verma (ed.) - recession and its aftermath; adjustments in the united states, australia, and the emerging asia (2013)

Starting with a brief theory and recent history of the US crisis and the recession in the fi rst, introductory chapter, the discussions in the second chapter turn to the area of the fi n

Recession and Its AftermathAdjustments in the United States, Australia, and the Emerging Asia

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Recession is an economic instability that touches every person, the economy, and society It ultimately also affects other economies depending upon the intensity of cross-country integration, openness, and trading Therefore, bringing out a book like this is de fi nitely the need of the hour when the world has just witnessed a global recessionary crisis

The initial thoughts for creating this volume arose during my visit to Wisconsin, Madison, USA, in the post recession year of 2010 There, a few contributors to this book and many other academicians informally deliberated on the issue of fi ghting the recession which took place during 2007–2009 in the USA The US economy was trying its best to recover by taking expansionary measures It was also delibe-rated by some that the US recession had probable impacts on Europe, Australia, emerging Asia, and other continents After my return from the USA, I formally started this project, had discussions with a large number of researchers, and invited many economists from this fi eld to contribute a chapter Some of them have con-tributed and some wanted much more time to contribute As time is a very important factor for this kind of study where the book should be published on time, only 11 contributions could be compiled in this volume The chapters in this volume mostly focus on the USA, Australia, China, India, and Malaysia However, the contributors also discuss European economies and Asian economies, such as those of Pakistan, Nepal, Bhutan, the Maldives, South Korea, Indonesia, and a few other core countries for a general description of recession

In creating this volume we were assisted by a large number of people and tions First and foremost we must thank the contributors, whose unconditional commitment and prompt submission of their chapters made my job as the editor quite smooth and easy I am also thankful to many of my colleagues and friends, including Nirankar Srivastava, P.K Sinha, several colleagues from various other institutions, and Ejaz Ghani, who is currently at the World Bank, for motivating me

institu-to convert this dream project ininstitu-to reality

Sagarika Ghosh, Sahadi Sharma, and their colleagues at Springer came forward

to bring out this volume Their valuable comments on the preliminary draft further reduced many shortcomings I am extremely thankful to them for their work on the

production of this volume in about 5–6 months I also thank Madhu Patel, Atul Kumar, and Vinit Kumar for typesetting and computational work Lastly, I am thankful to our postgraduate students and PhD scholars, to whom I have been teaching macroeconomics for many years, for raising many complicated questions This helped to re fi ne the project

I dedicate this book to Kamta Prasad, with whom I had a research association and from whom I learned the workings of a complex economy I expect this volume

to be of immense help as a reference book for postgraduate students, research ars, academicians, corporate consultants, fi nancial experts, and other members of universities and research institutions in the fi elds of economics, management, and commerce across the globe

N.M.P Verma

1 Understanding Recession: Conceptual

Arguments and US Adjustments 1N.M.P Verma and V Dutta

2 The Financial Crisis and the Great Recession

in the United States 23Mukti Upadhyay and Tim Mason

3 Dynamics of Deflation and Unemployment:

Fall into an Abyss of Depression 47Anson Wong and Michael Chu

4 Market Fluctuations and Country Risk

Relationships for Australian and Indian Energy 67John Simpson

5 The Chinese Economy After the Global Crisis 81Liang-Xin Li

6 The Role of Macroeconomic Fundamentals

in Malaysian Post Recession Growth 113

Lee Chin

7 Impact of Global Financial Crisis on Economic Wellbeing:

A Case of South Asia 129

Nikhil Chandra Shil

8 The Asian Economic Crisis and Malaysia’s Responses:

Implications for the Banking Sector 157

Balakrishnan Parasuraman, Beatrice Lim, Fumitaka Furuoka,

Catherine Jikunan, and Lo May Chiun

9 Output Growth in Post Liberalized India:

An Input–Output Structural Decomposition Analysis 179

K.K Saxena, Sarbjit Singh and Rahul Arora

10 The Recent Recession: Impact and Future

Prospects for the Indian Banking Sector 215

Rahul Arora Department of Humanities and Social Sciences, Indian Institute of Technology , Kanpur , India

Lee Chin Department of Economics, Universiti Putra Malaysia , Serdang , Malaysia

Lo May Chiun Universiti Malaysia Sarawak , Kota Samarahan , Malaysia

Michael Chu School of Continuous Education, Baptist University of Hong Kong , Kowloon , Hong Kong

V Dutta School of Public Policy, University of Maryland , College Park , MD , USA

Fumitaka Furuoka Universiti Malaysia Sabah , Kota Kinabalu , Malaysia

Catherine Jikunan Fumitaka Furuoka , Institute of Asia-Europe Centre, University

of Malaya , Kuala Lumpur

Liang-Xin Li Catherine Jikunan, Malaysian Trade Union Congress, Kota Kinabalu , Sabah , Malaysia

Beatrice Lim Universiti Malaysia Sabah , Kota Kinabalu , Malaysia

Tim Mason Department of Economics, Eastern Illinois University , Charleston , IL , USA

Balakrishnan Parasuraman Faculty of Entrepreneurship and Business , Universiti Malaysia Kelantan, Kota Bahru , Malaysia

Basanta K Sahu Indian Institute of Foreign Trade , New Delhi , India

K K Saxena Department of Humanities and Social Sciences, Indian Institute of Technology , Kanpur , India

Nikhil Chandra Shil Department of Accounting, American International University , Bangladesh

John Simpson School of Economics and Finance, Curtin University , Perth , Western Australia

Sarbjit Singh Department of Humanities and Social Sciences, Indian Institute of Technology , Kanpur , India

Mukti Upadhyay Department of Economics, Eastern Illinois University , Charleston ,

of existing inventory, and monetary and fi scal balancing

In this volume an attempt has been made to appraise the working of a market economy where short-term disturbances may occur, the market fails, a recessionary cycle emerges, and after certain fundamental measures have been taken the market recovers Starting with a brief theory and recent history of the US crisis and the recession in the fi rst, introductory chapter, the discussions in the second chapter turn

to the area of the fi nancial crisis and recession in the US economy In this chapter the authors have highlighted the fi nancial factors responsible for the severe historic crisis The third chapter relates de fl ation to unemployment It discusses theories about the relationship between de fl ation, price levels, and unemployment and the reason why de fl ation is a bigger threat than in fl ation, and recommends recovery by adopting appropriate policy measures The chapter analyzes the cases of a few European economies as well The fourth chapter examines energy and resources trade and equity investment relationships between Australia and India The chapter investigates macroeconomic and fi nancial economic risk The study utilizes macro-economic data In the fi fth chapter, attention is diverted to the dragon, the biggest economy, that of China Here the author discusses the slowing of growth caused by the recession and how to achieve and maintain a faster rate of growth in the future

In the sixth chapter we focus on the Malaysian economy The macro variables chosen are exports, imports, price level, money supply, interest rate, exchange rate,

and government expenditure The co-integration method was used to assess the long-run equilibrium linkages among the selected variables For the short-run causality, the study uses the Granger tests based on the vector error-correction model In the seventh chapter, the global fi nancial crisis is seen from the South Asian perspective The author has tried to show the extent of the global fi nancial crisis and its effects on South Asia In this chapter, the impact of recession is dis-cussed for core Asian countries such as Bangladesh, Pakistan, Nepal, Bhutan, and the Maldives In the eighth chapter the authors have tried to relate the Asian crisis and the Malaysian economy The retrenchment of workers is critically examined here exclusively for the Malaysian economy Further, the authors also examine the recessionary impact in South Korea, Indonesia, and other Eastern countries

