Welcome to part 2 of the Recession series.

In our last post, we talked about what a Recession is and how it occurs. We looked at a model of the Baby Sitters Co-op that gave us an understanding of how a recession actually occurs. We realized that a recession does not mean lack of resources, it just means lack of resolve to start using those resources. If you haven’t read my last post, please do so first.

We ended last week with a question: To counter the recession, the co-op managers forced a mandate that each couple would need to go out twice a month and have their child baby-sat by others. In other words, there would be some artificial demand created by this and there would be more babies being sat and consequently, more baby sitters. Do you think this will work?

Most of the readers who read the post reverted to me with the same answer – the above measure will NOT end the recession. And they were right. What the above measure will do is to force the couples to spend two (and only two) baby sitting coupons per month. Instead of increasing demand, this will only cause resentment in the couples because they are now being forced to spend coupons in a time-based manner instead of spending them at their own free will. Also, the number of coupons being circulated would be rather limited and fixed.  In the real world, since each couple will end up receiving coupons regardless of demand and supply, the incentive to perform better baby sitting would be taken away too.

So what is the solution? Luckily, one of the couples knew an Economist who suggested a solution. Here is how it worked: The Co-Op board went wild and printed a large number of coupons and provided a bunch of  ‘bonus’ coupons to each couple for use. Each couple was provided with a large number of coupons to spend. Couples soon realized that since they had so many coupons available to them now, there was no more need to hoard them and prepare a backup reserve.

Couples who realized this fact eagerly started to go out and have their kids baby-sat by other couples. The other couples in turn had a surplus of coupons and started to spend them liberally by going out more and spending more coupons and on and on it went. The end result was that there was a healthy circulation of coupons and the Baby Sitters Co-Op came out of recession.

Although this is a simple example, we can immediately draw some parallels with the real world. First, the Baby Sitters Co-Op is the entire USA and the Board of the Co-Op is the Federal Reserve Board. The “coupons” is our currency. Now you can complete the analogy and realize why the Fed is pumping billions of dollars into the economy.

In simple terms – the Fed is trying to:

• Get those of us who are hoarding and saving money in bad times to go out and start spending some of it in the stores.
• This will lead to the stores having more money and selling more
• This will lead to a need for more employees i.e. more jobs and more employed people
• The newly employed people will get paid salaries, some of which they will spend in the stores

and the above cycle will repeat till the economy comes out of the current recession.

Credits: The complete credit for the example goes to Paul Krugman and his book – The return of Depression Economics – and the Crisis of 2008 from W. W. Norton. I strongly recommend reading it, if you can.