Common Causes of Economic Recession

March 21, 2023 R47479

Common Causes of Economic Recession
March 21, 2023
In the short term, the economy fluctuates between periods of increasing economic activity—
expansions—and decreasing economic activity—contractions, or recessions. Recessions are
Lida R. Weinstock
characterized by decreases in output and employment. The periods of recession, although
Analyst Macroeconomic
temporary, can cause significant economic hardship. For this reason, smoothing, or decreasing
Policy
the volatility of the business cycle, can help to ease the short-term output and employment losses

caused by economic downturns. Countercyclical fiscal and monetary policy—policy that works
to counter the business cycle—can be helpful on this front, although there may be situations in

which policymakers would opt for pro-cyclical policies instead.
Recessions are determined and defined by the National Bureau of Economic Research (NBER), an independent nonprofit that
performs economic research. NBER defines recession as a “significant decline in economic activity that is spread across the
economy and that lasts more than a few months.” There is no single numerical criterion for recession; rather, NBER looks at
a variety of factors in determining recessions, including income, employment, consumption, sales, and industrial production.
Owing to the criteria and methodology for determining recessions, NBER normally officially declares the beginning and end
of a recession several months after the fact, meaning that policymakers are often required to weigh policy options prior to the
official declaration of a recession.
Recessions are the result of shocks to aggregate supply or aggregate demand in the economy or both. A supply shock occurs
when something reduces the economy’s ability to produce output at a given price level. A demand shock occurs when
something reduces businesses’ and households’ willingness to consume and invest at a given price level. Supply-induced
recessions tend to be characterized by decreased output and increased prices, while demand-induced recessions tend to be
characterized by both decreased output and prices. For this reason, supply shocks are often more challenging to deal with,
because (1) demand-side policies that would increase output may result in further price increases, or (2) available supply-side
policy tools may not be equipped or able to counter the shock (e.g., an increase in global oil prices).
The proximate causes of recession are many and varied. Any number of events can send the economy toward recession by
affecting aggregate demand, aggregate supply, or both. Sometimes determining a single causal event is not possible—the
belief by consumers and businesses that the economy may slow in the near future can result in large enough behavior changes
to result in recession. Oftentimes, however, economists can point to a specific event. A few of those most common causes of
recession in the United States are as follows:
 Supply shocks. Under certain circumstances, a sudden drop in the available supply of commodities crucial
to the production process can result in sudden price increases and dysfunction in economic activity. If the
shock is large and wide-reaching enough, the economy can enter into a recession.
 Mistimed or outsized policies. Contractionary monetary or fiscal policy can prove beneficial to the
economy when timed and sized correctly. However, given lags in data and policy effects, it can also be
challenging to properly scope such policies. The result can sometimes be a drop in aggregate demand large
enough to result in recession.
 Financial crises. Dysfunction in financial markets, if widespread and deep enough, can result in greater
economic problems. When financial markets do not function properly, this can lead to tightening credit
conditions throughout the economy and decreased demand.
 Housing market crashes. Owner-occupied housing represents a significant share of household wealth in
the United States. As with other assets, price bubbles can grow and then burst in the housing market,
leading to greater economic stress and recession. Additionally, patterns of residential construction have
historically followed a similar pattern to the business cycle, making the housing market a potential
predictor of economic conditions.
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Introduction
If and when a recession may occur is never completely predictable. However, there is a concern
currently among some policymakers and economists that the U.S. economy may be headed for
recession in the near term or is already there. The economy over the past two years has been
characterized by unusually high inflation and uneven growth. Furthermore, policies that can
lower inflation can also result in recession, depending on timing and size. Despite easing inflation
and a low unemployment rate at present, many economists still predict that a recession is coming.
For example, the January 2023 Wall Street Journal Economic Forecasting Survey (a quarterly
survey of over 70 private sector economists) showed that forecasters estimated the probability of
recession in the next 12 months to be 61%.1
A major reason that recessions can be difficult to predict (and why it is difficult to know if the
United States is currently headed for recession) is that recessions can have several different
proximate causes. Further, whether or not a policy stance, specific event, or trend in the economy
results in recession is context dependent. However, there are certain fairly common causes of
recession in the United States. This report provides an overview of recessions and discusses some
common causes, both generally and in the current economic context. The report also considers
policy options for Congress and the Federal Reserve if the economy were to enter a recession.
The Business Cycle
Over time, economic activity tends to fluctuate between periods of increasing economic activity,
known as economic expansions, and periods of decreasing economic activity, known as
recessions. Real gross domestic product (GDP)—total economic output adjusted for inflation—is
the broadest measure of economic activity. The economy’s movement through these alternating
periods of growth and contraction (or recession) is known as the business cycle. The turning point
between an expansion and contraction is known as a peak, and the turning point between a
contraction and expansion is known as a trough, as shown in Figure 1.
Figure 1. Stylized Depiction of the Business Cycle

Source: Congressional Research Service.
As the economy moves through the business cycle, a number of additional economic indicators
tend to follow the same pattern as GDP. During an economic expansion, economy-wide

