Why Do Recessions Happen and Why Should You Care? The Ultimate IB Economics Guide

Why Do Recessions Happen and Why Should You Care? The Ultimate IB Economics Guide

Recessions aren't just boring news headlines - they're economic earthquakes that can ripple through everything from your part-time job prospects to your parents' mortgage payments. We'll break down the three major theories that explain why economies can be out of balance, using real examples that'll make sense of this chaotic mess.

Imagine you're scrolling through TikTok when your mum bursts in, stressed about mortgage rates. Your mate's dad just got made redundant from his tech job. The local Nando's is cutting shifts. Welcome to the world of recession, and no, it's not just adults being dramatic.

The UK literally just crawled out of a recession in 2024 after two consecutive quarters of economic decline, and understanding why these economic meltdowns happen is crucial for your IB Economics exam (and for not looking clueless when adults start panicking about "the economy").

What Is a Recession? (And Why It's Not Just a Big Word)

Before we dive into the juicy theories, let's get our basics sorted. Economic fluctuations are basically the economy having mood swings - sometimes it's buzzing with activity (boom times), sometimes it's proper miserable (recession). It's like your motivation levels during exam season, but for entire countries.

Potential output (Production) is what an economy could produce if everything was running smoothly - all workers employed, factories humming, everyone getting stuff done. Actual output (Production) is what actually happens and gets produced and done in real life, which is usually a bit messier because, well, life is not a 1+1=2 game.

Think of it like this: potential output is your revision timetable saying you'll study 8 hours a day. Actual output is you managing 3 hours because Netflix exists and your phone keeps buzzing.

Theory #1: The Keynesian Approach - When Spending Goes Out of Control

The Story Behind the Theory

Back in the 1930s, the world was having the mother of all economic breakdowns - the Great Depression. While everyone was scratching their heads wondering how a booming economy could suddenly implode, this absolute legend called John Maynard Keynes figured it out.

Keynes basically said: "Mate, it's all about spending." When people and businesses stop splashing the cash, the whole economy goes down because everyone's spending is someone else's income.

The Multiplier Effect: Why One Person's Shopping Spree Matters

Here's where it gets more interesting. Keynes discovered something called the multiplier effect—basically, when someone spends money, it doesn't just disappear. It bounces around the economy like a pinball, creating way more impact than you'd expect.

Let's say your local council hires a new teacher for £4,000 a month. That teacher doesn't just stuff the money under their mattress - they spend it. Maybe £3,600 goes on rent, groceries, petrol, nights out. Now the landlord, Tesco, Shell, and the local pub all have extra cash. They spend it too, and so on.

What is extraordinary about this? That original £4,000 salary actually boosts the economy by £40,000 total. That's a multiplier of 10! It's like economic magic, except it's basic maths.

Real-World Recession Drama: The Reverse Multiplier

Now flip it around. When companies start laying people off - like the massive tech layoffs we've seen recently with over 95,000 workers cut in 2024 - the multiplier works in reverse.

Picture the following scenario: A major air con factory in Indiana shuts down, binning off 1,500 workers. Those workers can't afford their usual Costa runs, meal deals, or weekend shopping trips. Local businesses see sales plummet. They start cutting hours or laying off their own staff. As one economist put it: "there's a multiplier effect - whenever somebody loses their jobs, they stop consuming in the local economy".

House prices drop because people are moving away. The council gets less tax revenue, so they hire fewer teachers and police. It's like dominoes, but in a depressing way.

What Makes the Multiplier Stronger or Weaker?

The marginal propensity to consume (MPC) is basically how much of every extra pound someone spends rather than saves. Students typically have an MPC close to 1 (spend everything), while your grandparents might have a lower MPC (more likely to save).

Taxes are party poopers for the multiplier. With a 25% tax rate, that teacher only keeps 75p of every pound earnt. If they spend 90% of that, only 67.5p of each original pound actually gets spent. This shrinks the multiplier from 10 to about 3.

During the UK's 2023-2024 recession, high taxes and inflation meant people were saving more and spending less, weakening the multiplier effect.

Government to the Rescue?

Keynes reckoned governments should step in during recessions - if private sector spending is tanking, pump some public money into the economy. Cut taxes, build infrastructure, give people cash. It's like economic CPR.

Additionally, different types of spending have different multipliers. Giving money to skint people works better than tax cuts for the wealthy (because rich people are more likely to save it rather than blow it on a Friday night out).

Theory #2: Monetarists - "It's the Money, Stupid"

Milton Friedman's Revenge Plot

Fast forward to the 1960s. Milton Friedman looked at Keynes' theory and said, "Nah mate, you've got it wrong." According to Friedman, economic fluctuations weren't about people's shopping habits - they were about central banks being absolute weapons with money supply.

Friedman and his mate Anna Schwartz did some proper detective work, studying every major recession in US history. Their conclusion? The Federal Reserve (America's central bank) kept causing recessions by being completely useless at managing money.

The Fed's Greatest Hits (of Economic Destruction)

1920: Fed prints too much money, gets worried about inflation, slams on the brakes so hard they cause a recession.

