What causes an economic depression?

Expert Answers
Ashley Kannan eNotes educator| Certified Educator

An economic depression is caused by a massive slowdown of business activity.  This slowdown causes a decrease in a nation's gross national production and helps to begin an adverse psychological belief in the consumer that is enhanced by a rise in prices and unemployment, and a decrease or lack of increase of incomes and sales.  As the depression increases in length and magnitude, the implications become wider as the symptoms also increase, causing greater fear and lack of confidence in the economic system.  A depression can be very problematic to a national psyche and can also initiate a great level of change in both consumer habits and political culture.

krishna-agrawala | Student

I will differ from the answer posted above in that massive slowdown of business activity is actually depression rather than cause of depression.

An economic depression is a significant and extended reduction in business activities in an economy which is characterized by drop in business volumes, prices, incomes of individuals, and employment. During depressions many businesses fail and many people loose their jobs.

The depression can last from less than a year to several years. A milder slow down in business activity is called recession. Depressions and recessions can be at different levels of economic aggregation - industry, region, nation or the world.

Economies all over the world are characterized by a cycle of economic boom and economic slowdown following each other. The root cause of these cycles is the tendency for collective behavior of people to be marked by cycle of excessive greed and optimism followed by excessive pessimism and fear. When going is good people believe act as if good time will last for ever. In expectation of better future they start spending more. Thus demand increases and businesses make more profit, and to increase their profit further they produce more, This also increases employment and general income levels. Unfortunately, in this process people buy and spend more than what they have. To meet the shortage they rely on loans, which manufacturers and financial institutions are very happy to advance in view of booming business.

Also, in a period of boom, people start investing in assets like immovable property and stocks. As a result their prices rise, and people start believing that the prices will continue to rise, and in this expectation, and in their greed to benefit from the price rise invest more and more in these assets, giving further push to price. This result in a cycle of rising prices. This what leads to boom in the economic cycles.

However there is a limit to what loans people can repay, and the prices of assets that can be justified by their real value. Therefore at some stage of this spiralling demand and prices, the reality starts to pinch people. They find that they cannot repay the loans that they have taken, and that the value they can realize from asset they have bought is lower than the price they have paid. This stets the reverse spiral of pessimism and fear in motion. This subsequently results is recession and depression.

Recessions may be triggered by some specific events also. For example, recessions may start after war due to sudden drop in war time spending. Also failure of some big corporation in an economy can also trigger recession. In these periods of globalization, recession in any one part pd the world can trigger similar effect in other parts.