In the ninth chapter, the focus is on the Indian economy In this chapter input–output analysis is done with the help of time-series data In the tenth chapter, challenges and opportunities facing the Indian banking sector are examined The chapter states that the banking sector could perform miracles in the Indian economy because it is better regulated and a plethora of service demands exist The last chapter

is again con fi ned to the discussion of fi nancial sector activities and reforms The chapter highlights the experiences of India and the way other countries have reacted

to the recent global economic slowdown This slowdown provides some challenges and opportunities for the Indian economy Since India is one of the emerging economies, it has the potential to increase its exports to advanced economies This way, India can earn more foreign exchange This will act as a cushion and dilute the effects of a slump on the economy The chapter concludes that despite India’s high economic growth performance, it has not been able to remain insulated in this global decline

Each chapter concludes with deliberations on macroeconomic results, and the implications for speci fi c policies, some of which have been tried and others have still to be examined Further, in this volume we examine the policies necessary for the regulation of the economic system and give a brief assessment of the extent to which global policy coordination has been discussed in policy circles even if it has not been seriously implemented Concluding remarks appear in all 11 chapters on the relevant themes and speci fi c to the economies concerned With this overview of the following analysis, we present a summary of each chapter

The opening essay by N.M.P Verma and V Dutta conceptualizes the working of

a market economy and the frequent occurrences of business cycles in a country

or in many economies simultaneously The chapter reviews many dimensions

of economic activities, such as the issue of frequent market failure, various approaches of cyclical movements, and conceptual concern for controlling reces-sion The authors have reviewed the opinions of classicalists and new classicalists and the modern approaches The classicalists were concerned with medium-term

fl uctuations in real GNP This fl uctuation was explained through a few theories of the business cycle With the advent of Keynesianism, business cycle theories were not being accepted During the post-Keynesian period many economists, such as Harrod, Domar, Hicks, Samuelson, Frisch, and Goodwin, gave their own views

on adjustments of market fl uctuation With the introduction of new-classicalist

approaches, “short run” could not be a suitable duration for a macro study Hence, a new business cycle theory was developed which was based on rational expectations and sustained market clearance In the end, conceptual arguments have been linked with the US slump It has been argued that inadequate information and lack of regulations in the fi nancial sector caused the US recession A recession caused by

fi nancial factors lasts longer than a recession caused by other factors

In the second chapter, Mukti Upadhyay and Tim Mason examine the US

reces-sion The chapter provides the historical background to the fi nancial crisis The recent recession is termed the “Great Recession.” The recession lasted for about

2 years, and its intensity was severe After the Great Depression of the 1930s, the present recession showed the longest contraction of the US economy The federal government became indifferent in protecting the investor Lehman Brothers Because

of this, uncertainty started in the credit market As a consequence, the credit market showed freezing tendencies Other major fi nancial institutions are also reviewed, including Citigroup, American International Group, and Bank of America, which faced insolvency Although many monetary and fi scal policies were adopted by the government, the actual output of the economy still deviated signi fi cantly from the potential output The authors trace how the fi nancial system, left for all intents and purposes to its own devices, has deepened the instability inherent in capitalist systems found in the USA and many other countries The chapter is full of discus-sions on the macroeconomic dilemma Finally, regulation of the fi nancial system is examined The chapter concludes with the need for global policy coordination

The dynamics of de fl ation and unemployment globally is reexamined by Anson Wong and Michael Chu in the third chapter This chapter examines global economic

issues of de fl ation and unemployment after the fi nancial crisis of 2008 It starts with

an overview of recent economic performance around the world A number of fi gures visualize the recent development of GDP, in fl ation, and unemployment in the USA, the UK, and European countries Then, it applies theories such as the quantity theory of money to illustrate the relationship between de fl ation and unemployment

It also discusses a number of determinants of the de fl ation and recession after the crisis, so that readers can understand more easily the global issues The examples of

de fl ation in Japan and Hong Kong during the 1990s and 2000s are reviewed Besides, the chapter describes the threats that de fl ation and depression pose to the economy

A number of possible solutions to solve the problems of de fl ation and recession are given, and the chapter concludes with examples of successful recovery from the curse of recession

In the fourth chapter, John Simpson examines energy and resources trade and

equity investment relationships between Australia and India This chapter nizes the logic of the growing strength of trade and investment relationships in the energy sector between India and Australia as a basis to build upon this relationship for mutual economic bene fi t India is a large and powerful economy with a depen-dence on coal to generate electricity for domestic and industrial use Australia is a developed, low-political-risk country Australia is well endowed with natural gas as well as coal and other resources, such as iron ore The opportunity exists here for India to diversify its supplies of cleaner-burning natural gas through its imports and

recog-through foreign direct investment in Australia in natural gas and coal India has a dynamic and rapidly growing share market and economy, and this also presents opportunities for Australian foreign direct investment in the resources sector Australia needs to diversify its inward and outward foreign direct investment as well

as its exports of natural gas, coal, and iron ore

Econometric analysis of sectoral stock market and country risk data reaf fi rms a strong basis for a substantial increase in two-way trade and investment The caveat for increased foreign direct investment in India’s electricity sector is that microeco-nomic reforms need to continue to assist in making state electricity boards more viable The increase in economic cooperation is all the more important in the uncer-tain times that have followed the global fi nancial crisis Western Europe and the USA are burdened by public debt problems, and their growth projections have subsequently suffered India and Australia share a regional location and both are democracies with a belief in free enterprise India’s growth rate is very high and Australia’s growth rate is consistently the highest of the OECD countries India and Australia are not part of the European Monetary Union and have less exposure

to the same debt problems, either by accident or by design They have a unique opportunity to expand their cooperation over the ensuing decades

Liang-Xin Li focuses attention on the Chinese economy since the global crisis in

the fi fth chapter Since the Chinese economy took a fast growth path toward the top

of the world economy, it is interesting to examine China’s way of development He demonstrates what China was doing, is doing, and will do to achieve economic expansion during and after the global crisis Many thoughts and theories about Chinese economic reforms are analyzed The road map and goal of Chinese economic growth are examined and outlined How to keep the Chinese economy growing faster after the recession is the chapter’s key issue

The role of macroeconomic fundamentals in Malaysian post recession growth is

presented by Lee Chin in the sixth chapter The Malaysian economy experienced

contraction during the 1997–1998 Asian fi nancial crisis Nevertheless, the economy started to recover in 1999 and grew steadily in the following years The Malaysian government has made much effort to help the economy recover, such as adopting monetary policies that aim to promote monetary stability and suf fi cient liquidity in the economy, keeping the in fl ation rates low, and adopting currency control which pegs the ringgit at the rate of RM 3.80 to one US dollar As a result of the stable exchange rate, the external sector also achieved a good surplus Thus, it is the aim

of this chapter to fi nd out the roles of monetary policy (money supply and interest rate), fi scal policy (government expenditure), the external sector (exchange rate, exports, and imports), and the general price level in Malaysian post recession growth The techniques of co-integration and Granger causality are employed to examine the relationships between economic growth and these macroeconomic variables The results show that an increase in exports and government expenditure or a depre-ciation of the exchange rate will promote long-term economic growth, whereas an increase in in fl ation, the interest rate, and imports will reduce economic growth Furthermore, the price level and government spending in fl uence economic growth

in the short run In a nutshell, the fi ndings suggest that fi scal policy is probably the

most appropriate tool in promoting economic growth in Malaysia during the post recession period

Nikhil C Shil examines the fi nancial crisis from a South Asian perspective in the

seventh chapter The global fi nancial crisis came as an economic devil and swiped away a lot, imposing a signi fi cant toll on the world economy The crisis that started

in September 2008 lasted for about 2 years, but by now most of economies have started reviving Thus, now is the time to look back and evaluate what happened Initially, the South Asian countries were affected much owing to a high level of integration with economically advanced countries, but later they managed to mitigate their problems The author tries to present a complete picture, covering the back-ground to the global fi nancial crisis, its impact on South Asian countries, the present status, and future challenges The contribution is a conceptual one depending on different secondary sources of information combined with the author’s own judgments The scenario of recessionary impact is shown in the case of core Asian countries such as Pakistan, Nepal, Bhutan, Bangladesh, and the Maldives

