Here are the answers with discussion for this Weekend’s Quiz. The information provided should help you work out why you missed a question or three! If you haven’t already done the Quiz from yesterday then have a go at it before you read the answers. I hope this helps you develop an understanding of Modern…
Saturday quiz – March 31, 2012 – answers and discussion
Here are the answers with discussion for yesterday’s quiz. The information provided should help you understand the reasoning behind the answers. If you haven’t already done the Quiz from yesterday then have a go at it before you read the answers. I hope this helps you develop an understanding of Modern Monetary Theory (MMT) and its application to macroeconomic thinking. Comments as usual welcome, especially if I have made an error.
Question 1:
Economists use two multipliers to estimate the impact on GDP of an expansion in government spending associated with rising tax rates. The spending multiplier indicates the extent to which GDP rises as a result of the extra aggregate demand arising from the increased government spending. The tax multiplier indicates the impact of rising tax rates on GDP as labour supply is reduced because of the disincentives associated with taxation. The net effect on GDP is the sum of these two impacts.
The answer is False.
Mainstream economics analysis does posit that rising marginal tax rates distort the labour supply choice – by increasing the hourly cost of work and providing greater incenctives for workers to choose more leisure. This allegation forms the basis of their case for substantial tax cuts and proportional tax systems; and, as a consequence, reduced budget deficits.
As an aside there is no empirical evidence to support this claim. Most of the credible studies find very little evidence of a negative tax elasticity within normal ranges that these variables shift. The most significant tax effect is found at the intersection of the welfare system and the wage system where workers who work an extra hour while on benefits often face 100 per cent marginal taxes (loss of benefit equal to earnings). But that is another story again.
However, in terms of this question, the trick was in understanding what the tax multiplier is.
First, it is a macroeconomic rather than a microeconomic concept. Households are assumed to pay some tax out of gross income and the tax rate (keeping it simple) specifies that proportion. In reality, there are a myriad of tax rates but the total effect can be summarised by a single (weighted-average!) tax rate.
Households consume out of disposable income. Assume the overall propensity to consume is 0.80 – which means that overall consumers will spend 80 cents for every extra dollar of disposable income received.
So, if the tax rate rises, then disposable income falls. If nothing else changes, then this fall in disposable income will lead to a reduction in consumption (equal to the propensity to consume times the fall in disposable income). The resulting fall in GDP is defined as the tax multiplier.
Similarly, when tax rates falls and increase disposable income, the reverse occurs.
You should not confuse the hypothesised tax multiplier effect with the increase in tax revenue that occurs as a result of the automatic stabilisers. This effect occurs with no discretionary change in the tax regime. It is a common mistake to assume that because tax revenue is rising that tax policy is becoming contractionary.
Further, at the individual level, as GDP growth recovers most people will not be paying higher taxes at all while others will be paying a substantial increase – why? Because they move from unemployment (zero taxes paid) to earning an income (some taxes paid).
You may wish to read the following blog for more information:
- Pushing the fantasy barrow
- Will we really pay higher taxes?
- Structural deficits and automatic stabilisers
Question 2:
EMU member nations face solvency risk because they do not issue their own currency. This source of risk would not be eliminated if these nations exited the Eurozone and re-established their currency sovereignty – that is, issued their own floating currency.
The answer is True.
The answer would be False if the sentence had added – “and only issues debt in its own currency”.
A national government that issues its own floating currency can always service its debts so long as these are denominated in domestic currency.
It also makes no significant difference for solvency whether the debt is held domestically or by foreign holders because it is serviced in the same manner in either case – by crediting bank accounts.
The situation changes when the government issues debt in a foreign-currency. Given it does not issue that currency then it is in the same situation as a private holder of foreign-currency denominated debt.
Private sector debt obligations have to be serviced out of income, asset sales, or by further borrowing. This is why long-term servicing is enhanced by productive investments and by keeping the interest rate below the overall growth rate.
Private sector debts are always subject to default risk – and should they be used to fund unwise investments, or if the interest rate is too high, private bankruptcies are the “market solution”.
Only if the domestic government intervenes to take on the private sector debts does this then become a government problem. Again, however, so long as the debts are in domestic currency (and even if they are not, government can impose this condition before it takes over private debts), government can always service all domestic currency debt.
