What is a recession and what causes it?

It’s normal for economies to fluctuate. And on any given day, the economy might trend slightly up or down. But when the economy declines for a prolonged period of time, that might indicate that a recession is happening. 

Learn more about what a recession is, what causes recessions and some potential recession indicators. Plus, find out what people can do to prepare for any kind of economic downturn.

Key takeaways

  • A recession describes a period of widespread, prolonged economic decline.
  • The National Bureau of Economic Research (NBER) determines if the U.S. economy is officially in a recession.
  • It’s hard to pinpoint exactly what causes a recession. But some factors that might contribute to recessions include economic shocks, stock market crashes, fiscal and monetary policy, asset bubbles bursting and psychological factors.
  • According to the Department of Labor, recessions are hard to predict. Some economists look for an inverted yield curve—which happens when long-term interest rates are lower than short-term interest rates—to predict recessions, but it’s not always a sure sign. 

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What is a recession?

Generally speaking, recessions are prolonged periods of economic decline. Some say that a recession is marked by two consecutive quarters of decrease in gross domestic product (GDP)

But recessions are actually more complicated than that. And looking only at GDP ignores other potentially important indicators of recessions.

Who determines that an economy is in a recession?

The NBER determines if the U.S. economy is officially in a recession. 

The NBER says that its “traditional definition of a recession is that it is a significant decline in economic activity that is spread across the economy and that lasts more than a few months.”

When deciding whether a recession is happening, the NBER looks at factors like industrial production, employment rates, personal income and more. 

But the NBER also notes that “there is no fixed rule about what measures contribute information to the process or how they are weighted in our decisions.” So exactly how it decides whether the economy is in a recession might change. 

There’s also no fixed amount of time that the NBER takes to decide whether the economy is in a recession. It waits until it has enough data to make a confident determination.

What causes a recession?

While it’s not always possible to pinpoint the exact causes of a recession, it can help to understand some of the factors that may contribute to recessions.

  • Economic shocks are events that have an unexpected effect on the economy. For example, a war or pandemic might cause a sudden change in the supply or demand of certain products or services.
  • Stock market crashes refer to a major, often unexpected, drop in stock prices. One of the most famous stock market crashes happened on October 28, 1929. It’s cited as one of the main causes of the Great Depression.
  • Fiscal policy refers to the ways the executive and legislative branches of the federal government work to influence the economy, like by raising or lowering taxes. 
  • Monetary policy describes the actions the Federal Reserve takes to reach economic goals, like stabilizing prices and interest rates. Both fiscal policy and monetary policy can play a part in recessions.
  • Bursting of asset bubbles happens when an asset or industry grows rapidly and then crashes. For example, some consider the housing bubble burst of 2007 to be a leading contributor to the recession that followed. 
  • Psychological factors are also cited by some economists as contributing factors to some recessions. These can include things like people making risky investments during economic booms or cutting back on spending in anticipation of an economic downturn. 

Remember, these are just some things that economists argue may contribute to recessions. After all, economies are complex. And different recessions may be caused by a different combination of factors.

How a recession affects the market and its players

Recessions affect different parts of the economy in different ways. And people might experience the worst of a recession at separate times. 

For example, investors may feel the effects of a recession most when stock prices fall. Other people might feel a recession is at its worst when layoffs happen.

And when the economy starts to bounce back, the stock market is often the first thing to start trending upward—while high unemployment rates might linger. That can affect how different people experience and judge the end of a recession, too. 

Is it possible to predict a recession?

There’s no guaranteed way to predict a recession. The Department of Labor says this is partly because there have been relatively few recessions in the U.S. So it can still be hard for economists to collect enough data to pin down exactly what leads to a recession.

Some economists look for something called an inverted yield curve to help predict recessions. An inverted yield curve happens when long-term interest rates are lower than short-term interest rates.

And while inverted yield curves have come before some recessions, there have also been times when an inverted yield curve happens and a recession doesn’t follow. So while it can be one indicator that a recession may happen soon, it’s not a sure sign. 

How can you prepare for a recession?

Thinking about economic downturns can be scary. But there are some things you can do that might help you feel more prepared to navigate tough financial times. 

  • Start an emergency fund. Building an emergency fund can give you some peace of mind knowing you have money saved to cover unexpected expenses.
  • Pay down debt. Paying down debt—especially high-interest debt—could help ease your financial strain.
  • Build a budget. Budgets can help you see where your money is going, make sure you’re living within your means and make it easier to find ways to cut down on expenses when you need to. 
  • Keep your resume up to date. Keeping your resume updated can help you stay a step ahead of the game if you have to deal with an unexpected job loss.

Recessions in a nutshell

Recessions can be difficult to navigate. But the more you know about how they work and what you can do to prepare, the more resilient you can be to any kind of economic change. 

If you want to read more about navigating tough financial times, you can learn how unemployment insurance works, how to save money while paying off debt and how to be resilient during financial uncertainty.

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