Why an Economy May Enter a Recession

Why may an economy enter a recession? Discuss how a government might use fiscal policy to combat recession, and what difficulties it might face in doing so.

A recession can be caused firstly by a negative demand shock. Here, fall in Aggregate Demand reduces Price and reduces Y below Y*. Such a shock could arise from a drop in consumer confidence, for example. This pessimism reduces demand for all goods at all prices, shifting AD leftward to AD1. The nation’s output falls below its productive potential Y* to Y1 and the general price level drops. The falling level of output, lower sales and production means firms will reduce employment. If a long and deep recession occurs, and unemployment rises above the natural rate by the time the recovery happens, the natural rate will rise

A more adverse cause of a recession, and the worst scenario for a government is a negative aggregate supply shock. This can happen