1 Harriet Torry and Anthony DeBarros, “Economists in WSJ Survey Still See Recession This Year Despite Easing
Inflation,” Wall Street Journal, January 15, 2023, https://www.wsj.com/articles/despite-easing-price-pressures-
economists-in-wsj-survey-still-see-recession-this-year-11673723571.
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employment, incomes, industrial production, and sales all tend to increase alongside rising real
GDP. Additionally, over the course of an economic expansion, the rate of inflation tends to
increase, although the 2009-2020 expansion showed that inflation can remain low throughout the
expansion. During a recession, the opposite tends to occur. All of these indicators do not shift
simultaneously, but they tend to shift around the same time.
Although these fluctuations in economic activity are referred to as a “cycle,” the economy
generally does not exhibit a regular and smooth cycle as shown in Figure 1. Predicting recessions
and expansions is notoriously difficult due to the irregular pattern of the business cycle. A single
quarter of economic data can be too short to predict a trend, although this was not the case during
the initial months of the COVID-19 pandemic. During an expansion, there may also be short
periods of decreasing economic activity interspersed within an expansionary period, and vice
versa.2 Recessions are also not a consistent length or depth—the past two recessions, for example,
were two months and 18 months but were both deep relative to most historical recessions—but
they have all ended eventually with or without policy intervention.
Over the business cycle, the rate at which the economy is expanding or contracting can be
significantly different. For example, during the 2009-2020 expansion, real GDP grew at an
average pace of about 2.3% per year, whereas real GDP shrank at an annual rate of 31.4% in the
second quarter of 2020 before growing at an annual rate of 33.1% in the third quarter.3 (Most
contractions and expansions are not as severe as those seen in 2020 as a result of the pandemic,
but they can differ notably.) Over longer periods of time, the volatility of the business cycle
averages out to reveal a pattern of growth in the economy. Determinants of long-term growth are
out of the scope of this report, which focuses only on the short term.4
Technical Definition of Recession
Recessions are not determined by the federal government and are not defined in statute. The
National Bureau of Economic Research (NBER)—an independent nonprofit organization that
conducts and disseminates economic research—defines recession as a “significant decline in
economic activity that is spread across the economy and that lasts more than a few months,” but it
does not have a set numerical formula to define a recession. Instead, NBER evaluates three
criteria—depth, diffusion, and duration—using a variety of monthly economic indicators
including income, employment, consumption, sales, and industrial production.5
A popular rule of thumb is that recessions feature at least two consecutive quarters of negative
GDP growth, but this rule of thumb is not technically correct. Although NBER considers GDP
growth in its quarterly business cycle dating, it cites several reasons for not using the two-quarter
rule as a definition for recessions. NBER:
 does not rely on just one indicator,
 considers depth of declines in activity,

2 For further discussion of the business cycle and the economy, see CRS In Focus IF10411, Introduction to U.S.
Economy: The Business Cycle and Growth, by Lida R. Weinstock.
3 For GDP data, see U.S. Department of Commerce, Bureau of Economic Analysis (BEA), “Gross Domestic Product,”
https://www.bea.gov/data/gdp/gross-domestic-product.
4 For discussion of determinants of long-term growth, see CRS In Focus IF10408, Introduction to U.S. Economy: GDP
and Economic Growth, by Mark P. Keightley and Lida R. Weinstock.
5 NBER, “US Business Cycle Expansions and Contractions,” https://www.nber.org/research/data/us-business-cycle-
expansions-and-contractions.
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 uses more frequent monthly data (so as to provide monthly dates for recessions),
and
 accounts for discrepancies in output and income data.6
An outsized impact to one criterion can make up for a weaker impact to another. For example,
NBER declared the United States to be in a recession from March to April 2020—less than two
quarters—owing to the extreme drop in economic activity, despite the brevity of the contraction.
NBER considers length and depth of economic downturns in determining recessions. It dates
recessions and expansions with a lag so as to consider economic activity over longer periods. This
lag is not consistent across all business cycle dating, but it can be many months. Practically, this
means that the economy enters recession before the recession is officially announced, which can
make timing policy responses challenging.
Common Causes of Recession
Economic growth is the result of the interaction between aggregate supply (total production) and
aggregate demand (total demand). There are two general types of causes of economic recession:
supply shocks and demand shocks. A supply shock occurs when something reduces the
economy’s ability to produce output at a given price level. A demand shock occurs when
something reduces businesses’ and households’ willingness to consume and invest at a given price
level. Supply and demand shocks happen unpredictably and irregularly, which is why expansions
are not a regular length and recessions are hard to consistently avoid. Supply shocks and demand
shocks can be caused by a variety of events, some of the most common of which are discussed
below.
Not all economic shocks are so clear cut, and some have both supply and demand components.
For example, the COVID-19 pandemic resulted in significant supply and demand disruptions. On
the supply side, the pandemic caused disruptions in the production process as labor and trade
became constrained. On the demand side, fears and mandated restrictions resulted in sudden
decreases in consumer and business spending. While the following sections categorize shocks as
purely supply or demand, in actuality, shocks may affect the economy through several channels.
Supply Shocks
Supply shocks, depending on their severity and breadth, can result in recession. When an event
disrupts an economy’s productive capacity, typically by making an input to the production
process scarce or relatively expensive, output will typically decrease and prices increase.7 In other
words, supply-shock-induced recessions tend to exhibit falling output and employment and
increased inflation. Owing to the increase in prices, a supply shock can often dampen aggregate
demand as well, further exacerbating the downturn.
While supply shocks can come from anywhere in supply chains, typically shocks to inputs of the
production process that are integral to production across the economy are the most likely to result
in recession. For example, oil shocks are one of the most common causes of supply-related
recession, as oil products (and other sources of energy) are used in the production of nearly all
goods and services within the United States in addition to being a direct-to-consumer commodity.

