In a recession, fiscal policy and monetary policy can, in theory be used to increase Aggregate Demand and boost economic growth. However in practice there can be many difficulties with boosting a countries economic growth rate and reducing unemployment.
Factors Which Make it Difficult to Prevent Recessions
1. Confidence. In a recession, confidence may be so low that cuts in interest rates and taxes do not have the effect of increasing demand. For example, in a liquidity trap lower interest rates are ineffective in increasing spending because they do not change people’s behaviour. This occurred during the 2009 recession when interest rates were slashed to 0.5%, but failed to encourage spending and lending.
2. Balance Sheet Recession. In a balance sheet recession, firms, banks and consumers have lost substantial sums and become highly indebted. Banks become reluctant to lend because they need to improve their balance sheets. These losses may be aggravated by falling asset prices (such as house prices). Therefore in a balance sheet recession it can be very difficult for policies to make any difference. For example, when interest rates were cut in 2008 to 0.5%, it didn’t really make much difference because banks didn’t want to lend – even though it was cheaper to borrow, it was very difficult to get sufficient loans from banks
3. Hysteresis. This is an argument that when unemployment is high it is difficult to change that fact. – Workers become de-skilled and de-motivated. Therefore, even an increase in AD doesn’t solve unemployment because many workers don’t have the relevant skills and capacities to get a job.
4. Paradox of Thrift. – In a recession people often want to save. But, this just makes the recession worse. It can lead to a negative multiplier effect. A fall in spending leads to less output. Lower output creates unemployment and so even more people have less skills. See: Paradox of Thrift
5. Fears over Debt
One policy response to a recession is to pursue expansionary fiscal policy (higher government spending and lower tax) this requires an increase in government borrowing. However, governments may be reluctant to borrow for fears that higher borrowing leads to fears over debt default and higher bond yields. This was an issue for several countries in the Eurozone during 2010-11 crisis.