Readers Question: Can inflation cause a recession?
Inflation is not the main cause of recessions. Usually, recessions are caused by factors such as high-interest rates, fall in confidence, fall in bank lending and decline in investment. However, it is possible that cost-push inflation can contribute to a recession, especially if inflation is above nominal wage growth.
- For example, in 2008, inflation was higher than nominal wages (leading to a fall in real wages) and this contributed to lower consumer spending and was a contributing factor to the 2008 recession.
- It is also possible inflation can indirectly cause a recession. If economic growth is too high, this can cause higher inflation and the growth can prove unsustainable and lead to a ‘boom and bust’ economic cycle. In other words, inflationary growth is often followed by a recession.
- Also, if inflation is too high, the Central Bank and/or government may respond by tightening monetary or fiscal policy. This reduces inflation but also causes a fall in aggregate demand and lower economic growth. Therefore, a recession is often caused by policies to reduce inflation.
Cost-Push Inflation and Recession
If there is a rapid rise in commodity prices, then consumers will see a fall in disposable income (aggregate supply will shift to the left). This squeeze on living standards can lead to lower growth and aggregate demand. Firms will also face rising transport costs, they may respond by cutting down on investment. This is another factor that may push the economy into recession.
In 1974, the trebling of oil prices was definitely one factor in causing a short-lived but deep recession in the UK.
In 2008, rising oil prices was one factor in causing a fall in consumer spending. Also, cost-push inflation encouraged Central Banks to keep interest rates higher than they should; this can contribute to the decline in aggregate demand.
However, cost-push inflation wasn’t the main cause of the 2008-11 recession. More important factors in pushing the economy into recession were:
- Credit crunch – Boom and Bust in credit markets led to a shortage of finance and therefore less investment.
- Falling house prices – falling house prices cause lower wealth and consumer spending
- Loss of confidence – bank collapses, falling stock markets and falling house prices have all changed consumer and business expectations meaning people are more willing to save than spend.
- Decline in world trade.
Boom and Bust Cycles
In the late 1980s, the UK experienced an economic boom, economic growth was above the long-run trend rate of economic growth. This caused inflation to increase to 10%.
But, then the boom ran out of steam. Also, the government decided they need to tackle this inflation of 10%, and so pursued tight monetary policy (high-interest rates). This increase in interest rates (combined with the strong exchange rate, UK were in ERM) caused a fall in aggregate demand and recession.
Indirectly, we can say inflation contributed to a recession.
Inflation does not mean demand falls
It would be a mistake to just sa .- Inflation means prices go up, therefore, people can’t afford goods. Therefore demand falls and we get a recession. A level students often write this, but this analysis is at best incomplete. It is more likely inflation is caused by rising demand.
- Inflation in the 1980s was caused by the rapid rise in consumer spending. The recession was caused by efforts to reduce the inflation rate.
- It was a similar situation in the 1981 recession. The Conservatives were determined to reduce the high UK inflation of late 1970s. They successfully reduced inflation through pursuing monetarist policies, but it caused a recession.