Economic Instability

What is cyclical economic instability?

Cyclical economic instability is as a stage in which the economy is going through a recession or an unhealthy expansion associated with an increase in the price level. Although the economy might be pretty stable for the majority of the time, there are periods in which it may experience economic instability.

A robust economy experiences expansion, maintains price stability, has a high employment rate, and enjoys consumer confidence. Businesses can be competitive, consumers are not adversely affected by the impacts of large monopolies, and the earnings of typical households are sufficient to satisfy their daily needs. The majority of individuals are even able to spend money on a few leisure activities.

On the other hand, instability in the economy causes a rise in prices, a loss of confidence among consumers, and an increase in the amount of effort that must be expended just to survive.

Instability in the economic system results when the elements that impact an economy are not in a state of equilibrium. Inflation is characterized by a decline in the value of money and occurs whenever an economy experiences periods of instability.

This results in higher pricing, increased unemployment rates, and overall anxiety among consumers and companies struggling to maintain their financial stability. To put it another way, people do not seem to be happy. They no longer invest and cannot purchase much due to their limited financial resources. This contributes to an even worse slowdown in the economy.

Macroeconomic Instability

Macroeconomic instability occurs when the price level fluctuates, unemployment increases, and the economy produces less output. Macroeconomic instability comes with a deviation in the economy from its equilibrium level, often causing distortions in the market.

These distortions in the market then harm individuals, businesses, multinational companies, etc. Macroeconomic instability is concerned with deviations in macroeconomic variables such as the aggregate price level, aggregate output, and the level of unemployment.

Causes of Economic Instability

The main causes of economic instability are:

• fluctuations in the stock market
• changes in the interest rate
• fall in home prices
• black swan events.

Fluctuations in the stock market

The stock market provides one of the primary sources of saving for individuals. Many people invest their retirement money in the stock market to enjoy future benefits. Additionally, their trading stock price significantly influences multinational companies in the stock market.

If the prices were to fall, the company would incur losses, pushing them to lay off the workers they support with income. Considering these fluctuations in the stock market, such as the value of stocks dropping down significantly, can be pretty harmful to the economy.

Interest Rate Changes

Changes in the interest rate often cause the economy to experience a period of instability. Dropping the interest rate down to significantly low levels would inject a lot of money into the economy, causing the price of everything to go up. This is what the U.S. economy is currently experiencing in 2022.

However, to counter inflation, the Federal Reserve may decide to increase the interest rate. But as you might have heard, it fears that a recession might be coming along the way. The reason for that is that when the interest rate is high, borrowing becomes expensive, causing less investment and consumption.

Fall in home prices

The real estate market is one of the most important markets for the U.S. economy and economies around the world. A fall in home prices would send shocking waves around the economy, causing a period of instability. Think about it, people who have mortgage loans may find that the value of their houses has decreased to the point where they owe more on the loan than the property is now worth if home prices continue to decline.

They could stop making their payments on the loans, and they might also cut down on their expenditures. If they stop making payments on loans, it brings trouble to the bank, as it has to pay back depositors. This then has a spillover effect, and as a result, the economy becomes unstable, and the institutions suffer financial losses.

Black Swan Events

Black Swan Events include events that are unexpected but have a significant impact on the economy. Such events could be considered natural catastrophes, such as a hurricane hitting one of the states in the U.S. It also includes pandemics such as COVID-19.

Economic Instability Effects

Effects of economic instability could occur in many ways. The three main impacts of economic instability include: business cycle, inflation, and unemployment.

• Business cycle: The business cycle could be expansionary or recessionary. An expansionary business cycle occurs when the total output produced in the economy is growing, and more people can find jobs. On the other hand, a recessionary business cycle occurs when the economy has less output, which results in higher unemployment. Both could be affected and triggered by economic instability.
• Unemployment: Unemployment refers to the number of people who are looking for a job but cannot find one. As a result of economic instability, the number of unemployed people could grow significantly. This is indeed harmful and has other negative effects on the economy. The reason for this is when there are many unemployed people, consumption drops in the economy, which then causes losses to businesses. Subsequently, businesses end up laying off even more workers.
• Inflation: Periods of economic instability could also cause the price level of goods and services to increase. When an event causes problems with the shipment of goods and services, which would harm the supply chain, it will make production more expensive and challenging. As a result, businesses would end up producing less output, and as you might know, less supply means higher prices.

Figure 1. Unemployment rate in the U.S., StudySmarter Originals. Source: Federal Reserve Economic Data¹

Figure 1 shows the unemployment rate in the United States from 2000 to 2021. In periods of economic instabilities such as the 2008-2009 Financial Crisis, the number of unemployed increased to almost 10% of the U.S. workforce. The unemployment rate went down until 2020 when it increased to slightly over 8%. The economic instability during this time resulted from the COVID-19 pandemic.

Economic Instability Solution

Fortunately, there are many solutions to economic instability. We've seen that several factors could lead to economic instability. Identifying those causes and designing policies that address them is a way to stabilize the economy again.

Some of the solutions to economic instability include: monetary policy, fiscal policy, and supply-side policy.

Monetary policies

Monetary policies are fundamental when it comes to combating the economic crisis. Monetary policy is conducted by the Federal Reserve. It controls the money supply in the economy, which impacts the interest rate and the price level. When the economy is experiencing a significant increase in the price level, the Fed increases the interest rate to bring down inflation. On the other hand, when the economy is down and less output is produced, the Fed decreases the interest rate, making it cheaper to borrow money thereby increasing investment spending.

Fiscal policies

Fiscal policies refer to the government's use of tax and government spending to affect aggregate demand. When there are recessionary periods, where you have low consumer confidence and lower output produced, the government may decide to increase spending or decrease taxes. This helps boost aggregate demand and raises the output produced in the economy.

Supply-side policies

Often, the economy is troubled by a decrease in output. Businesses need the necessary incentive to keep producing or increase their production rate. Increasing production leads to lower prices while everyone enjoys more goods consumed. Supply-side policies aim to do just that.