6 NBER, “Business Cycle Dating Procedure: Frequently Asked Questions,” https://www.nber.org/research/business-
cycle-dating/business-cycle-dating-procedure-frequently-asked-questions.
7 Olivier Blanchard and David R. Johnson, Macroeconomics, 6th ed. (London: Pearson, 2013), pp. 133-160.
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Other major commodities and inputs in the production process, such as labor or technology, can
significantly boost or restrain aggregate supply in the economy. Thus, supply shocks can and have
had their origins within the United States, but events outside of the country also affect domestic
aggregate supply.
Example: 1970s Oil Crises
The 1970s were marked by two oil shocks. The first, taking place over several months in 1973-
1974, occurred when the Organization of the Petroleum Exporting Countries instituted an oil
embargo on the United States. The embargo significantly decreased U.S. oil imports and
increased the price of oil nearly fourfold.8 The United States experienced another oil shock in
1978-1979 when the Iranian Revolution resulted in decreased global production of oil. The shock
also resulted in an increase in demand for oil, perhaps due to fear of further disruption.
Altogether, the price of oil roughly doubled.9 Both shocks were followed by recessions
(November 1973 to March 1975 and January 1980 to July 1980), and inflation remained high into
the 1980s. Although they played a large role in these recessions, the oil shocks were not the sole
contributing factors to the recessions, and oil shocks have not been the primary cause of
recessions since then owing to a variety of factors, including increased domestic production and
the buildup of oil reserves.10 The U.S. economy is continually experiencing various supply
shocks, but most are not significant enough to cause a recession.
Current Conditions
The U.S. economy has seen several significant supply shocks in the past few years. In some ways,
the COVID-19 recession was a supply shock: The need for social distancing halted commerce
significantly, creating challenges in supply chains and resulting in idle productive resources (e.g.,
workers and factories). The Russian invasion of Ukraine also created significant supply
disruptions in several commodities markets in 2022. Although this did not result in recession in
the United States, these frictions can be seen in large price increases in several commodities, most
notably energy, which fed through to high inflation.11 Many supply chain issues improved in the
latter half of 2022, and most economists expect these issues to continue to improve absent further
shocks.12
Demand Shocks
A demand shock is characterized by an event or series of events that result in consumers and
businesses cutting back on spending. Recessions induced by demand shocks exhibit lower output,
but unlike supply shocks, they tend not to result in price increases and at times can even result in
overall price level decreases (deflation).13 For this reason, countercyclical monetary and fiscal

8 Michael Corbett, “Oil Shock of 1973-74,” Federal Reserve History, November 22, 2013,
https://www.federalreservehistory.org/essays/oil-shock-of-1973-74.
9 Laurel Graefe, “Oil Shock of 1978-79,” Federal Reserve History, November 22, 2013,
https://www.federalreservehistory.org/essays/oil-shock-of-1978-79.
10 Nico Valckx, “Lower Oil Reliance Insulates World from 1970s-Style Crude Shock,” International Monetary Fund,
May 5, 2022, https://www.imf.org/en/Blogs/Articles/2022/05/05/lower-oil-reliance-insulates-world-from-1970s-style-
crude-shock.
11 For example, see Bureau of Labor Statistics, “Archived CPI News Release Table 1,” March 2022,
https://www.bls.gov/cpi/tables/supplemental-files/news-release-table3-202203.xlsx.
12 See CRS Insight IN12091, Will Inflation Continue to Fall?, by Lida R. Weinstock and Marc Labonte.
13 Blanchard, Macroeconomics, pp. 133-160.
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policy may work better (or have more desirable outcomes) in dealing with demand as opposed to
supply shocks.
Spontaneous Changes to Private Demand
Changes in consumer or business confidence can impact aggregate demand. If individuals believe the economy wil
perform poorly in the future, they are likely to increase how much they save to prepare for lean times ahead. The
associated decrease in spending would lower aggregate demand. Similarly, if businesses perceive that the economy
is about to enter a recession, they are less likely to make investments in new machinery or factories because
consumers would not be able to afford their new products during the recession. These types of changes in
behavior can occur spontaneously and be the proximate cause of recession. These types of behaviors can also
result from a specific shock and further deepen the shock’s demand impact.
There are many distinct events that can cause decreased demand and recession, several of which
are discussed below. They could be caused by policy changes (e.g., contractionary fiscal or
monetary policy) or developments in the private sector (see text box above).
Contractionary Fiscal Policy
During an economic expansion, economic conditions are generally strong. Unemployment falls or
is low and wages and private spending both tend to increase. During such periods of strong or
improving economic conditions, policymakers may choose to enact contractionary fiscal policy—
a decrease in government spending or transfers or an increase in taxes. When such policy is timed
appropriately, it can be beneficial to the economy and stop the economy from overheating. From
another perspective, it can be challenging to parse economic conditions in real time, and
sometimes such policies can be mistimed, resulting in overtightening and recession.
Contractionary fiscal policy works to temper aggregate demand. When the government raises
individual income taxes, for example, individuals have less disposable income and decrease their
spending on goods and services in response. The decrease in spending reduces aggregate demand
for goods and services, slowing economic growth temporarily. Alternatively, when the
government reduces federal spending, it reduces aggregate demand in the economy, which again
temporarily slows economic growth. Contractionary fiscal policy could also be expected to result
in lower interest rates and more investment, a depreciation of the U.S. dollar and a shrinking trade
deficit, and a slowing inflation rate.14 These effects tend to spur additional economic activity,
partly offsetting the decline resulting from the initial policy. Whether the decrease in aggregate
demand is problematic for overall economic performance depends on the overall state of the
economy at that time. If private demand is strong enough, contractionary policy would not result
in recession.
Example: Post–World War II Recession
The U.S. economy experienced a recession in 1945 as World War II was ending. This recession
largely resulted from large decreases in government spending. Wartime spending had been large,
resulting in the largest deficit-to-GDP ratio to date, peaking at nearly 30% in 1943. The removal
of such large stimulus—the government was running a budget surplus of 1.7% by 1947—