1930s: During the Great Depression, the Fed sits there like a deer in headlights instead of pumping money into the economy.

1936-37: Fed gets trigger-happy again, tightening money supply and causing another recession.

It's like your mate who can't find the middle ground - either blasting music at full volume or complete silence, nothing in between.

The Quantity Theory: Money's Magic Formula

Friedman's quantity theory of money basically says that if you want stable prices and steady economic growth, you need smooth, predictable increases in money supply. Think of it like a steady drip-feed rather than randomly hosing the economy with cash or starving it completely.

The UK's recent recession partly happened because the Bank of England kept hiking interest rates to fight inflation, but this squeezed household budgets so hard it pushed the economy backwards.

Modern Reality Check

Here's the thing though - recent evidence suggests Friedman might have been a bit overenthusiastic. Other factors like trade wars (hello, Smoot-Hawley tariffs in 1931) also caused recessions. It's not just about money supply.

But the monetarists did force economists to take money seriously, leading to more sophisticated approaches that combine both Keynesian and monetarist insights.

Theory #3: Real Business Cycle Theory - When Life Gives You Lemons

Supply Shocks Are the Real MVPs

By the 1970s and 80s, economists Finn Kydland and Ed Prescott were looking at recessions and thinking, "Hang on, maybe it's not demand or money - maybe it's just that sometimes external stuff hits the economy like a brick wall."

Real Business Cycle (RBC) theory says fluctuations happen because of changes to the economy's productive capacity - basically, our ability to actually make stuff changes over time.

Technology Shocks: The Good, The Bad, and The Game-Changing

Positive technology shocks are like finding a cheat code for the economy. The Industrial Revolution massively increased wages and population because suddenly we could produce loads more stuff with the same amount of work.

More recently, the internet was a "general-purpose technology" that transformed information sharing and created massive opportunities across multiple sectors. Think about how smartphones completely changed everything from shopping to dating to how we waste time.

But technology shocks can be negative too. Supply chain disruptions in 2024 have forced companies to completely rethink how they manage operations, with AI and IoT reshaping entire industries.

Oil Shocks: When Energy Gets Expensive

The 1970s oil crises were classic negative supply shocks. Oil prices made everything more expensive to produce and transport. It's like if suddenly all food delivery got 3x more expensive - everyone would eat out less, restaurants would struggle, delivery drivers would lose shifts.

Modern Examples: Supply Chain Chaos

Recent tech layoffs show how technology shocks work in practice. Companies overhired during the pandemic (positive shock), then AI advancement meant they needed fewer workers (another tech shock), leading to over 100,000 layoffs globally.

COVID-19 was basically a massive negative supply shock - suddenly we couldn't produce or consume loads of things normally. Then government stimulus was a positive demand shock trying to counteract it.

Real-World Case Study: The UK's 2023-2024 Recession Rollercoaster

Let's put all three theories together with Britain's recent economic drama:

Keynesian Elements: Consumer spending fell as households faced high inflation and rising mortgage rates, creating a negative multiplier effect that pushed the economy into recession.

Monetarist Elements: The Bank of England's aggressive interest rate hikes to fight inflation made borrowing expensive and reduced economic activity.

RBC Elements: Supply chain disruptions and technological changes forced businesses to restructure operations.

The UK economy contracted for two quarters but then grew 0.6% in Q1 2024, marking the end of the recession. All three theories help explain different bits of this economic soap opera.

Why This Matters for Your Future (Beyond Just Exams)

Understanding economic fluctuations isn't just academic exercise - it's about reading the world around you:

• Job prospects: Recessions mean fewer graduate jobs and more competition

• Interest rates: Affect student loans, future mortgages, credit cards

• Policy debates: Understanding multipliers helps you evaluate government spending promises

• Investment: Knowing about business cycles helps with long-term financial planning

Tech layoffs have already affected everything from commercial real estate to where companies locate new offices, showing how economic fluctuations ripple through society.

Exam Success: What IB Examiners Want to See

For Paper 1: Be able to explain all three approaches and their key mechanisms (multiplier effect, money supply, technology shocks).

For Paper 2: Use real-world examples to evaluate which theory best explains specific recessions. The UK's recent experience shows elements of all three theories working together.

For Paper 3: Practice calculating multipliers and drawing business cycle diagrams. Remember that different countries might experience different types of shocks.

Top tip: Always mention that modern economies are complex and multiple factors usually interact. Don't just pick one theory and stick to it religiously.

The Bottom Line

Recessions happen because economies are complex systems where loads of moving parts can go wrong simultaneously. Whether it's people losing confidence and spending less (Keynesian), central banks mucking up money supply (Monetarist), or external shocks hitting the economy (RBC), understanding these patterns helps you make sense of economic news and policy debates.

Most importantly, real economies usually involve elements of all three theories. The UK's recent recession and recovery showed demand-side problems, monetary policy effects, and supply-side disruptions all playing roles.

So next time your parents start fretting about "the economy," you can actually contribute to the conversation instead of just nodding and hoping they'll change the subject to something more interesting. Plus, you'll absolutely smash your IB Economics exams.

Stay well