Readers Question: Undertake an evaluation of the causes of economic instability and the role, if any, that the government can play in reducing economic instability by constraining their discretion in policy making.
Economic instability can include a volatile inflation rate and volatile rate of economic growth. It can involve higher unemployment and uncertainty about the economic cycle.
1. Changes in house prices
If house prices increase faster than inflation, this creates a wealth effect and improved consumer confidence, therefore spending and AD increase. A fall in house prices, however, would cause the opposite effect. E.g. when house prices fell 15% in 1992, the UK entered a recession, with negative growth of 2%. Falling house prices in 2006-08 were a major factor behind the economic instability of 2007-08. Falling house prices caused a negative wealth effect but also falling house prices led to bank losses.
2. Fluctuations in Stock Markets
A big fall in stock markets can trigger falls in consumer confidence and lead to a recession. The Wall Street crash of 1929 was a primary cause of the great depression. However, the stock market crash of 1987 did not cause an economic downturn. In fact, in the UK it was followed by an unprecedented economic boom. This was partly due to the way the government responded by cutting income tax and cutting interest rates.
3. Global Credit Markets
The subprime mortgage problems in the US caused many firms to go insolvent. This cause a big fall in confidence in lending money. This shortage of credit led to a shortage of credit. This caused the problems of northern rock and reduced consumer confidence. See: credit crisis
4. Changes in Interest Rates
Interest rates are used as a tool in controlling inflation. However, they can also have an impact on consumer spending. Sometimes interest rates may have little impact; however, if they coincide with other factors they can cause a much bigger than expected fall in consumer spending. For example, in the UK, many homeowners have a variable mortgage. Therefore a small change in interest rates can have a big effect on disposable income. If an increase in interest rates was combined with another factor such as the slowing down of house price growth it may cause a big fall in spending.
Note, interest rates can have a delayed effect. E.g. the effect of interest rate increases last year may continue to affect consumer spending for up to 18 months