Why bailouts are not working?

With governments all around the world announcing bailout packages totaling trillions of dollars, the questions remains - why is the global economy not recovering? The answer lies in understanding the concept of ‘velocity of money’.

Let us take a simple case in which there are only two people in a given country - Mr. A, who sells clothes and Mr. B, who sells food. Suppose Mr. A has $100 and buys food worth $100 from Mr. B every month. Mr. B then spends the $100 buying clothes from Mr. A every month. Thus the total value of transactions each month is $200. Hence the annual GDP (gross domestic product) for the country is $2,400.

As can be seen, with just $100 worth of money in the economy, the GDP can be as high as $2,400. The reason is - velocity of money - or in simple terms how fast does money flow from one person to the other. In this case the velocity of money is 24.

Now let us consider another case in which both Mr. A and B suddenly have a millions of dollars each. However, they decide to keep all their extra money in mattresses and still carry out transactions like they were doing before. Consequently the GDP for the country will still be $2,400. Even though there is millions of dollars worth of money in the economy, the GDP is still $2,400!

As can be seen, the amount of money does not really matter if it is idle. The money in the mattress is non-existent for all practical economic purposes. If people decide not to spend money, the velocity of money goes down.

This is exactly what is happening right now. Even though governments all over the world are pumping in huge amounts of money into the economy, people and companies are taking in the money and not spending it. As in the above example, the money is going into the ‘mattress’ and hence is not having any material impact on the economy.

As can be seen from the graph below, the velocity of money goes down significantly during recessions (years highlighted in grey). This is the reason why the numerous bailouts all over the world do not seem to be having any effect.

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This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can also be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.

Saving is bad for the economy!

We have all been taught the virtues of saving money. Indian children are routinely reminded by their parents about spending less and saving more and schools teach stories extolling the virtues of thrift. In times of global economic crisis, most Indians, willingly or unwillingly, have started doing this. However, the impact of this on the Indian economy could be devastating indeed.

The basic reason is that – what is right for an individual may not be right for the economy as a whole. In difficult economic times, individuals are worried about their jobs and hence cut down on spending and start saving more. This is indeed good for the individual as it gives him a buffer in case he actually loses his job. However, imagine a scenario in which all individuals start saving more and spending less!

Less spending will lead to less purchase of goods and services. Hence factories will cut down on production and / or lay off workers. This will lead to further fall in demand leading to further layoffs. Eventually this vicious cycle will lead to deflation .

Hence, if everyone starts saving more, the economy will most certainly go down the drain. So what is the Indian government doing to induce people to save less and spend more? Typically governments have three major tools in their armory:

Reduce Interest rates: If interest rates on bank deposits fall, savers have less incentive to save. Also individuals will get cheaper loans to buy cars and houses. Companies will also find it easier to raise capital to build more factories.

Reduce Tax: Reducing tax on goods and services makes them cheaper, hence people buy more. Also reducing income tax means people have more money to spend. Alternatively, increasing salaries of government employees can have the same effect.

Increasing Government expenditure: Building new roads, bridges, upgrading ports, etc. can result in a huge increase in employment, leading to an increased spending.

India’s phenomenal growth in the last 5-6 years has been driven by a 300 million strong middle class, which was out on a spending spree. Now, with the middle class feeling the pinch of the economic crisis, they are starting to save more and cut back on their spending. The Indian government has already reduced interest rates, cut taxes selectively, and increased salaries to government employees. However, the results have been far from encouraging. The government will have to act forcefully and decisively before things start getting worse.


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This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can also be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.