recession causes

What is recession | Causes | Impact | Examples

Introduction

One of the most feared word among economist and government is “recession”. All central banks (across globe) work in sync to avoid possible recession scenarios by taking necessary corrective steps time to time.  In this article, we will dig deep on how and why do a country goes into recession, and what can it do to come out of this economic nightmare.

What is Recession?

Whenever there is fall in the economics activity, a downturn happens. A worldwide accepted procedure to measure economy of a country is Gross domestic product (GDP). So formal definition of a recession is whenever there is negative GDP growth rate for 2 consecutive quarters, the country is said to be in recession.

See also: How GDP is calculated

Causes of recession

Recession can be caused by both demand side and supply side shock. Different historical recessions have different reasons. Here we are listing most common reason for a recession to occur.

  1. Financial crisis – Sudden dip in liquidity will impact lending and capital movement. This type of crisis was seen during 2007-08 recession (also called subprime crisis), when excessive risk lending causes banks to fall. Great recession (1929) was also caused by failing of banks along with negative global trading environment, triggered by stock market crash.
  2. Rise in interest rate and lower spending– Sudden increase in interest rate will inflate cost of borrowing and this reduces demand. In 1979, UK government, in order to curb high inflation followed a tight fiscal and monetary policy. With increase in interest and lesser spending, it causes recession.
  3. Fall in asset prices – Sudden dip in asset (for example real estate). 1998 Asian tiger crisis was triggered by fall in the property market of tiger economies.
  4. Exchange rate increase – Sudden increase in exchange rate, reducing value of currency and deterring investment. Countries like Turkey and South Africa are heading to this type of recession (2019).

See also: Why exchange rate of Turkey falling.

  1. Deregulation– One of the reason for 2008 recession was deregulation in the financial industry, which permits banks to engage in hedge fund trading with derivatives. Banks then demanded more mortgages to support the profitable sale of these derivatives.
  2. War – War causes a sudden break in economic activities. 1945 and 1953 Korean recession was caused due this.

Impact of recession

Recession causes decline in economic activities. Common scenarios that we see in the recession are falling stock markets, companies business, and closure of businesses, low investment and job losses. 2007 recession due to financial crisis resulted in widespread closure of mortgage firms, and closure of big investment bank like Lehman Brothers, and widespread layoffs.

What is RBI doing to avoid recession?

Reserve Bank of India (RBI) is maintaining the monetary policy and flow of money in India by controlling exchange rate. RBI has done lot of homework to stop occurrence of next recession, or atleast lower the impact of next recession.

  1. Following with globally accepted Basel norms. These norms are accepted by all central banks to direct banks to follow strict liquidity criteria, check asset quality and follow necessary steps for financial risk management. All Indian banks are covered under Basel 3 norms.
  2. NPA resolution and IBC framework. India saw a huge credit jump from 2008 onward. This huge credit growth resulted in surge of bad loans. NPA resolution is a framework to identify bad credit and updating financial network to stop future credit to that firm. Insolvency and Bankruptcy code (IBC) created a unified framework to insolvency and bankruptcy.
  3. Foreign exchange reserve. RBI has been increasing its foreign exchange reserve to lower shock of exchange rate and money constraints.

See also: NPA resolution and IBC framework by RBI

See also: Banking sector reforms in India

Conclusion

In this article, we have seen how and why economic recession occurs. We have also seen cases of recent historical recessions and their reasons of occurrence. If you have any question, please write in comments below.

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