The U.K. economy experienced one of its worst postwar recessions in 1990-92, when output declined by a cumulative 3 ½ percent. This paper uses a vector autoregression (VAR) model to identify the shocks that were instrumental in causing the recession. The VAR approach is particularly useful when there are no strong priors about what caused the recession; it allows competing hypotheses of the recession to be distinguished without imposing many restrictions on the data.
The main finding of this paper is that the recent recession in the United Kingdom was precipitated primarily by shocks to consumption. This stands in marked contrast to the experience in 1979-81, when investment shocks were the main cause of the recession. The VAR analysis indicates that consumption shocks have a long lasting effect on GDP and, hence, offers a potential explanation for the long duration of the recession as well. The nature of the recovery taking place in the United Kingdom is shown to be basically consistent with the results of the model.
The VAR approach also allows a decomposition of the impact of monetary policy and expectational shocks on activity. The results of the paper indicate that the recent recession can be explained only in part by the prior monetary tightening and the subsequent collapse of the housing market. Expectational shocks are shown to have been equally important in bringing about the recession.