14 Blanchard, Macroeconomics, pp. 450-451.
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tightened economic conditions to the point of recession.15 The recession lasted from February to
October of 1945, and unemployment remained quite low, with a recession peak of 3.1%.16
Current Conditions
The scale of the fiscal tightening that resulted in recession in 1945 was much larger than policy
changes in the recent past. The government has not undertaken significant tax increases or
spending decreases in recent decades and has typically run a budget deficit. The likelihood of
more marginal fiscal tightening resulting in recession is uncertain but perhaps not likely.
Relatively large fiscal stimulus was enacted during the pandemic. As the economy recovered,
much of the temporary stimulus expired or was exhausted. The Congressional Budget Office has
estimated that further tightening legislation, such as P.L. 117-169, often referred to as the
Inflation Reduction Act of 2022, will reduce 10-year deficits, mostly in future years.17 Given the
current context of high inflation, further tightening could help bring down prices but also
increases the risk of recession, depending on the timing and scope of any such future policy.
Contractionary Monetary Policy
The Federal Reserve (Fed) controls monetary policy and has a mandate to use monetary policy to
promote maximum employment, stable prices, and moderate long-term interest rates. Stable
prices should lead to moderate long-term interest rates, so it is common for analysts to refer to the
Fed’s “dual mandate” of promoting maximum employment and stable prices. While the Fed has
several monetary policy tools it can use in times of severe crisis, under the normal ebbs and flows
of the business cycle, the primary tool it uses is the federal funds rate (FFR), a short-term private
rate that the Fed can manipulate in order to affect interest rates throughout the economy.18
The Fed typically uses contractionary monetary policy—raising the FFR—during periods of high
inflation. Rising interest rates work to lower prices by decreasing demand through two main
avenues. First, higher interest rates tend to reduce interest-sensitive spending and investment by
consumers and businesses. Second, higher interest rates domestically tend to cause the dollar to
appreciate as U.S. assets become more attractive relative to foreign assets. An appreciated dollar
makes imports relatively cheaper and exports relatively more expensive, reducing net exports.19
The Fed’s efforts to achieve and maintain both maximum employment and stable prices is
challenging. Contractionary monetary policy may be needed to maintain stable prices, but it is
usually eventually followed by recession (see Figure 2). Most recessions since the 1940s were
preceded by periods of rising interest rates. Periods of contractionary monetary policy followed
by recession are called “hard landings,” and those that are not are called “soft landings.” Soft

15 Office of Management and Budget, “President’s Budget Historical Tables,” Table 1.2—Summary of Receipts,
Outlays, and Surpluses or Deficits as Percentages of GDP: 1930-2027, https://www.whitehouse.gov/omb/budget/
historical-tables/.
16 Bureau of Labor Statistics, “The Current Population Survey—Tracking Unemployment in the United States for over
75 Years,” Figure 1: Unemployment rate and timing of changes to Current Population Survey measurement, 1940-
2017, January 2018, https://www.bls.gov/opub/mlr/2018/article/the-current-population-survey-tracking-
unemployment.htm.
17 Congressional Budget Office, Estimated Budgetary Effects of H.R. 5376, the Inflation Reduction Act of 2022, August
5, 2022, p. 3, https://www.cbo.gov/system/files/2022-08/hr5376_IR_Act_8-3-22.pdf.
18 For a discussion of unconventional monetary policy tools, see CRS Report R42962, Federal Reserve:
Unconventional Monetary Policy Options, by Marc Labonte.
19 For more information on monetary policy, see CRS In Focus IF11751, Introduction to U.S. Economy: Monetary
Policy, by Marc Labonte.
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landings are the intention of contractionary monetary policy, but hard landings often result
instead.
Figure 2. Effective Federal Funds Rate
July 1954 to February 2023

