Are we in a recession? What's happening to our economy? (Part 1)

With all these debates in the news about whether we are heading toward (or in) a recession, it can be a very confusing time for everyone. So before our emotion of fear takes us over, let's look at the underlying economic factors that determine the state of our economy.

First let's look at the facts:

- Oil prices are skyrocketing to over $100 dollars per barrel

- US dollar is dropping in value

- Housing prices are falling

- Banks are hesitant to lend and credit is scarce

The reasons for each of these events are quite diverse. I've explained the housing and banking situation in the pervious post. The US dollar is devaluating due to our huge trade deficit. Oil price is rising due to several reasons: increased demand from emerging countries such as china and India; lack of increase in supply from oil exporters; drop in the value of us dollars, which oil prices are denominated in; oil futures commodities traders speculating on the rise in oil, thereby pushing prices higher.

This graph shows the forces behind the rise in oil prices. The supply curve (short-term) is very inelastic due to OPEC's cartel production policies. The shift in demand is influenced by emerging foreign countries and oil speculators.

So how does this affect the US economy? Let's take a look at the Aggregate supply and demand curves of the whole US economy as modeled in economics.

Price stands for the consumer price index (CPI). Quantity is the output of the US economy, or GDP. Long term supply is always vertical because it does not depend on price (it counts on technology, human capital, and natural resources). Short term supply, on the other hand is upward sloping because changes in price affects people and factories in the short term. There is a long explanation of why that is, but I won't bore you with that. Interested parties can consult any economics textbook.

Now, because oil is a vital part of our economy, an increase in the price of oil increases the prices of many things in the economy (think transportation costs, power supply… etc). The devaluation of the dollar also increases the price of oil for the US as it is imported. This increase in price shifts the supply curve up:

As shown, this shift in the supply curve results in high prices and lower output quantity. This phenomenon is shown by people driving and buying less in the face of high gas prices, and factories cutting back in production in response to the lowered demand from consumers. Unfortunately, cutting production means laying off workers, which partially explains the recent 63,000 job loss report in February and potential future losses in the coming months.

A recession is defined as two quarters of decrease in GDP, or in other words, a drop in the quantity of output. These factors indicate a recession is already in progress. However, high oil prices are not the major negative factor affect the US economy. The biggest and most damaging factor affecting the economic curves inducing a recession is the falling housing prices and credit crunch. I'll discuss their repercussions on the economy as well as the response from the Federal Reserve in the next post.