect, there is a huge shift to right of the AD curve by the increase in government spending (Figure 4) although there will be crowding- out effect which decreases investment because increase in interest rate. (Figure 3) When the AD curve shifts right, economy is growing and unemployment rate will decrease. (Figure 10)
On the other hand, central banks should also use expansionary monetary policy which is alike during slowdown economic growth by slashing the interest rate or increase money supply. When central banks increase the money supply, the interest rate will fall and this will shift the AD curve to the right due to increase in investment. (Figure 5 and 6) For recession, central banks may use a different and indirect expansionary monetary policy by supporting the financing of investment banks and insurance company to sustain the financial system. As a prove, the Federal Reserve also implemented expansionary monetary policy to ease the recession with the hope that commercial banks will increase their lending to households and businesses. In actions, the Fed had lowered the short-term interest rates (MoneyCafe, 2010) and increase loans to commercial banks. Due to failure of traditional policies, the Fed comes out with new unprecedented policies which widen to every risky security including mortgage-based securities. Furthermore, the Fed extended loans for investment banks to maintain the U.S. financial system. In addition, the Fed gave financial support to AIG, the largest insurance company in the world when it faced financial problems because feared that AIG was unable to pay off the insurances that had been sold out especially to those banks which were suffering loss and would meltdown the financial system of U.S. (Moseley, 2009)
Source: MoneyCafe, 2010
Although economic slowdown and recession both are experiencing slowdown in economic growth, they do have some difference viewpoints since recession shows a negative GDP growth while economic slowdown has a positive GDP growth which is increasing at decelerating rate. As a conclusion, I stand still to the opinion that governments and central banks should respond differently to economic slowdown and recession because economic slowdown sometimes maybe a good sign to prevent high inflation so we do not have to worry so much for an economic slowdown when the country is developing too vigorous. Yet, we need to take immediate actions towards recession due to the impacts that recession will bring to our economy in the long run.