Source: Federal Reserve
Notes: Gray bars denote recessions.
Example: Double-Dip Recession Under Federal Reserve Chair Volcker
The U.S. economy experienced high inflation from the second half of the 1960s to the early
1980s.20 The high inflation period was eventually brought to an end after the Fed sharply
tightened monetary policy under then-new Fed Chair Paul Volcker. Volcker took office in August
1979. In his confirmation hearings prior to taking office, he pledged to make reducing inflation
his top priority.21 The FFR rapidly increased from about 11% when he took office to about 18% in
April 1980.22 As this tightening was implemented, the U.S. economy entered a recession from
January 1980 to July 1980. In response to the recession, the Fed eased monetary policy and the
FFR fell, but inflation decreased little despite the recession.23 Beginning in July 1980, the Fed
began tightening monetary policy and the FFR began increasing again. It peaked at over 19%,
and the economy entered another recession from July 1981 to November 1982.

20 See CRS In Focus IF12177, Back to the Future? Lessons from the “Great Inflation”, by Marc Labonte and Lida R.
Weinstock.
21 The chair has one equal vote of 12 on monetary policy decisions. Nevertheless, the chair has traditionally been
viewed as wielding an outsized influence over monetary policy decisions.
22 All data cited for the FFR are the monthly average of the effective FFR, which is the actual rate that federal funds are
lent in the marketplace.
23 Part of the decline in interest rates at this time was due to credit controls imposed by President Jimmy Carter, not an
easing of monetary policy.
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Volcker is often credited with restoring low and stable inflation by bringing inflation expectations
back under control and restoring Fed credibility on its commitment to price stability.24 However,
the aggressive tightening of monetary policy came with the tradeoff of relatively high
unemployment that recovered more slowly than low inflation was restored. During the recession
of 1981-1982, inflation decreased by over 6 percentage points while unemployment increased
over 3 percentage points and stood at 10.8% in November 1982, the last month of the recession.
Current Conditions
In response to high inflation, the Fed has been raising rates since March 2022. However, because
interest rates were zero when the Fed started raising rates, it took several rate hikes before
stimulus was largely considered to be fully withdrawn.25 Since the Fed has started tightening, it
has repeatedly pledged that it is committed to do what it takes to restore price stability.26 The Fed
has indicated that it anticipates continuing to raise rates for some time to come.27 Inflation has
been falling since peaking in June 2022, but output has remained relatively strong and the labor
market remains quite tight. Fed Chair Jerome Powell stated in February 2023 that “reducing
inflation is likely to require a period of below-trend growth and some softening of labor market
conditions.”28
Financial Crisis29
Financial instability and crises can result in recession and vice-versa (see text box). Financial
crises can be precipitated by any number of specific events and underlying risks, such as asset
bubbles, debt crises, or inadequate supervision or regulation of financial markets.30 Generally,
financial crises result in financial market disruptions, declining asset prices, tightening credit
conditions, and liquidity and solvency issues for financial institutions. All told, these conditions,
if widespread enough, decrease credit availability, and declining financial wealth can lead to
significant decreases in personal consumption expenditures and gross private domestic
investment, resulting in recession.31

