Tuesday, October 28, 2008

Recession: Simple Analysis

Many people think that prices are symmetrical in their impact - when prices go up, people buy less; when prices fall, people buy more. So, if we raise prices and then lower them back to the same levels as before, things will be back to where they were before.

No quite right!

Say, when prices are doubled and people's nominal incomes are unchanged, they can only buy half the quantity of the things they used to buy.

When this happens, businesses will have only halve the usual sales and warehouses full of unsold goods. They may try to lower the prices but they will be making losses. Instead, they retrench staff to produce half the usual volume, if they were to simply write off their unsold goods.

By retrenching, they are creating the signs of a recession - the recession has already set when prices were raised.

If prices were then reduced to the same old level, people will buy what they used to buy - which is the amount they earned - but without the income lost by those who were unemployed.

After the fuel and food price hike, there should be no doubt that the recession is already set for the world.

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