The Asian economic crisis and Malaysia’s responses and the implications for the banking sector are studied by Balakrishnan Parasuraman , Beatrice Lim , Fumitaka Furuoka , Catherine Jikunan , and Lo May Chiu This chapter examines

the Asian economic crisis which occurred during 1997–1998 and the Malaysian economy’s responses The chapter chooses the Asian fi nancial crisis as a case study

to examine its impact on the Malaysian economy and describes how the Malaysian government responded to the crisis It also focuses on the impact of the Asian fi nancial crisis on employment in the banking sector in Malaysia The Asian fi nancial crisis created havoc in countries such as Thailand, Indonesia, and South Korea, where these countries had to seek assistance from the International Monetary Fund in order to save their economies However, Malaysia took a different step in saving the country by refusing the International Monetary Fund package and aiming for a stricter fi nancial adjustment What is important here is how the crisis affected a number of people, most of whom were workers During the Asian fi nancial crisis, many workers lost their jobs because of the closure of many businesses (manufac-turing, construction, etc.), mergers and acquisitions, and other forms of reducing the workforce in order to save costs The unemployment rate in the country increased from 2.6 % in 1997 to over 5 % in 1998 In the fi nance, insurance, real-estate, and business service sectors, 6,596 workers were retrenched As a result of the crisis, the banking sector in Malaysia began to experience increasing nonper-forming loans, bringing about tight liquidity conditions This situation forced the banks into merger and consolidation exercises initiated by the government Besides mergers and acquisitions, the banks also embarked on downsizing, lean-trimming, organizational changes, and the introduction of new technologies In other words, many small banks were forced into merging with bigger banks and many excess workers were offered a “voluntary separation scheme.” These retrenched workers became the urban poor, facing the high costs of living and no opportunity

to obtain jobs as there was no safety net

The sources of output growth during the postliberalization and recessionary era

in India through an input–output structural decomposition analysis are described in

the ninth chapter by K.K Saxena , Sarbjit Singh , and Rahul Arora They have made

an attempt to decompose the changes in output growth in the Indian economy The study highlights four key components:

1 Mean growth of fi nal demand

2 Variations in the composition of fi nal demand

3 Fluctuations in input–output coef fi cients

4 Interface of both change in fi nal demand and technological change

Input–output tables have been utilized for this purpose Owing to the unavailability

of recent input–output tables, the analysis of recent years (2007–2008 to 2009–2010) was done using data from different economic surveys provided by the Ministry

of Finance, Government of India The modi fi ed method of decomposition of output growth from the demand side was utilized to calculate the percentage share of each component in the total fi nal demand change From 1993–1994 to 2006–2007, the total change in output was approximately 200 % Of this change, 89.27 % (87.46 % + 1.81 %) is explained by a change in fi nal demand by assuming constant input–output relations For the share of the interaction factor where changes in both the fi nal demand and the input–output relations were assumed, the contribution is just about 7 % To better understand the changes, the growth in output was further divided into fi ve more factors, that is, private consumption, government consumption, gross investment, exports, and imports Among these fi ve demand categories, domestic demand (sum of private consumption, government consumption, and investment expenditure) is the dominant source of output growth in the postlibera-lization era, which supports the hypothesis that the Indian economy is a domesti-cally demand driven economy From 1993–1994 to 2006–2007, the contribution of investment demand was highest and afterward, owing to the fi nancial crisis, con-sumption expenditure took the lead, with increased government consumption expenditure to overcome the negative impact of the crisis The economy again came back on track in the later half of 2009–2010, with more growth of investment demand in the economy

The recent recession and the challenges and opportunities for rebalancing Indian

banking are considered in the tenth chapter by D.K Yadav India is an emerging

economy Its growth rate was close to 10 % in prerecession years and was 7–8 % even during the recession This high growth rate of the economy is supported by the Indian fi nancial system After 1991, when the structural reform process was imple-mented, Indian companies became global, and multinational companies also entered the Indian economy This changing structure of the Indian economy is providing an opportunity for the Indian banking and fi nancial system to expand its business at the world level According to the Indian Bank Association report “Banking Industry Vision 2010,” there will be a greater presence of international players in the Indian

fi nancial system and some of the Indian banks will become global players in the coming years The current competitive position of the Indian banking system, however, is not satisfactory in terms of numbers and ranks Only 20 Indian banks, including private sector banks, appear in the list of the top 1,000 world banks, as

listed by the London-based magazine The Banker However, the current recessionary

problem, which started with the fi nancial crisis in the US economy and which now has European countries in its grip, has revealed the strong competitive position of Indian banks in terms of qualitative factors such as asset quality, capital adequacy position, and ef fi cient responsive regulatory structure When the leading large banks

of the world are collapsing, Indian banks are not only safe but have also produced signi fi cantly positive returns in terms of pro fi t This chapter is an effort to evaluate the competitive position of Indian banks in the postreform period, particularly in the post recession period It was found that Indian banks are competitive enough in comparison with their foreign counterparts and the current recessionary problem has improved their competitiveness in the global fi nancial market However, increas-ing their size by the well-structured process of bank consolidation, cost manage-ment, legal aspects of recovery management, improving risk management skills of banking staff, and speedy reform on the policy front are some of the challenges to be overcome to make a world-class competitive banking system a reality

In the fi nal chapter, Basanta K Sahu examines the impact of the global downturn

on the Indian economy Owing to increased integration of world markets, sion of the economic crisis from one country to the rest of the world has become easier Although the recent global economic slowdown has taken center stage in policy debates and discussions across the world, the variability and volatility of economic growth and trade performance are worrying and differ for different economies An impact has been experienced in almost all regions and sectors, with different degrees and dimensions This chapter seeks to analyze how the recent global downturn has impacted the Indian economy and resulted in an increasing sense of insecurity For India the crisis made matters much worse by causing sharp declines in exports of goods, reversal of capital fl ows, reduction in the volume of remittances, worsening balance of payments, increasing joblessness, rising prices, and deteriorating socioeconomic development scenarios Within the economy the performance of different regions and sectors has been different In this context, the chapter highlights the experiences of India and the way different economies reacted

transmis-to the recent global economic slowdown, which provides some challenges and opportunities for India India, being one of the emerging economies, has relied heavily on advanced countries for its exports and has experienced diverse impacts

of global slowdown Despite its good economic growth performance, India has not been able to remain insulated in this global decline In real terms, the growth in India’s exports and imports of both goods and services has declined and joblessness has been experienced owing to contraction of output in the export sectors However, transmission of the impacts through different channels seems to have been different for the Indian economy in comparison with other economies The chapter also discusses the precrisis macroeconomic scenario in India and critically analyzes the argument that the Indian economy has been less affected owing to its lesser integra-tion with the world as compared with its size and potential

The impacts of the crisis are differentiated spatially and sectorwise because many core sectors of the economy are driven by huge domestic demand and are able to absorb some kind of shocks originating from the global slowdown However, there are some important lessons for policy makers to consider, such as the balance

between development of the export sector and development of the nonexport sector,

to achieve and maintain the desired growth with strong macroeconomic fundamentals, especially in a crisis situation such as the recent global slowdown The chapter con-cludes with some policy suggestions, especially for developing economies, based

on trade and service sector led growth like in India

Thus, an attempt has been made to cover the broad perspectives of the global recession in all 11 chapters The volume starts with conceptualization of the issue

It highlights the US scenario and its probable effects on other larger economies, which include those of Australia, China, Malaysia, and India Nevertheless, it does not mean that European and other Asian economies have been left out While analyzing various issues, the authors have substantiated the arguments by citing the cases of a few European and many Asian economies