24 See, for example, William Poole, “President’s Message: Volcker’s Handling of the Great Inflation Taught Us Much,”
Federal Reserve Bank of St. Louis, January 1, 2005, https://www.stlouisfed.org/publications/regional-economist/
january-2005/volckers-handling-of-the-great-inflation-taught-us-much.
25 Depending on how it is being measured, the point at which monetary stimulus has been fully withdrawn is debated.
According to some models, monetary policy is still stimulative at present.
26 For example, Chair Jerome Powell recently stated, “My colleagues and I understand the hardship that high inflation
is causing, and we are strongly committed to bringing inflation back down to our 2 percent goal.” See Federal Reserve,
“Transcript of Chair Powell’s Press Conference,” February 1, 2023, https://www.federalreserve.gov/mediacenter/files/
FOMCpresconf20230201.pdf.
27 Federal Reserve, “Federal Reserve Issues FOMC Statement,” press release, February 1, 2023,
https://www.federalreserve.gov/newsevents/pressreleases/monetary20230201a.htm.
28 Federal Reserve, “Transcript of Chair Powell’s Press Conference.”
29 While financial crises generally show aspects of both demand and supply shocks, recent research suggests that
historically, financial crises behave more as demand shocks. See Felipe Benguria and Alan M. Taylor, After the Panic:
Are Financial Crises Demand or Supply Shocks? Evidence from International Trade, NBER Working Paper no. 25790,
April 2019, https://www.nber.org/system/files/working_papers/w25790/w25790.pdf.
30 For more information on the causes of financial crisis and financial market risks, see CRS In Focus IF10700,
Introduction to Financial Services: Systemic Risk, by Marc Labonte; and CRS Report R47026, Financial Regulation:
Systemic Risk, by Marc Labonte.
31 Stijn Claessens and M. Ayhan Kose, Recession: When Bad Times Prevail, International Monetary Fund,
https://www.imf.org/external/pubs/ft/fandd/basics/recess.htm.
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Macro-Financial Linkages
The financial sector and larger economy are closely tied, meaning that a financial market shock can lead to
macroeconomic disruption and an exogenous (external) macroeconomic shock can lead to financial market
disruption.32 Regardless of the type of initial shock, the interrelated nature of financial markets and the
macroeconomy means that feedback loops can be created during recessions and financial crises whereby
tightening financial conditions can further dampen demand, which can lead to further tightening, and so on. For
example, some research suggests that credit disruptions exacerbate economic downturns, and other research
suggests that some asset price cycles may be closely related with the business cycle.33 Research from the
International Monetary Fund analyzing macro-financial linkages in the United States found that an exogenous one-
percentage-point drop in banks’ capital-asset ratio would reduce real GDP by roughly 1.5% via credit availability
effects. Similarly, the authors found that an exogenous drop in demand by 1% of GDP would eventually become a
2% drop via financial feedback effects.34
Example: 2007-2008 Financial Crisis
The financial crisis that began in 2007 led to one of the longest recorded U.S. recessions, often
nicknamed the “Great Recession” owing to its deep and prolonged nature, followed by a sluggish
economic recovery. The financial crisis was precipitated by a housing market crash. In the lead up
there was a housing bubble, where prices rose rapidly and unsustainably, mortgage borrowing
increased, and underwriting standards deteriorated. As the housing market turned and home prices
fell, financial markets faced uncertainty surrounding the value of mortgage-backed securities and
the performance of other securities backed by bundled private credit. A quick selloff of mortgage-
related securities led to broader selloffs of other securitized products.35 The extreme tightening of
credit conditions led to illiquidity among several large financial institutions and, in some cases,
insolvency. Households, faced with tightening credit conditions in addition to the economic
effects of the housing market crash, saw increased debt and were forced to decrease spending.
Altogether, a painful recession resulted, and Congress and the Fed took unprecedented actions to
restore financial and economic stability.36
Current Conditions
Financial crises are unpredictable because risks to financial stability are diverse and hard to
identify beforehand. Many financial risks can result in crisis but never become systemically
destabilizing. The Financial Stability Oversight Council (FSOC)—a council of regulators headed
by the Treasury Secretary that was created after the 2008 financial crisis to monitor the stability
of the financial system—is tasked with identifying potential threats to financial stability. In its
2022 annual report, FSOC identified 14 sources of vulnerability: commercial real estate,

32 The economy is also interrelated to the other types of shocks described in this report. However, these interactions
may not always result in the kind of feedback mechanisms characteristic of financial crises.
33 Stijn Claessens and M Ayhan Kose, Frontiers of Macrofinancial Linkages, Bank for International Settlements,
January 2018, pp. 104-105, https://www.bis.org/publ/bppdf/bispap95.pdf.
34 Tamim Bayoumi and Ola Melander, Credit Matters: Empirical Evidence on U.S. Macro-Financial Linkages,
International Monetary Fund, July 1, 2008, https://www.elibrary.imf.org/view/journals/001/2008/169/article-A001-
en.xml.
35 For more information about securitization, see Andreas Jobst, What Is Securitization?, International Monetary Fund,
September 2008, https://www.imf.org/external/pubs/ft/fandd/2008/09/pdf/basics.pdf.
36 Ben Bernanke, “Financial Panic and Credit Disruptions in the 2007-2009 Crisis,” Brookings Institution, September
13, 2018, https://www.brookings.edu/blog/ben-bernanke/2018/09/13/financial-panic-and-credit-disruptions-in-the-
2007-09-crisis/; and John Weinberg, “The Great Recession and Its Aftermath,” Federal Reserve History, November 22,
2013, https://www.federalreservehistory.org/essays/great-recession-and-its-aftermath.
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residential real estate, nonfinancial corporate credit, short-term wholesale funding markets, digital
assets, large bank holding companies, investment funds, central counterparties, Treasury markets,
alternative reference rates, provision of financial services by nonbank financial institutions,
cybersecurity, third-party service providers, and climate change.37
Housing Market
Many economists look to the housing market as an indicator of the business cycle. Residential
fixed investment—spending on the construction of new single- and multi-family structures,
residential remodeling, and brokers’ fees—is a component of GDP, and a majority of past
recessions have been preceded by decreases in residential investment.38 Residential building
construction employs nearly 1 million people.39
Rising home prices typically encourage additional construction spending to take advantage of
higher prices, leading to more robust economic growth. A decline in housing prices typically
depresses construction spending, leading to more anemic economic growth. Fluctuations in the
housing market, particularly housing prices, can also have broader effects on the economy
through wealth effects. While houses in some ways behave as goods—for example, by providing
shelter to be consumed—economists typically think of houses as assets, similar to stocks or
bonds. In many ways houses are investments, and many view purchasing a home as a way to
build wealth. An increase in housing value encourages homeowners to spend more by borrowing
against greater home equity or saving less in response to greater equity, while decreasing or
stagnant value may result in less robust spending.40
The question is whether housing downturns cause or are caused by recessions. Residential
investment, although not a huge slice of GDP (it has fluctuated between 3% and 5% of GDP for
the past decade), tends to fluctuate more widely than other components of GDP (or other
industries’ contributions to GDP) and tends to account for a larger portion of decreases in GDP
immediately preceding recessions.41 Some economists argue that the housing market is becoming
less closely tied to the business cycle given that residential investment decreased significantly as
a percentage of GDP in the wake of the 2007 housing market crash and has not, to this point,
recovered.42 Additionally, some models have not been able to reproduce observations that
residential investment leads GDP with statistical significance.43 However, historically, periods of
decreases in residential investment (negative growth) have often preceded recessions (see Figure
3).

