Recession and Stimulus

In the last post (http://layconomics.blogspot.com/2009/09/real-growth-prosperity-and-standard-of.html) we understood that real growth involves an increase in prosperity.


In this post, we will try to understand, without bringing money into the discussion, what recession is and how stimulus spending can rejuvenate an economy into growing again.

Let's go back to our prosperous village. The village has grown in size and prosperity. It now consists of 6 people, Wesley the wise, Henry the hunter, Taylor the tailor, Fannie the farmer, Billy the builder and Debbie the designer. Fannie grows the grain, vegetables and fruits. Henry goes hunting rabbits every week and brings home enough meat. Taylor spins cotton and is responsible for making clothes. Billy is responsible for building houses for the village. Debbie makes designer footwear using rabbit hide. Finally, Wesley is responsible for safekeeping of the village and its wealth. The village economy is humming along via the exchange of goods and services. The employment rate in the village is 100% and everybody in the village has the luxury of enjoying high fashion and leisure. The villagers work 6 months in a year and enjoy 6 months of leisure time.


As time goes by, Henry finds it harder and harder to hunt as he is getting old. Often, he comes back empty handed and soon decides to not go hunting any more. He is unable to get any food or clothes in exchange for meat. Debbie, who depends on Henry's leather for her designer footwear finds herself in the same boat as Henry. They are both soon unemployed. At current consumption rates, the reserves will last only 4 months and Wesley will soon have to start rationing food. The employment rate falls to 66% and the economy goes into recession ...


Wesley "the wise" however, decides to stimulate the economy while he still has some reserves. He digs into the granary and meat stock (bailout, or in this case, handout) and employs Henry to work on advanced hunting tools (an economic stimulus package). As luck would have it, Henry discovers the bow and arrow and is soon hunting down more animals than he was before. He is not only able to hunt rabbits but is also able to hunt bigger animals like deer. Debbie finds employment again and has expanded her line of offerings to leather jackets. The village folk now have to work only for 4 months instead of 6. The employment rate is not only back to 100% but the folks are enjoying more leisure time and higher fashion. Wesley's "stimulus" plan has managed to rejuvenate the economy.


As we can see, stimulus can work by increasing employment and productivity.

On the other hand, if Henry had not discovered new tools, the stimulus would not have worked. Employment would have briefly risen to 84% with no corresponding real growth. If Wesley's earmark choice for the stimulus package had been poor (i.e. Wesley had asked Henry to work on a project with little chance of success) the stimulus would not have worked. The reserves would have been exhausted sooner than planned and the economy would have been in dire straits.

The example we gave here is a gross simplification. There are a number of ways a recession can strike. With the advent of money this number can only grow bigger. In the next post, we will understand the role of money and why it is indispensable to the modern economy. So, stay tuned!

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