N.M.P Verma (ed.), Recession and Its Aftermath: Adjustments in the United States, Australia,

and the Emerging Asia, DOI 10.1007/978-81-322-0532-6_1, © Springer India 2013

Recession is an economic phase when various sectors of the economy re fl ect working

at the bottom for at least two quarters of a calendar year Investment declines, ployment increases, income declines, the growth rate falls, asset values collapse, consumption falls, and overall the economy is in crisis Conventionally, a recession

unem-is said to occur when GDP falls for at least two consecutive calendar quarters For the US economy, a recession is of fi cially indicated by the National Bureau of Economic Research “Recession” is also termed “contraction” or “slump.” Following a recession, there is often a boom, i.e., expansion, and thus this reverses the effects

of a recession In a recession, there is a reduction in production, resulting in high unemployment During a boom, however, there is a rapid rise in prices The period from recession to recovery and boom is called a business cycle or trade cycle There are short-run macro problems but these do not last long because of corrective measures taken by one or many market players, including interventions by the government Recession is also known as failure of a market because its ef fi ciency declines The market is really a place of complex transaction relations A large number of buyers and sellers gather in a market and submarkets for clearing products and inventories

In classic economic theory, there was a small market and, therefore, there was hardly any effect on short-run macroeconomic balances The adjustments in cases of deviations from output and full employment take place through price and wage variations The classicalist was, however, concerned with medium-term fl uctuations of real GNP

N M P Verma ( * )

Department of Economics, Babasaheb Bhimrao

Ambedkar University , Lucknow , India

e-mail: nmpverma@gmail.com

V Dutta

School of Public Policy, University of Maryland ,

College Park , MD , USA

Understanding Recession: Conceptual

Arguments and US Adjustments

N M P Verma and V Dutta

This fl uctuation was explained by a few theories of the business cycle (Van der Ploeg 1985 ) With the advent of Keynesianism, business cycle theories were not accepted During the post-Keynesian period, many economists such as Harrod, Domar, Hicks, Samuelson, Frisch, and Goodwin gave their own views on adjustment of market

fl uctuation With the introduction of new-classicalist approaches, “short run” could not be a suitable duration for a macro study Hence, a new business cycle theory was developed which was based on rational expectations and sustained market clearance This opinion was developed by Lucas ( 1975 , 1977 ) The market plays a crucial and

ef fi cient role in coordinating production and distribution of goods and services It is a concept that is virtually a few decades old After the failure of the central planning system of the Soviet Union in 1992, the market economy suddenly became important The central planning of Russia was burdened with bureaucracy It neglected consumers and the agricultural sector It concentrated seriously on big industry and defense products Market exchange was partly decentralized and producers received many incentives to ful fi ll consumer desires Therefore, this led to a more ef fi cient system

A market economy also provides choices to ful fi ll desires There is no coercion in a market economy Therefore, it is considered superior and ef fi cient, and the new clas-sicalists believe in “free markets” for major economic decisions However, Keynesians emphasize how real-world markets might differ from the coherent activities of markets

in theory The real-world markets require illustrious institutions to work Markets on their own often cannot address numerous economic problems Thus, for very ef fi cient working of a market there should be prevalence of societal trust, infrastructure for smooth fl ow of goods and services (including information), and money as a medium and measure of exchange (Suresh 2009 ) 1

In this introductory chapter, the theoretical literature is critically analyzed The recent US recession is described in the light of theoretical developments The chapter ends with a description of the various macroeconomic measures already taken and likely to be taken by the US government to achieve economic recovery

The mechanism of a market is constrained and becomes less ef fi cient because of reasons such as public goods, externalities, transaction costs, market power, complex information, and escalating expectations (Akerlof and Allen 1985 ; Barro and Sala-i-Martin 1995 ; Varian 1979 ; Zarnovitz 1985 ) and concerns for consumer welfare and equity The failure of a market is thus a condition where the market produces inef fi cient and below-optimum outcomes Since public goods are unrivaled, nondiminishable, and nonexcludable, it is generally not possible to transact in the market In the situation of free riders, public goods can be provided and even delivered through public outlets and agencies Often, they may be delivered by levying various taxes so that the cost is virtually borne by the public Externalities both positive and negative also affect the market They create problems in the measurement of the real social value of goods or services, which differs from the market value Externalities often damage the natural environment because of negative side effects Since damage

is not priced, it does not have a price tag Similarly, higher transaction costs may lead to higher prices, which may discourage demand This may thus also lead to market imbalances Further, every fi rm wants to grow and get more market share Even in the case of military goods and defense services, the major part of the market

is shared by government agencies These growing market shares may lead to their affecting the price of inputs and outputs and also employment in a market This way, the market is less ef fi cient (Goodwin et al 2009 )

In neoclassical analysis, there is no discussion of resources being allocated in such a way that people can satisfy their basic human needs If platinum can result in more pro fi t than medicines, then a fi rm would invest in platinum production and marketing rather than in medicines This makes the market inef fi cient Further, the market does not consider social obligations, such as caring for the sick, elderly, children, the otherwise able, widows, and other needy persons Lastly, information systems and investment expectations also create market failure In a neoclassical model, decentralization leads to ef fi cient consequences The consumers and producers have easy access to all the relevant information they need to make the best choices

In a static macro analysis, this is possible because there is a low data requirement

In a dynamic analysis, however, a lot of data and information are required relating

to choices and expectations This complicates the analysis based on market data and the results deviate from the expectations and choices As a result, the market is less

ef fi cient and, therefore, it is termed a market failure The classical macroeconomists believed that a market generally operates smoothly as long as various government agencies do not intervene But often government intervention is necessary for the welfare of people when a market fails, and various service deliveries do not take place In contrast, Keynesian economists believe that market economies need more interference from the government side In the case of both shortage and surplus

of marketable goods and services, the government has to intervene rationally for stabilization (Sloman and Sutcliffe 2004 )

Unemployment in a recession is like a cyclical unemployment which is caused

by fl uctuations in many macro variables There is a fall in aggregate demand for goods and services in the national boundaries In the USA in the period from 1961

to 2007, the unemployment rate was 3.4% in 1969 and 10.8% in 1982 According to the National Bureau of Economic Research, the recession ended in 1991 but reap-peared in 2001 The continued loss of employment up to 2003 was a period of “job-less recovery” because GDP grew but its growth rate was too slow for jobs to be created for new entrants During the phase of contraction, unemployment rises, whereas in a recovery or boom, unemployment falls When production in an economy

is falling, producers require fewer workers The opposite of this is true for a boom According to Okun 1981 , a 1% fall in the unemployment rate causes an approxi-mately 3% boost to real GDP Thus, there is a direct relationship between the rate of unemployment and rapid real GDP growth Monthly data from the Bureau of Labor Statistics for 1990–1991, 2001, and 2007 show that unemployment increased swiftly

in the US economy During a recession, the rate of in fl ation falls or even becomes negative As an economy moves toward a boom, investors invest more The demand for raw materials and labor increases; these factors raise the cost of production and thus the rate of in fl ation increases During a recession, this process is reversed and

thus the rate of in fl ation falls So during a recession there is rising unemployment and a falling rate of in fl ation, whereas during a boom there is falling unemployment and an increasing rate of in fl ation (Goodwin et al 2009 ) These tendencies are often analyzed by the theory of the trade cycle or business cycle

In Fig 1.1 , GDP contracts from an upswing to a downswing and expands from a downswing to a boom Y 0 Y 1 , or the dotted block, shows the full employment range

If the output is outside this area, then there is macroeconomic instability To lize the economy, a few corrective policy measures are required There are many theories concerning the economic cycle (Begg 1977 , 1982 ; Black 1982 ; Blinder 1981 ; Farmer 1998 ; Fischer 1988 ; Frisch 1933 ; Hansen 1985 ; Harrod 1963 ; Hicks 1950 ; Kalecki 1935 , 1937 ; Macmallium 1988 ; Mellander 1993 ) In the following analysis, many key theories are critically discussed