37 FSOC, 2022 Annual Report, https://home.treasury.gov/system/files/261/FSOC2022AnnualReport.pdf.
38 Edward E. Leamer, Housing Is the Business Cycle, NBER Working Paper no. 13428, September 2007, p. 4,
https://www.nber.org/system/files/working_papers/w13428/w13428.pdf.
39 For industry employment data, see Bureau of Labor Statistics, “Current Employment Statistics,”
https://www.bls.gov/ces/data/.
40 While rising house prices can be beneficial for those who already own homes and can lead to economic growth, these
higher prices can also create affordability issues for non-owners. For more information on the housing market and
economy, see CRS In Focus IF11327, Introduction to U.S. Economy: Housing Market, by Lida R. Weinstock.
41 The Economist, “Housing Was the Business Cycle,” July 18, 2020, https://www.economist.com/finance-and-
economics/2020/07/18/housing-was-the-business-cycle.
42 The Economist, “Housing Was the Business Cycle.”
43 Morris Davis and Jonathan Heathcote, Housing and the Business Cycle, Federal Reserve, November 1, 2003, p. 2,
https://www.federalreserve.gov/pubs/feds/2004/200411/200411pap.pdf.
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Figure 3. Fixed Residential Investment
Q2 1947-Q4 2022

Source: Bureau of Economic Analysis
Notes: Gray bars denote recessions. Underlying data are annualized.
Example: Housing Market Crash of 2007
While housing markets can potentially be used as an indicator of recession without being the
underlying cause of the recession, disruptions in the housing market have also directly resulted in
recession. The most recent example of this is the housing market crash that began in 2007 and led
to a financial crisis and ultimately the Great Recession. A key reason the housing crash led to a
financial crisis was the housing bubble that preceded it.
In 2007, after a long period of steadily rising house prices and increased lending, house prices
began to fall.44 Residential investment began falling in 2006 and ended up falling over 50% in
real terms between 2006 and 2009.45 Output fell as a direct result of the drop in residential
investment and as an indirect result of decreased home value, which likely contributed to a drop
in consumer spending. The crash also led to a rise in mortgage defaults and foreclosures,
contributing to both decreases in demand and the financial crisis that shortly followed.
It is difficult to separate the effect of the housing crash from the effect of the financial crisis when
evaluating whether the crash caused a recession. The beginning of the recession came after the
crash and the beginning of the financial downturn but before the worsening of the financial crisis.
Had there been a housing crash but no financial crisis, the recession would not have been as long
and deep, but whether there would have still been a recession is subject to debate.

44 For example, see Federal Housing Finance Agency, “Purchase Only House Price Index,” https://www.fhfa.gov/
DataTools/Downloads/Pages/House-Price-Index.aspx.
45 BEA, National Income and Product Accounts, Table 1.1.6 Real Gross Domestic Product, Chained Dollars,
https://apps.bea.gov/iTable/?reqid=19&step=2&isuri=1&categories=survey.
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Current Conditions
After a rapid increase in housing prices beginning in mid-2020, house prices began to moderate in
mid-2022.46 To this point there have not been consistent price decreases, but it is possible that this
could occur as the Fed continues to raise interest rates, making mortgages more expensive. The
housing sector is generally very sensitive to monetary policy, so while it is hard to disentangle the
primary cause of a recession under such circumstances, the pattern of residential investment may
nonetheless provide an indicator of whether a recession is imminent, regardless of whether the
housing sector is the actual cause. Residential investment has been falling since the second
quarter of 2022, most recently falling by over 20% in the third and fourth quarters of 2022, and
by 10.7% for 2022 as a whole.47 If residential investment does lead GDP, this could be a sign of a
recession to come. Further, if it turns out that the rapid increase in housing prices led to an asset
bubble similar to 2007, the housing market itself could result in recession in the future.
Policy Options for Smoothing the Business Cycle
Government policy, specifically monetary and fiscal policy, can impact aggregate demand either
directly or indirectly. Congress, together with the President, is responsible for fiscal policy in the
United States through changes in the levels of government spending and tax revenue. Fiscal
policy can directly increase aggregate demand by increasing government spending, reducing
taxes, increasing government transfers to individuals, or a combination of the three.48 To
maximize the effect on aggregate demand, the government can finance these policy changes by
borrowing money from the public (i.e., increasing the publicly held federal debt), referred to as
deficit financing.49 Most recently, the government used fiscal stimulus tools during the pandemic
when, for example, it sent out stimulus checks directly to consumers and when it temporarily
increased unemployment benefits.
Monetary policy can also be used to impact aggregate demand.50 The Fed implements monetary
policy by changing short-term interest rates and the availability of credit in the economy. For
example, lowering interest rates can encourage businesses to make new investments and
individuals to buy new goods that are financed by credit, as lower interest rates make it less
expensive to borrow money.
Fiscal and monetary policy are determined independently, so Congress may choose to defer to the
Fed to stabilize the business cycle, or the Fed may judge that it can reduce its response in light of
fiscal actions. Congress and the Fed may independently choose complementary policies that
increase the effectiveness of their respective policies or conflicting policies that neutralize each
other’s effects.

