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Economic Depression

A state of financial turmoil

What is an Economic Depression?

An economic depression is an occurrence wherein an economy is in a state of financial turmoil, often the result of a period of negative activity based on the country’s Gross Domestic Product (GDP) rate. It is a lot worse than a recession, with GDP falling significantly, and usually lasts for many years. In the US, the Great Depression lasted for a decade, with the unemployment rate reaching 25% and wages falling by 42%.

 

Economic Depression

 

Causes of an economic depression

An economic depression is primarily caused by a worsening consumer confidence that leads to a decrease in demand, eventually resulting in companies going out of business. When consumers stop buying products and paying for services, companies will need to make budget cuts, employ fewer workers, and even lay off employees.

But let us look more deeply into other factors that lead to economic depression.

 

1. Stock market crash

The stock market is composed of stocks that investors own in any given company. Changes in shareholdings can be a reflection of how an economy is doing. When the stock market crashes, it can be an indication of investors’ declining confidence in the economy.

 

2. Decrease in manufacturing orders

A business flourishes on the demand for its products and services. When manufacturing orders reflect a decline, especially for an extended period of time, it can lead to a recession and worse, an economic depression.

 

3. Control of prices and wages

Price controls happened once during the term of former U.S. President Richard Nixon when prices kept going higher. Also, when wages are controlled by the government and companies are not allowed to lower them, businesses may be forced to lay off their employees to survive.

 

4. Deflation

Deflation is basically the lowering of consumer prices over time. It may seem like a good thing because people can now afford to buy more commodities but underneath it is the fact that prices are lowered because of a decline in demand, too. When people wait for deflation to happen, an economic depression may be on its way.

 

5. Oil price hikes

How oil price hikes can cause a ripple effect on almost everything in the market is common knowledge. When it happens, consumers lose their purchasing power, which can lead to a decline in demand, putting businesses out.

 

6. Loss of consumer confidence

When consumers are no longer confident in the economy, they will alter their spending habits and eventually reduce the demand for goods and services.

 

Signs of an upcoming economic depression

Before an economic depression happens, there are things that people should take notice of in order to be able to prepare for one. They include the following:

 

1. Worsening unemployment rate

A worsening unemployment rate is usually a common sign of an impending economic depression. Once the unemployment rate rises to 4%, it will already be more difficult to bring it down. With high jobless numbers, consumers will lose their purchasing power and eventually lower demand.

 

2. Rising inflation

Inflation can be a good sign that demand is higher due to wage growth and a sturdy workforce. However, too much inflation will discourage people from spending, and it can result in a lowered demand for products and services.

 

3. Declining property sales

In an ideal economic situation, consumer spending is usually high, including the sale of homes. But when there is an impending economic depression, the sale of homes goes down, signaling a falling confidence in the economy.

 

4. Increasing credit card debt defaults

When credit card usage is high, it is usually a sign that people are spending, which is good for the GDP. However, when debt defaults rise, it could mean that people are losing their ability to pay which signals an economic depression.

 

Ways to prevent another economic depression

There is always that constant fear of another ‘Great Depression’ happening, which is why economists suggest the following policies to keep it from happening.

 

1. Expansionary monetary policy

An expansionary monetary policy involves cutting interest rates to encourage investment and borrowing. When interest rates are lower, consumers will enjoy more value for their money and will be encouraged to spend more.

 

2. Expansionary fiscal policy

An expansionary fiscal policy means increasing government spending, reducing taxes, or a combination of both. Tax reduction gives consumers disposable income which, in turn, encourages spending.

 

3. Financial stability

Financial stability involves the government guaranteeing bank deposits, which promotes the credibility of banks.

 

Final thoughts

An economic depression is something that the world’s kept at bay for decades. However, there is always the chance for it to occur again if not all sectors of the economy work together to prevent it.

 

More resources

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

  • Cyclical unemployment
  • Quantitative Easing
  • Reaganomics
  • Stagflation

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