In the multiplier–accelerator information theory, consumption depends on previous income Investment can be either autonomous investment or induced investment Autonomous investment is a function of infrastructure and other basic needs of the economy and thus is virtually determined by the rates of growth of consumers and technical prosperity It is not governed by various market forces and operations

In contrast, an induced investment is guided by market operations and

related forces If sales are increasing, then induced investment will also follow an increasing tendency A recession will occur if sales are decreasing followed by induced investment

As shown in Fig 1.2 , there is a minimum output which is consistent with zero induced investment Since there is always some amount of autonomous investment, output cannot go below this point If income goes up, the induced investment line would move upward In another situation, the maximum output is given by full employment at a different time point If income goes up, then full employment output will also go up, that is why lines II and FE are parallel to each other Both of these lines are moving upward (see Jha 1991 for details)

The output rises after point N There line II becomes positive through the impact

of the accelerator Since the multiplier is effective, with the rise in investment, output increases Such a phenomenon further increases the investment and thereafter the output This leads to a situation of boom or expansion The economy touches the full employment zone From now onward, the output can grow slowly, pushed by the rate of growth of autonomous investment In the next period, income falls, and line II drops through the accelerator effects This decreases the GDP through the multiplier effect This again lessens the investment As a consequence, the economy

is confronted by recession Capitalists do not intend to invest, a II becomes zero Output cannot fall further because of autonomous investment This would raise II

from zero This tendency would further increase income The economy would recover from the recessionary phase If we deal with the dynamic state, N to S is the duration of the boom or expansion Along the line S 1 to S 2 , we would have the full employment situation Along the opposite path, S 2 to S 1 , the economy goes into recession, and along S 3 to S 4 , the economy proceeds toward zero for II At point S 4 , however, the recovery would be established Thus, the fl uctuation and fl exibility in the economy is caused by multiplier–accelerator interactions, which are also affected

by consumption and investment behaviors Consumption is changed by consumers and investment is altered by capitalists The dynamic economy, in a dynamic situa-tion, thus moves like a clock pendulum where one side is in recession and the other side is a boom This cycle keeps on moving on short intervals The market fails and recovers through reformatory actions of various market and nonmarket agencies

In this model of Hicks ( 1950 ), Samuelson, and Frisch, the issue of inventory does not emerge; therefore, Metzler used the “inventory” factor to explain the business cycle in an economy Normally, every fi rm maintains a buffer stock of raw materi-als, assets, goods, and services because of uncertain future demand There is autono-mous investment Firms produce to meet estimated demand as well as to keep a fraction of produce as a shock absorber stock of inventories The following situation may develop:

1 The projected demand may be equal to the physical demand

2 The expected demand may be higher than or lower than the real demand If the estimated demand is equal to the actual demand, then a full employment equilib-rium will be established If there is a deviation from this point of equality, there will be fl uctuation This happens because sales expectations do not materialize Thus, the actual buffer stock will be different from the desired one This discrepancy will produce fl uctuations in the market which we term a case of “market failure.” The higher inventories will lead to low labor demand and production This creates

a recessionary situation The recovery starts once this condition is exhausted Once it is over, an “upswing” in the economy will occur However, Kaldor ( 1940 ) gave another reason for this kind of occurrence

To show contraction and expansion in the economy, Kaldor ( 1940 , 1960 ) chose saving and investment as the determining factors of nonlinear dynamics in the economy

In every economy there is always a traditionally determined mean rate of investment

If there is low level of real national income, then a situation occurs where pro fi t tunities are being missed When for a fi rm income is higher than the decreasing returns

oppor-of scale and the rising costs oppor-of fi nancing, this results in less investment propensity There is also a negative association between capital stock and investment An increase

in capital stock reduces the marginal ef fi ciency of capital, so investment is lower for each income level If the capital stock falls, the investment will move upward As regards the saving function, like for investment there is a mean saving propensity which is historically determined on the basis of earlier economic behavior

If income is higher than the normal level, pro fi t will also be higher Since saving

by capitalists exceeds saving by workers, saving propensity will increase Similarly,

in the case of falling income relative to the normal level, pro fi ts will decline This

will result in a greater fall in savings To conclude, the marginal propensity to save

is higher at low levels of income (Solow 1956 , Solow et al 1966 )

At the point of equilibrium, the level of income saving will be equal to the level

of investment Again there is scope for saving being higher or lower than investment Thus, as shown in Fig 1.3 , there are three equilibrium points A, B, and C Here A and C are a stable equilibrium and B is an unstable equilibrium because a minor slip from B will force the equilibrium to either A or C The only difference is that at point A income is low and investment is low (zero) If capital depreciates, investment shifts upward toward B If this trend continues further, then A will move to C after passing through B The economy will maintain expansion at C If the economy moves from C to A through B, a reverse movement, then recession occurs At point

A, employment will be low 2 Thus, according to Kaldor ( 1940 , 1960 ) the reason for recession is the discrepancy between investment and saving To the right of B, investment is greater than saving This shows there is a rise in income On the left side of B, investment is less than saving This shows that income will fall Even if either investment or saving is linear, this type of cycle will still occur

Goodwin (1951) used capital stock and investment as the determining factors for contraction and expansion of the economy If the real and desired capital stocks are equal, then net investment will be zero Gross investment will be equivalent to depreciation If the expected capital stock is less than the actual capital stock, then gross investment will be zero The capital stock can only decrease by the extent of depreciation, which is fi xed Conversely, if the expected capital stock is more

S(Y) I,S

than the actual capital stock, then difference of the two will be matched through investment Thus, gross investment will be a positive value in this situation The periodic dissimilarity in actual and expected capital stock will bring about boom and recession The period of boom or even recession may vary depending upon the amount of depreciation of capital goods and investment

In this analysis, K a is the actual capital stock K e is the expected capital stock, I is investment, and D is depreciation In Fig 1.4 , the actual capital stock is equal to the expected capital stock at A 5 If because of disturbance Δ K a > 0,then K a > K e and

the total investment will be zero since I − D = 0 Net investment will be negative until

the actual capital stock is larger than the intended capital stock At point A 1 , K a = K e , and the desired stock shifts to a higher equilibrium point Since the actual stock at

A 1 is smaller than this new desired stock, the net stock shifts to A 4 from A 1 Until the capital stock is lower at A 3 , net investment will be I − D Once it reaches A 3 , the same mechanism shifts in the amount of intended capital stock It will appear along

A 1 to A 4 The boom and recession may not necessarily be of similar intensity and length 3 Alternatively, there can be three cases as follows:

Case 1: If K a > K e , there is zero gross investment, and capital stock can decrease by

the amount of D

Case 2: If K a < K e , gross investment equals I

Case 3: If K a = K e , net investment ( I − D ) is zero, and gross investment equals I = D

Thus, in this model the cause of the business cycle is the deviation of the actual capital stock from the desired or intended capital stock, which is further reduced by depreciation and investment behavior This argument was further re fi ned

According to Blinder and Fischer (1981), a chronic business cycle appears because of monetary shocks An increase in money stock will escalate prices and sales As a result, investment will fall Once this investment is exhausted, there will

be a higher level of production and investment Thus, the upswing and downswing

in the market is caused by unexpected monetary shock Naturally, if there is an expansion or contraction of the money supply then it will affect prices and even the interest rate If people expect a change in the supply of money, they may also expect

an escalation in prices If the initial interest rate does not change substantially, then

a fall in interest rate may cause a rising real interest rate As a result, investment will fall Thus, monetary shock will cause a business cycle However, this opinion was again re fi ned by Long and Plosser ( 1983 ) They argued that a business cycle is possible without considering complete information The decision regarding labor and capital inputs is considered at the beginning The actual output is, nevertheless, not exactly known at that particular point of time As a result, there is a variation

in inputs applied which is fi xed and expected, but output hardly coincides with expectations Such fl uctuations and resultant business cycles are independent of monetary shock