46 For more information on trends in housing prices, see CRS In Focus IF12048, High Home Prices: Contributing
Factors and Policy Considerations, by Mark P. Keightley and Lida R. Weinstock.
47 BEA, Gross Domestic Product, Fourth Quarter 2022 and Year 2022 (Advance Estimate), January 26, 2023,
https://www.bea.gov/sites/default/files/2023-01/gdp4q22_adv.pdf.
48 For further discussion of fiscal policy, see CRS In Focus IF11253, Introduction to U.S. Economy: Fiscal Policy, by
Lida R. Weinstock; and CRS Report R45723, Fiscal Policy: Economic Effects, by Lida R. Weinstock.
49 For discussion of specific policy options for countering recessions, see CRS Report R45780, Fiscal Policy
Considerations for the Next Recession, by Mark P. Keightley.
50 For further discussion of monetary policy, see CRS In Focus IF11751, Introduction to U.S. Economy: Monetary
Policy, by Marc Labonte.
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Countercyclical fiscal and monetary policy, when implemented successfully, can help smooth the
business cycle. For example, countercyclical fiscal policy might include increasing government
spending during a recession to help stabilize demand and return the economy to (sustainable) full
employment and then decreasing government spending during an expansion to stop the economy
from growing too quickly and resulting in high inflation. When unsuccessful, these policies may
exacerbate the fluctuations of the business cycle, which is most likely to occur when
countercyclical policies are mistimed or improperly sized—too much contraction even during an
expansion can result in recession, for example, or too little stimulus during a recession can
prolong the downturn. Because of lags in policy effectiveness and economic uncertainty, often it
is not possible to tell in real time that a policy change is needed until it is too late.51
There are reasons why policymakers would choose not to use countercyclical policies in certain
circumstances. For example, inflation sometimes occurs during recessions. In such a case, the Fed
may decide that contractionary monetary policy is appropriate despite recessionary conditions if
the Fed prioritizes inflation reduction over employment concerns. On the other hand, Congress
might decide to prioritize stabilizing the size of the federal debt over counteracting a recession
through expansionary fiscal policy. Policymakers weigh the tradeoffs of these costs against the
benefits of ameliorating the recession. One key factor determining the size of the benefits is the
potential length and severity of the recession with and without countercyclical policy.
Automatic Stabilizers
Levels of federal spending and revenue (and therefore, the deficit) differ over time due to changes in the state of
the economy in addition to deliberate choices made each year by Congress. During economic expansions, tax
revenue tends to increase automatically as rising incomes and employment result in greater individual and
corporate income tax revenues. Likewise, spending tends to decrease automatically as federal spending on income
support programs, such as food stamps and unemployment insurance, tends to fall during economic expansions as
fewer people need financial assistance and file unemployment claims. The combination of rising tax revenue and
falling federal spending tends to improve the government’s budget deficit. The opposite is true during recessions,
when federal spending rises and revenue shrinks automatically. These cyclical fluctuations in revenue and spending
are often referred to as automatic stabilizers. Even in the absence of congressional action, these automatic
stabilizers provide some amount of countercyclical support. Therefore, when examining fiscal policy, it is often
beneficial to take into account these automatic stabilizers to get a sense of the stance of fiscal policy.52
Most countercyclical policies are demand focused. Economists often consider supply-driven
recessions to be particularly pernicious given that fiscal and monetary policy may not be well
suited to affect supply in the short term, policy tools that can affect supply tend to take longer
than tools that affect demand, and policy tools that affect demand in the short term can decrease
unemployment or prices but not both.

51 For example, the Fed’s interest rate decisions are often viewed in retrospect as having been too aggressive or not
aggressive enough given what economists came to learn about economic conditions after the fact, information that the
Fed has to estimate in real time. For more information, see CRS In Focus IF10207, Monetary Policy and the Taylor
Rule, by Marc Labonte.
52 For further discussion of automatic stabilizers, see CRS Report R45780, Fiscal Policy Considerations for the Next
Recession, by Mark P. Keightley.
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Author Information

Lida R. Weinstock

Analyst Macroeconomic Policy

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