What Causes Recessions?

More specifically, what causes non-Covid recessions? Here’s Nick Rowe’s answer:

At some level, Nick and I basically agree. But I am going to answer the question slightly differently. It’s not necessarily wrong to say recessions are caused by money hoarding, or by interest rates being set too high, or by a drop in spending on C+I+G+NX, but I don’t find any of these explanations to be the most useful way of framing the issue.

In my forthcoming book (July 16, 2021), I argue that if monetary policy X is the most reasonable way to prevent recessions, then recessions are caused by not doing monetary policy X. More specifically, I believe the most effective way to prevent recessions (except the Covid recession) is to stabilize 1-year forward NGDP growth expectations at around 4%/year. So in that sense, recessions are caused by sharp declines in NGDP growth.

As an accounting matter, NGDP is the monetary base times base velocity. So you could say that Nick is describing the empirical fact that declines in M*V are mostly due to declines in V.And Nick would probably agree with me that it’s the central bank’s job to offset decreases in velocity by increasing the supply of money during periods where money demand is increasing. (Lower velocity is equivalent to higher money demand.)

The basic monetary model of recessions is symmetrical, and thus falling NGDP could be produced by either an increased demand for money or a decreased supply of money. That raises an interesting question. Are recessions merely “errors of omission”, periods where the central bank fails to accommodate an increase in money demand, or are some recessions caused by declines in the growth rate of the (base) money supply.

Here’s the US monetary base growth rate from 1918 to the mid-1960s:

The sharp drop in base growth seems to have lagged in the 1920-21 recession, but that’s a bit misleading. That recession was quite mild during the first 8 months of 1920, and thus the (plunging) supply of base money actually correlates pretty well with falling NGDP during the short but severe 1920-21 slump. Base growth also turned negative in 1929-30, although velocity also declined sharply during that year. Base growth fell especially sharply before and during the 1937-38 slump. It also turned negative right before the 1949 recession, and the growth rate fell to roughly zero during the three Eisenhower recessions.

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