Causes of Economic Instability

Readers Question: UNDERTAKE AN EVALUATION OF THE CAUSES OF ECONOMIC INSTABILITY AND THE ROLE, IF ANY, THAT THE GOVERNMENT CAN PLAY IN REDUCING ECONOMIC INSTABILITY BY CONSTRAINING THIER DISCRETION IN POLICY MAKING

Part 1 Causes of Economic Instability

Fluctuating Aggregate Demand

Aggregate Demand can be volatile for various reasons:

1. Changes in house prices.

UK house prices have been rising much faster than inflation, this creates a wealth effect and improved consumer confidence, therefore spending and AD increase. A fall in house prices, however, would cause the opposite effect. E.g. when house prices fell 15% in 1992, the UK entered a recession, with negative growth of 2%

2. Fluctuations in Stock Markets

A big fall in stock markets can trigger falls in consumer confidence and lead to a recession. The Wall street crash of 1929 was a primary cause of the great depression. However, the stock market crash of 1987 did not cause an economic downturn. In fact in the UK it was followed by an unprecedented economic boom. This was partly due to the way the government responded Cutting income tax and cutting interest rates.

3. Global Credit Markets

The sub prime mortgage problems in the US caused many firms to go insolvent. This cause a big fall in confidence in lending money. This shortage of credit led to a shortgage of credit. This caused the problems of northern rock and reduced consumer confidence.

4. Changes in Interest Rates

Interest rates are used as a tool in controlling inflation. However, they can also have an impact on consumer spending. Sometimes interest rates may have little impact, however, if they coincide with other factors they can cause a much bigger than expected fall in consumer spending. For example, in the UK, many homeowners have a variable mortgage. Therefore a small change in interest rates can have a big effect on disposable income. If an increase in interest rate was combined with another factor like slowing down of house price growth it may cause a big fall in spending.

• note interest rates can have a delayed effect. E.g. the effect of interest rate increases last year may continue to affect consumer spending for up to 18 months

5. Global Factors

In an era of globalisation there is an increasing interdependence of the world economy’s. For example, if China’s boom was to end, there would be a marked slowdown in global growth. It used to be case the world was very dependent on the US economy. if the US economy suffered a recession, it would often drag the rest of the world into recession. This was because the US was the world’s biggest consumer of imports. However, it is argued that the world is less dependent on the US economy because of the development of new economies like China and India. Nevertheless global factors are of great importance.

Supply side factors

1. Price of Oil

An increase in the price of oil can cause economic instablity, especially if it is a sudden increase like in the 1970s. higher oil prices increase the costs of firms and cause the AS curve to shift to the left. This causes both inflation and lower growth.

However, it is worth noting that although the oil price is now nearing nearly $100 a barrel, it is not having a huge effect. The impact on economies like the UK is less than it was in the 1970s, partly because the increase in price has been more gradual. Costs of transport are still not a major problem. It would require a much bigger increase to have a really damaging impact.

• Causes of Recessions
  
• Are UK recessions caused by failure of Monetary policy?