A political business cycle was introduced by Nordhaus ( 1975 ) and Lachler ( 1978 )

In this model, the economy is moving without any change over time It is the ment agencies and their operational policies which encourage monetary policies or

fi scal policies There is also coincidence of election dates, recession, and recoveries The government makes certain policies before the election date which may bring about a business cycle Prior to the Obama administration coming to power in the USA, there was a recession After normal functioning of the government had resumed, 1 year later, the US economy started showing symptoms of recovery Even

in India, prior to the election, there was a mild recession, partly because of US effect, which turned into a boom once the new government took charge Enough money was pumped into the economy through Sixth Pay Commission arrears given to nearly 3.8 million central government employees Later, several states also revised salaries and distributed arrears to the respective state employees Thus, a change in monetary policy contains business cycles (Sims and Zha 1996 ; Smets 1997 ) However, there can be deviations from the rule either by changing the systematic components of monetary policy or by considering an exogenous shock which leaves systematic monetary policies unchanged Nevertheless, the monetary transmission mechanism has been criticized on the basis of the role of the central bank (Favero 2001 , p 172) This may be termed structural distress

To show the slump, two growth models are also worth mentioning: one pounded by Harrod and Domar and the other by the neoclassicalist Solow Either there is an upswing or a downswing, but ultimately it is a question of a fl exible “rate

pro-of growth.” Domar (1946) and Harrod ( 1948 ) were very much concerned with growth and instability They experienced the effects of the Second World War The economies which were damaged were trying to recover fast; the underdeveloped economies were trying to take initiatives for faster economic growth The advanced capitalist economies which were free from slumps were attempting to achieve a long-run rate of growth and the socialist economies were trying to take a lead,

expand, and surpass the richer capitalist economies Both Harrod and Domar raised three questions pertaining to economic growth and instability First, the possibility

of steady growth, which will be equal to the saving–output ratio ( s ) divided by the capital–output ratio ( C ), where both s and C are fi xed Second, if growth is steady, then there may be the possibility of instability in steady growth If s / C is realized as

expected by capitalists, then it is “warranted” rate of growth If it dos not ize, in other words, if there is a growth rate other than that warranted, then instabil-ity problems will occur in the economy Thus, instability will lead to recession It all depends on the anticipation of investors If investors anticipate more than warranted

material-growth ( s / C ), the actual rate of demand will be more than the high expected material-growth

rate and then investors will realize that they expected less In another situation, if investors anticipate a growth rate lower than the warranted one, then the actual growth rate will be lower than the expected growth rate, and investors will realize that they expected more rather than very little Under these two situations, the mar-ket gives a red signal of disequilibrium to capitalists If actual demand falls short of expected demand, then utilization of potentiality may be underused This will lead

to a slump if it prevails for quite some time, followed by de fl ation If actual demand

is higher than expected demand, then fi rst dishoarding of inventory will take place Once inventory is exhausted, prices will rise Then the economy will have to be bal-anced between cumulative de fl ation and cumulative in fl ation To have an adjust-ment in the economy, capitalists may raise or reduce growth expectations in conformity with prices, either higher or lower than expected If we want to link it with employment, then in the case of a warranted growth rate higher than the natural

growth rate of the labor force ( n ), full employment will occur once the initial shock

has been absorbed Otherwise, if the warranted growth rate is lower than rate of growth of the labor force, then mass unemployment will occur in the economy

Thus, for adjustment in the economy there are only three variables, s, C , and n Here

n includes technological change as well Because of technology ( m ), labor can be

absorbed or replaced by machines In this Harrod–Domar model the saving–output ratio and the capital–output ratio are fi xed and therefore the model cannot properly explain market fl uctuation in a dynamic economy Suppose

Y X t / t =geC s/

where g is the expected growth rate of demand

Similarly, the actual growth rate of demand g a = ( Y t − Y t − 1 )/ Y t , and g a = g e = s / C = g w ,

where g w is the warranted growth rate This is a case of stable growth

If g a > g e , this situation will lead to fi rst dishoarding, and then in fl ation will occur

If g a < g e , this will lead to undercapacity production or recession and a fall in prices and unemployment

Besides Harrod and Domar, Cambridge economists such as Kaldor ( 1960 ), Pasinetti ( 1965 ) , Kalecki (1954), and Robinson (1956) felt the instability problem in the economy was because of a difference in income and saving propensities among workers and investors They agreed on adjustment through savings Pasinetti, while correcting Kaldor, incorporated returns on the accumulated value of a worker’s sav-ing If the rate of return is the same for workers and for capitalists, then the economy will ultimately converge on a growth path which will be affected by the propensity

of capitalists to save under certain assumptions In the case of a rise in saving by workers, there would be a fall in the income of capitalists The economy will be balancing off the initial impact Thus, investment will decline if the income of capitalists declines This will lead to constrained investment and a slump in the economy Thus, the Cambridge version uses income distribution as a factor for balancing the economy

The neoclassical economists tried to resolve the instability problem of Harrod and Domar The capital–output ratio is the reason for instability here (Solow 1956 )

If the warranted growth rate is greater than the natural growth rate including technology, then wages will be costlier than capital because of the full employment barrier Capitalists will search for labor-saving techniques Then the retrenchment

of labor will begin This will increase the capital–output ratio and reduce s / C until

it coincides with the natural and technological rate of growth Conversely, if the

warranted growth rate ( s / C ) is lower than the natural and technological growth rate,

then real wages and real interest rates will fall, more labor intensive technologies

will reduce the capital–output ratio, and s / C will increase until it equals the natural

and technological growth rate Thus, in the neoclassical model (Solow 1956 and Swan 1956 ) the capital–output ratio ( C ) adjusts the economy and brings about equi- librium, whereas s , n , and m (technology) remain constant

moving average models are generated by using a linear combination of stochastic processes Furthermore, a stochastic process becomes stationary if its joint density function does not depend on time This means a stochastic process becomes stationary

when for each J 1 , J 2 , … J n , the joint distribution, F ( X t , X t + j 1 , X t + j 2 … X t + jn ), does not

depend on t

The Cowles Commission (CC) approach is a conventional method of econometric modeling for monetary transmission It helps evaluate quantitatively the impact by monetary factors In this traditional analysis, there are three stages 4 :

1 Speci fi cation and identi fi cation of the model

2 Estimation of parameters of the model

3 Simulation of effects of policies formulated by monetary authorities

This CC approach for identifying macroeconometric models failed in 1970 because

it did not represent data and theory It was also not effective for forecasting and thus policy-framing That is why the London School of Economics (LSE) approach, pro-pounded by Lucas ( 1975 ) and Sims ( 1980 ) , the intertemporal optimization (real busi-ness cycle approach), was developed The LSE approach for macroeconomic modeling shows the ineffectiveness of the CC approach for the practical purposes of forecasting power as well as policy-framing This happens because the CC approach does not represent data and logical theoretical orientations The CC approach hardly takes projections into account explicitly Therefore, the CC approach mixes into the economy “deep parameters” such as preference and technology factors and “expected parameters” which are unstable across different policy authorities Because of insta-bility problems, the CC approach is useless in policy formulation and simulation, (Lucas 1976 ) There are several causes for our omission of relevant variables or the dynamics for the included variables, including the static equation The LSE solutions

to solve these problems use the theory of reductions Here modeling is interpreted as

a very simpli fi ed representation of the unseen statistics-generating process The quacy of the statistical model is evaluated by analyzing the reduced form, and the LSE approach starts its speci fi cation and identi fi cation procedure with a general dynamic reduced form model The congruency of such a model cannot be directly assessed against the data-generation process, which is unobservable

