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 their discretion in policy making.
Economic instability can include a volatile inflation rate and volatile rate of economic growth. It can involve higher unemployment and uncertainty about the economic cycle.
Causes of Economic Instability
Fluctuating Aggregate Demand
Aggregate demand can be volatile for various reasons:
1. Changes in house prices
If house prices increase 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%. Falling house prices in 2006-08 were a major factor behind the economic instability of 2007-08. Falling house prices caused a negative wealth effect but also falling house prices led to bank losses.
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 by cutting income tax and cutting interest rates.
3. Global Credit Markets
The subprime 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 shortage of credit. This caused the problems of northern rock and reduced consumer confidence. See: credit crisis
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 rates was combined with another factor such as the 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 economies. For example, if China’s boom was to end, there would be a marked slowdown in global growth. It used to be the 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.
6. Government Debt Crisis
If markets fear government debt is unsustainable or likely to face liquidity shortages, bonds will be sold. This will tend to push up interest rates on bond yields. This increases the government debt interest payments and puts pressure on the government to cut spending and reduce the budget deficit. This can cause a negative spiral of lower growth and lower tax receipts. (sovereign debt crisis)
Graph Showing Quarterly Growth in UK
The 1991 recession was caused by:
- Higher interest rates
- Falling house prices causing a decline in consumer wealth and spending
- Strong (overvalued) Pound making exports too expensive
- Global credit crunch
- higher oil prices
- falling asset prices
Supply-side Causes of Economic Instability
1. Price of Oil
An increase in the price of oil can cause economic instability, 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.