Skip to content

Lesson M03.L05: Introduction to Short-Term Fluctuations: What Causes Recessions?

Module: Unemployment and the Labour Market; Introduction to Short-Term Fluctuations Level: intro Duration: 30 minutes Learning Objective: Explain demand and supply shocks as drivers of recessions; categorise the causes of Australian recessions since 1970 (oil shock, credit crunch, COVID-19). Data as of: 2024 Provenance: OpenStax Macro 3e | RBA Education | ABS National Accounts

Explanation

Economies do not grow smoothly. They go through business cycles — alternating periods of expansion (growth above trend) and contraction (growth below trend or negative). A recession is conventionally defined as two consecutive quarters of negative real GDP growth.

Short-term fluctuations are driven by economic shocks — sudden, unexpected events that disrupt supply or demand:

Demand shocks shift the amount of goods and services that households, firms, and governments want to buy. A negative demand shock reduces spending (e.g., a financial crisis causing banks to tighten lending, or a collapse in consumer confidence). A positive demand shock boosts spending (e.g., a large government stimulus).

Supply shocks affect the economy's ability to produce. A negative supply shock raises costs and reduces output simultaneously (e.g., a sharp rise in oil prices). A positive supply shock lowers costs and raises output (e.g., a technological improvement).

Australian recessions since 1970:

Recession Approximate dates Primary cause Type
1974–75 1974–1975 OPEC oil price shock; inflation surge Negative supply shock
1982–83 1982–1983 Tight monetary policy; drought; global downturn Negative demand & supply
1990–91 1990–1991 High interest rates; credit crunch; asset price collapse Negative demand shock
2020 Mar–Jun 2020 COVID-19 pandemic; lockdowns Simultaneous demand & supply shock

The 2020 COVID recession was unique: lockdowns simultaneously crushed demand (consumers couldn't spend) and disrupted supply (businesses couldn't operate), causing Australia's first technical recession in nearly 30 years. Real GDP fell 7% in the June 2020 quarter alone, before rebounding sharply with government stimulus (JobKeeper, JobSeeker supplement, cash grants).

Worked Example

The 1974–75 Oil Shock in Australia

In late 1973, OPEC (Organization of Petroleum Exporting Countries) quadrupled oil prices. Trace the impact through the Australian economy:

Step 1 — The initial supply shock: Oil is an input to almost all production (transport, manufacturing, heating). Higher oil prices → higher production costs for Australian firms.

Step 2 — Effect on output: Firms facing higher costs reduce production (or raise prices). Real GDP growth slows; the economy contracts.

Step 3 — Simultaneous price effect: Higher input costs push up consumer prices. Australia's CPI inflation surged to around 17% by 1975 — unusually, the economy experienced both rising unemployment and rising inflation at the same time, a combination called stagflation (stagnation + inflation).

Step 4 — Policy dilemma: Traditional demand-management tools couldn't fix stagflation: stimulating demand worsened inflation; tightening policy worsened unemployment. The oil shock revealed the limits of demand management and helped end the post-war Keynesian consensus.

Comparison with 2020 COVID shock: - Oil 1974: pure supply shock → stagflation - COVID 2020: simultaneous demand + supply shock → sharp GDP collapse but initially low inflation (demand destruction dominated), followed by supply-chain inflation in 2021–22

Common Misconception

Misconception: Recessions are always caused by government policy mistakes.

Correction: While poor policy can worsen a recession (e.g., raising interest rates too aggressively as in 1990), many recessions originate in external shocks entirely outside government control — OPEC's oil price decisions, global financial contagion, or a pandemic. Australia's 2020 recession was triggered by a virus, not a policy error. Government policy response can amplify or dampen the effects, but it is rarely the sole cause. Understanding shock origin — demand vs. supply, domestic vs. external — is the first step to designing an appropriate policy response.

Practice Prompts

  1. A bushfire season destroys a large portion of Australia's agricultural output and disrupts supply chains. Is this a demand shock or a supply shock? What effect would you expect on prices and output? → Answer: This is a negative supply shock. It reduces the economy's productive capacity. Expected effects: output falls (lower real GDP) and prices rise (inflation increases) — the combination known as stagflation. Policy response is difficult because stimulating demand would worsen inflation.

  2. The Reserve Bank of Australia raises the cash rate sharply from 1% to 4% within 12 months to fight inflation. Household mortgage repayments rise, consumer spending falls, and business investment slows. What type of shock has the RBA effectively created? What is the likely impact on unemployment? → Answer: The RBA's tightening is a negative demand shock — it reduces aggregate spending. Output falls below potential, and cyclical unemployment rises as firms cut back production and hiring. (Note: This is the intended effect when demand-pull inflation is the problem — it is a deliberate policy action, but it still operates as a negative demand shock to the real economy.)

  3. Name two Australian recessions since 1970 and classify the primary shock that caused each. → Answer: Any two from the table, e.g.: (1) 1990–91 recession — caused primarily by a negative demand shock: the RBA raised rates to record highs (~17%) to fight inflation, triggering a credit crunch that collapsed investment and consumer spending. (2) 2020 COVID recession — simultaneous negative demand and supply shock: lockdowns stopped consumers spending (demand) and prevented businesses from operating (supply). Both caused sharp contractions in real GDP.

Visual — Business Cycles Around Trend Output

Business cycles are fluctuations around a rising long-run trend Time Real GDP Peak Trough Peak Trough Trend output Recession / contraction Expansion Australia: 1974–75, 1982–83, 1990–91, 2020

Figure: Real GDP does not grow in a straight line. It oscillates around a long-run trend, moving through expansions, peaks, recessions, and troughs — exactly the pattern economists describe as the business cycle.

Further Resources