However, a series of investigative tests are proposed as criteria for evaluating the validity or congruency of the baseline model The congruent model should feature true random residuals; hence, any departure of the vectors of residuals from a random normal multivariate distribution signal indicates a misspeci fi cation Once the baseline model has been validated, the reduction process begins by simplifying the dynamics and reducing the dimensionality of the model by omitting the equations for those variables for which the null hypothesis of exogeneity is not rejected The LSE approach re fi nes it by decomposing it into different categories, determined by the purpose of the estimation by the model (Favero 2001 , p 92) After the last investigation for the validity of the reduction process is complete, the econometric model is used

to make forecast and policies

The LSE approach hardly questions the potential of macroeconometric modeling for simulation and policy evaluation At the juncture of simulation and policy evaluation

there is hardly any difference between the traditional CC approach and the LSE approach, but the LSE approach provides better identi fi cation and speci fi cation of the model, and the importance of estimation is deemphasized No innovation is proposed at the phase of simulation and policy evaluation The vector autoregressive (VAR) approach has much in common with the LSE method; however, it differs from the LSE method as regards the purpose of the speci fi cation and estimation In the CC approach the typical question asked within a macroeconometric model is as follows: “What is the optimal response by the monetary authorities for movement in variables to achieve given targets for the same variables?” The VAR method knows about the Lucas critique and puts a question such as “How should a central bank react to shocks on macroeconomic variables?” This has to be answered within the framework of quantitative general equilibrium models of the business cycle (Favero

2001 , p 162) So the answer will depend on the theoretical model rather than an empirical model The VAR method is con fi ned to deviations from the monetary rule which gives solution to the problem of endogeneity of money The fi rst type of deviation is obtained by modifying the response of the central bank rates to macro-economic conditions such as fl uctuations in output, prices, and the consumer price index The other deviation is seen by considering an exogenous shock which does not alter the response of the monetary authority VAR models have concentrated on simulating thoughts, leaving the systematic component of monetary policy unal-tered Nevertheless, the VAR approach has been criticized because it views central banks as “random number generations.” This is not correct since monetary rules are explicitly estimated in structural VAR models However, the focus is not on rules but on deviations from rules Deviations from monetary rules help detect the response of mac-roeconomic variables to monetary incentives unexpected by the markets The mon-etary impulses (such as policy rate and interest rates) relevant to the transmission analysis are, therefore, structural shocks (Favero 2001 , p 172)

The LSE and VAR models of monetary transmission mechanism have a common structure, which is as follows (Favero 2001 , p 163):

1 1

where Y and M are vectors of macroeconomic (nonpolicy) variables (e.g., output

and prices), and variables controlled by monetary aggregates and other factors, respectively Matrix A shows the contemporaneous relations among the variables

C ( L ) is a matrix fi nite-order lag polynomial.

Y M

v v v

æ

ºç ÷ö

is a vector of structural disturbances to the nonpolicy and policy variables;

non-zero off-diagonal elements of B allow some shocks to affect directly more than one

endogenous variable in the system The main difference between the two methods lies in the objectives for which both models are intended

5 Inadequate Information and Downswing

Information about the structure and activities of markets has a great bearing on business fl uctuations If markets are decentralized and buyers, sellers, and other agents have limited and incomplete information about other markets, price signals

do not give correct information This leads to frequent failure of markets and shocks appear These shocks could have been avoided in the case of perfect and unlimited information about the markets (Phelps et al 1970 ) The world market is composed

of many country-speci fi c markets (islands in Phelps’s analysis) Shocks affect the demand in each market They affect nominal money and productive sector The suppli-ers may react to these shocks They do not have complete information to distinguish between them

In this model of Lucas, nominal monetary shocks and real output shocks are totally caused by decentralized markets and imperfect market information In this model, however, there is no issue of maximization This was dealt with by Barro (1976, 1981 ) Further, there is no dynamics in this model Unexpected money affects output for one period Thus, it is a static analysis The central points of limited infor-mation and lack of proper coordination in decentralized markets are, nevertheless, very important Two opposite directions of research have been followed since this contribution of Lucas The belief that aggregate demand movements have an important effect on output by explaining the comovements in money and output in terms of reverse casualty and dismissing the rest of the evidence on the effects of demand shocks as weak has been dislodged Imperfections can lead to strong effects

on aggregate demand and output (Blanchard and Fischer 1989 ; Prescott 1987 )

Fiscal measures have enough potential to reduce fl uctuations in a market Taxes and (the government) transfer payments (TTP) reduce fl uctuations in income In the case of a change in income, TTP change automatically Subsequently, with the vari-ation in TTP-led income, the multiplier is also reduced This means fl uctuations in income due to a variation in investment lead to lower spending and bring about a stabilization effect on the economy This way fl uctuations in economic activities are moderated and automatic stabilization becomes possible provided actions taken on

fi scal policies are timely A delayed action on fi scal policies may not counter the

fl uctuations when it is desired Therefore, TTP are supposed to be a better method

of stabilization because they directly vary with income During a recession, various activities in the economy are at a low level With a fall in output and employment, taxes also fall automatically and the government transfer payments increase As a result, disposable income is not reduced, and consumption is not lowered The economy does not feel a severe attack on various activities It is also worth mentioning that since TTP change automatically with income and bring about rapid changes in the

economy, for instance, if an employee retires, taxes are no longer withheld from the employee and his/her tax liability will be reduced Further, he/she may be entitled to other or compensatory bene fi ts governed by transfer payment rules This brings about automatic stabilization If the TTP are of a discretionary nature for which the government has to make provisions in the time of recession, then TTP occur slowly because the government takes time to frame rules and enforce them in the economy effectively The only drawback with TTP-led automatic stabilization is that as income and employment rise, taxes increase and transfer payments decrease Such changes reduce the rate of rise in disposable income This means automatic stabilizers help retard the economic recovery from recession However, there is evidence that these TTP stabilizers contained the length and intensity of the US recessions in 1953–1955, 1957–1959, 1960–1961, 1969–1970, and 1973–1975 US (Lewis 1962 ; Sharp and Khan 1980 )

If we link fi scal policies and TTP, then the budget de fi cit is considered as an sionary policy of the government Similarly, a surplus is considered as contractionary policy In this situation, de fi cits and surpluses are not a true measure of fi scal policy because TTP vary with income During a recession, income from taxes is reduced and transfer payments increase This pattern causes a budget de fi cit As a consequence, the

expan-de fi cit is due to the recession, and is not due to expansionary fi scal policies Thus, a budget de fi cit occurs in a recession because of the effects of TTP, which are self-regulating stabilizers of a market If the policies of the government are contractionary, then the full employment budget shows a surplus The full employment surplus is a better indicator of the effect of fi scal policies than the actual surplus or de fi cits since

it shows that fi scal policy is contractionary (Edgmand 1985 )

The estimated time of the beginning of the US recession was mid-2007 In 1 year, between September 2007 and October 2008, 16 banks in the US went bankrupt Further, more than 100 banks of the approximately 7,000 banks were in the danger zone The Federal Reserve was very alert to this situation First, the recession affected the USA and then spread over Europe and emerging Asian countries For example, the gross external liabilities of the three major Icelandic banks were estimated to be equal to almost fi ve times the GDP of Iceland During this period a few other esti-mates were made For instance, as per the UN baseline survey in 2008, the world output grew by 2.5 %, but in 2009 it grew by 0.4% to 1.0% There was a −0.5 % growth rate in developed countries taken together The corresponding fi gure was 4.6 % in 2009, which is relatively low in comparison with 5.9 % in 2008 (Kumar

2009 ) The ILO provided unemployment data for the duration of the recession It estimated that unemployment at the world level increased from 5.7 % in 2007 to 7.1 % in 2009 As a result, about 51 million more people were unemployed in 2009

in comparison with 2007 In South Asia the unemployment rate grew from 5.3 to 6.4 % As a result, seven million more people were retrenched This increased the

poverty in South Asia and the world The other effect of rising unemployment and the recession was a fall in the average wages of workers The average monthly wages declined by 0.26 % to 3.45 % in October to December, 2008 and by 0.26 % in January

