An economic crisis is a situation which occurs unexpectedly where the economy of a country experiences a sudden downturn, which has been brought on by a financial crisis. The most recent economic crisis that the UK has experienced is the current Coronavirus outbreak which is occurring. Before this it was the Great Recession which lasted for just over a year, starting from 2008. An economic crisis can have multiple effects on the economy including unemployment. As a result to this policymakers have to decide if they’ll intervene and respond to the crisis and this can be done by several approaches.
Keynesian economics was developed by John Maynard Keynes. Keynesian economists argue that wages and prices are ‘sticky downwards’. This means the adjustment is sluggish and an active stabilisation policy can be implemented to bring the economy back to equilibrium or else the economy will be stuck below full employment. To do this an expansionary policy can be implemented. The purpose of this is to increase the economic growth to a healthy level, which is especially needed during the contractionary phase of the business cycle. The aim is to avoid a recession by reducing unemployment and increasing consumer demand.
The AD/AS model is a model that explains price level (inflation rate) and level of output (GDP) through the relationship between aggregate demand and aggregate supply. These are represented by the aggregate demand and supply curves. In an economic crisis, the cost of wages will increase causing the cost of production to rise. As shown by Figure 1 this causes AD1 to shift to the left to AD2.
Figure 1: AD/AS Model showing expansionary fiscal policy approach
Therefore a policymaker can implement an expansionary policy to shift AD2 back to AD1. This occurred in 2008-2009, when governments around the world adopted ‘stimulus packages’ to prevent the recession from being even worse and unemployment rates from continuing to increase. On March 26th 2020, in the midst of the coronavirus outbreak, the U.S. Senate also approved a $2 trillion stimulus bill to backstop the economy from the economic impact of the coronavirus outbreak.
Monetary policies can also be implemented in response to an economic crisis. These involve the central bank intervening in the money market to ensure that the interest rate that has been announced is also the equilibrium interest rate. One of the most popular approaches is for the government to set out the policy targets, but for the central bank to be given independence in deciding interest rates. This approach has been adopted by the UK today. The government can later alter its monetary policy by altering the money supply or altering interest rates. By lowering interest rates, this could possibly encourage spending in an economic crisis. This could lead to the economy being stabilised in an economic crisis.
Alternatively, a policymaker can also choose to follow the classical view when responding to an economic crisis. Classical economists argue that the economy should be left alone to adjust by itself. They argue that government intervention has a lot of unintended consequences which can occur. This was shown when a demand shock occurred, which was the Credit Crunch which started in 2007. The model below shows an AD/AS model showing this.
Figure 2: AD/AS model showing classical view approach
The initial equilibrium was at Point A, but as credit dried up investment and consumer demand fell. This is shown by the shift from AD1 to AD2 and the economy moves from A to B. At point B there is a negative output gap, as unemployment and prices are falling. If the government and Central bank chooses not to take any action, then the excess supply of labour in the labour market will bid down the nominal wage. This results in input costs and prices falling, causing SRAS1 to shift to the right SRAS2. As the SRAS shifts down, the new position is point C, which would now show the economy being back at full employment.
Fiscal policies can cause a difficulty in predicting the effects of changes in taxes. This is due to the fact that increasing people’s disposable income would cause a cut in taxes and this would eventually increase the amount they spend but also the amount that people are saving. Therefore it’s difficult to know what will happen if a fiscal policy is implemented. Monetary policies can also be unreliable. This is because no matter how low the interest rates, people cannot be forced to spend or save. It can also be ineffective if it is implemented too late.
To conclude, it is evident that it is up to the policymaker to observe and analyse the state of the economy to decide which approach would be appropriate.