There are several things to try and avoid recession. Basically, the government and monetary authorities need to try and increase aggregate demand (consumer spending, investment, exports). There is no guarantee that they will work. It will depend on the policies and also the causes of the recession.
For example, it is easier if the downturn affects just one country. In a global downturn, you are more subject to the fate of economies.
If the recession is caused by very high interest rates, then cutting interest rates may help avoid a recession. But, if you have a large fall in asset prices / bank losses (often called balance sheet recession) it is more difficult because even if you cut interest rates, banks may still not lend.
Policies to avoid a Recession
1. Cutting Interest Rates. Cutting interest rates should help to boost aggregate demand. Amongst other things, lower interest rates reduce mortgage interest payments, giving consumers more disposable income. Lower interest rates also encourage firms and consumers to spend rather than save. (effect of lower interest rates)
As well as cutting base rates, the monetary authorities could try and reduce other interest rates in the economy. e.g. the Central Bank could buy government bonds or mortgage securities. Buying these bonds causes lower interest rates and helps to boost spending in the economy.
However, lower interest rates don’t always work. In 2008- 09, interest rates were cut to 0.5% in the UK, yet it didn’t avoid a recession. This was because
- Banks didn’t pass the base rate cut onto consumers
- Although interest rates were low, banks were reluctant to lend and consumers reluctant to spend.
- This is known as a liquidity trap
In 2011, there is the prospect of a second recession, but interest rates are already low. Therefore, in this case it is not helpful.
2. Preventing Home repossessions. Home repossessions can cause bank losses and falls in consumer spending. The government may try to freeze mortgage rates to preventing house repossession. (e.g. Effects of Freezing subprime rates )Also, the Federal Reserve
3. Expansionary Fiscal Policy. Cutting taxes increases consumer disposable income. This can be a policy to increase consumer spending. However, it will cause higher government borrowing. This may not be practical for countries who are already seeing a rise in government bond yields (e.g. Euro members like Greece, Ireland and Italy, have little scope for expansionary fiscal policy)
Also, there is no guarantee tax cuts will boost spending if confidence is very low. Can tax cuts avoid a recession?
As well as tax cuts, the government could try higher government spending on capital investment projects. This directly injects money into the economy, it may be more effective than tax cuts, if tax cuts are just saved.
4. Devaluation. A devaluation in the exchange rate can cause a boost in aggregate demand. A fall in the value of the dollar, makes exports cheaper and imports more expensive increasing domestic demand. (see: effects of devaluation)
However, in a global recession, demand for exports may be quite inelastic. Also, in a global recession, countries may begin competitive devaluation. This is when several countries try to gain a competitive advantage by devaluing currency against others, but it proves self-defeating.
5. Quantitative Easing If interest rates are already zero, then the Central Bank may have to pursue unconventional monetary policies. This involves the Central Bank electronically creating money and using this money to buy long dated securities. This increases bank reserves and should help encourage bank lending. Also, it reduces interest rates on bonds which should help encourage spending and investment. See: Quantitative Easing explained
6. Higher Inflation Target. This is a conscious decision to target growth rather than inflation. See: Optimal inflation target