2009 In India also, negative growth rates were estimated in the farming and allied sectors (−2.2 %) and in manufacturing sectors (−0.2 %) To improve the situation, public interventions were made The government used public funds to buy tainted assets The euro region contracted by 1.5 % Japan contracted by 12 % per annum The UK, Russia, and Canada are in recession The economies of China, Brazil, South Asia, and India slowed down Other economies such those of as Spain, Mexico, Ireland, Iceland, Singapore, Greece, Ecuador, Hungary, and Latvia are in deep eco-

nomic trouble The US extended its bailout package to US $8.38 trillion ( New York Times 2009 ) OECD countries also offered large stimulus packages to big business houses The main reason for the global downturn was the economic activities adopted during the phase of global integration A crisis in one economy will certainly affect other economies because of externalities The markets of the USA and other coun-tries have accepted the uniform model of major operations Many people suspect there are fi nancial irregularities because banks work on the basis of mutual con fi dence

of borrowers and lenders When investment bankers joined the fi nancial market, they were regulated for a long period Investment banks along with some other fi nancial banks buy huge amounts of assets by borrowing from others to make high returns Shareholders were assured of high pro fi ts They earned good credibility in asset transactions and wanted fewer regulations for such transactions Even US stock mar-kets aligned with the desires of these fi nancial institutions and investment bankers and deregulated several provisions The trading of fi nancial assets increased rapidly

As a result, asset prices rose and capital gains accrued Wealth and assets increased

on paper This mechanism can continue automatically if the asset values keep rising The capital gains were invested back into the fi nancial sector However, this chain of appreciation of assets and capital gains could not go on forever It was later observed that the hiatus started in subprime lending for mortgages of housing assets and credit cards As a consequence, the value of assets started falling Investment gains started reducing; lending was no longer pro fi table, and the market started losing business This generated a reverse gear from boom to recession Bailouts and other types of stimulus packages were extended by the relevant governments in all countries in a Keynesian manner (Godley & Izurieta 2002 ; Kumar 2009 )

The slump has affected the US economy In 2010, poverty was more than 15 %, which accounts for nearly 46 million people The poverty rate has been estimated as the highest since 1993 This rate is also the highest in developed countries According

to the de fi nition of poverty, a household with four persons including two children having an annual income of $22,113 or below is a poor household Racewise there

is also immense disparity in poverty Blacks and Hispanics together accounted for

54 % of the poor, with whites accounting for 9.9 % and Asians for 12 % The ployment rate hovered above 9 % for the second year Even insurance cover has declined, from 16.3 to 16.1 % The US economy is facing the lingering effects of recession, with high unemployment, high poverty, high numbers of uninsured persons, large cuts in public spending, high in fl ation, and an energy crisis (Census Bureau

unem-Annual Report 2011 ) In total, a recession caused by inadequate fi nancial information and unethical responses normally continues for a slightly longer duration This happens because fi nancial market activities take more time to be absorbed clearly in the economy or economies

The US economy was coming out of the great global recession of 2008–2009 (Pollin 2010 , 2011 ; S&P 2011 ) The economy was recovering and trying to make

an upswing On August 5, 2011, there was a historic downgrading of US debt by credit rating agency Standard and Poor’s (S&P) from AAA to AA+ Many agencies have tried to challenge this rating, which seems to be fallacious Meanwhile the product and money market has started giving a bad signal The USA is likely to face recession It may be said that the mid-2007 slump and the 2011 likely expectation

of recession will intensify the downswing in the US economy As a consequence, its effects may be seen on Indian and other economies as well It can be further added that other credit rating agencies, Moody’s and Fitch, rated US government bonds as AAA The downgrading of US debt is really the second global distress signal and therefore needs close perusal because the rating announcement somehow appeared just after the US government managed to reach a ceiling on the budget cutting agree-ment on August 2, 2011, after successful discussions The present scenario is hardly identical to the global fi nancial crisis of mid-2007 or the crisis following the fall of Lehman Brothers in September 2008 At this juncture the issue is linked to debt discipline This is expected to be a laudable approach by the US government A large number of core countries maintain a policy of disciplined expenditure But these countries do not have a sound and scienti fi c borrowing policy In that context, the present initiative of the USA seems a genuine and post recessionary disciplined step for economic adjustment The debt ceiling deal is up to US $2.4 trillion; how-ever, a debt reduction of only $2 trillion has been decided by the US government There are three types of US debt:

1 The gross public debt at present amounts to approximately 95 % of US GDP

2 After subtracting the “debt to itself” category from the gross public debt, the US government has a debt burden of 60 % of GDP, which has been borrowed from private and external sources

3 If “ fi nancial” assets such as gold reserves, foreign exchange reserves, public bonds, and other assets are subtracted or discounted, then net public US debt is about 40 % of GDP at the end of 2010 (Weeks 2011 )

The debt payment of the US government was 1.6 % of GDP in 2010 Even for Japan this was 1.4 % The S&P statement has been rejected by the US government for at least two reasons First, the debt burden reduction is less than the higher limit Second, it is constitutionally and hence legally correct to pay the debt and reduce the burden in the due course of time Third, the calculation of S&P is full of statistical

errors In the past, S&P made a similar mistake, which raised the debt burden by almost US $2 trillion (Bellows 2011 ) Thus, this time there is no need to panic This

is merely a budgetary adjustment During the years before the recession there was approximately $2.1 trillion a year of private borrowing For the household sector, borrowing reduced substantially because of the collapse of asset values during the recession For the business sector, however, this was not the trend The government debt creation from mid-2008 to mid-2010 was $1.7 trillion per annum on average During the same period, private sector debt contraction was $2.5 trillion below the norm for the previous period (for details, see Table 1.1 ) Thus, it can be concluded that the problem with public debt creation in the USA since the recession took hold

is that “it is inadequate rather than excessive” for the task at hand (Izurieta 2011 ) Implementation of the Buffett Rule is also in the pipeline in the USA Warren E Buffett has on many occasions suggested that the richest Americans normally pay a smaller fraction of their income in federal taxes than do the middle-income work-force This happens because investment gains are taxed at a lower rate than wages

To reduce the long-term de fi cit, imposition of higher taxes on investment gains may

be a better fi scal solution The other way of de fi cit reduction is by reforming bene fi cial programs such as Medicare, Medicaid, and Social Security Taxing the investment gains may lead to a reduction in investment Just after the recession, a proper rebalancing is needed The government is also presently planning to curtail public expenditure drastically

We reach the conclusion that market instability is caused by many factors, such as changes in consumption, production, investment, inventory, saving propensity, cap-ital–output ratio, labor force, technology, and various services, including fi nancial services In addition, monetary and fi scal policies of the government also play a crucial role in maintaining an ef fi cient market Even externalities and public goods lead to market failure In this chapter we have theorized about the downswing and upswing of the market and deduced an appropriate VAR method to estimate it US recessionary situations that were caused by unregulated fi nancial networking and collapse of assets have been analyzed

It has also been argued that estimation of public debt in August 2011 by the credit rating agency S&P created panic Actually, the public debt data generated by the agency are fallacious Merely small public debt repayment may not result in a heavy loss in investment and hence a fall in employment and consumption, and may not lead to a recession This is a post recessionary budgetary adjustment because the

US economy has kicked off the downswing phase There are many other factors for balancing the US economy However, frequent market failures are symptoms of a capitalist economy Their frequency and intensity can be contained by alert market monitoring and prompt public interventions Simple rules, transparent management, and proper computation of data can help check a recession A minor slip from the full employment equilibrium can push the economy again into a recessionary cycle

Households Firms

State and local governments

Federal government Percent growth of debt stock (annualized)