The solvency risk the private sector faces on all debt is inherited by the national government if it takes on foreign-currency denominated debt. In those circumstances it must have foreign exchange reserves to allow it to make the necessary repayments to the creditors. In times when the economy is strong and foreigners are demanding the exports of the nation, then getting access to foreign reserves is not an issue.
But when the external sector weakens the economy may find it hard accumulating foreign currency reserves and once it exhausts its stock, the risk of national government insolvency becomes real.
The following blogs may be of further interest to you:
- Modern monetary theory in an open economy
- Debt is not debt
- The deficit and debt debate
- Debt and deficits again!
Question 3:
For a nation running a current account deficit, national income adjustments will ensure government budget is in deficit no matter what the government’s intentions are if the private domestic sector is spending less than its income.
The answer is True.
This question requires an understanding of the sectoral balances that can be derived from the National Accounts. But it also requires some understanding of the behavioural relationships within and between these sectors which generate the outcomes that are captured in the National Accounts and summarised by the sectoral balances.
Refreshing the balances (again) – we know that from an accounting sense, if the external sector overall is in deficit, then it is impossible for both the private domestic sector and government sector to run surpluses. One of those two has to also be in deficit to satisfy the accounting rules.
The important point is to understand what behaviour and economic adjustments drive these outcomes.
The basic income-expenditure model in macroeconomics can be viewed in (at least) two ways: (a) from the perspective of the sources of spending; and (b) from the perspective of the uses of the income produced. Bringing these two perspectives (of the same thing) together generates the sectoral balances.
From the sources perspective we write:
GDP = C + I + G + (X – M)
which says that total national income (GDP) is the sum of total final consumption spending (C), total private investment (I), total government spending (G) and net exports (X – M).
From the uses perspective, national income (GDP) can be used for:
GDP = C + S + T
which says that GDP (income) ultimately comes back to households who consume (C), save (S) or pay taxes (T) with it once all the distributions are made.
Equating these two perspectives we get:
C + S + T = GDP = C + I + G + (X – M)
So after simplification (but obeying the equation) we get the sectoral balances view of the national accounts.
(I – S) + (G – T) + (X – M) = 0
That is the three balances have to sum to zero. The sectoral balances derived are:
- The private domestic balance (I – S) – positive if in deficit, negative if in surplus.
- The Budget Deficit (G – T) – negative if in surplus, positive if in deficit.
- The Current Account balance (X – M) – positive if in surplus, negative if in deficit.
These balances are usually expressed as a per cent of GDP but that doesn’t alter the accounting rules that they sum to zero, it just means the balance to GDP ratios sum to zero.
A simplification is to add (I – S) + (X – M) and call it the non-government sector. Then you get the basic result that the government balance equals exactly $-for-$ (absolutely or as a per cent of GDP) the non-government balance (the sum of the private domestic and external balances).
This is also a basic rule derived from the national accounts and has to apply at all times.
So what economic behaviour might lead to the outcome specified in the question?
If the nation is running an external deficit it means that the contribution to aggregate demand from the external sector is negative – that is net drain of spending – dragging output down.
Assume, now that the private domestic sector (households and firms) seeks to increase its overall saving ratio (as a percentage of GDP). Consistent with this aspiration, households may cut back on consumption spending and save more out of disposable income. The immediate impact is that aggregate demand will fall and inventories will start to increase beyond the desired level of the firms.
The firms will soon react to the increased inventory holding costs and will start to cut back production. How quickly this happens depends on a number of factors including the pace and magnitude of the initial demand contraction. But if the households persist in trying to save more and consumption continues to lag, then soon enough the economy starts to contract – output, employment and income all fall.
The initial contraction in consumption multiplies through the expenditure system as workers who are laid off also lose income and their spending declines. This leads to further contractions.
The declining income leads to a number of consequences. Net exports improve as imports fall (less income) but the question clearly assumes that the external sector remains in deficit. Total saving actually starts to decline as income falls as does induced consumption.
So the initial discretionary decline in consumption is supplemented by the induced consumption falls driven by the multiplier process.
The decline in income then stifles firms’ investment plans – they become pessimistic of the chances of realising the output derived from augmented capacity and so aggregate demand plunges further. Both these effects push the private domestic balance further towards and eventually into surplus
With the economy in decline, tax revenue falls and welfare payments rise which push the public budget balance towards and eventually into deficit via the automatic stabilisers.
If the private sector persists in trying to increase its overall saving ratio then the contracting income will clearly push the budget into deficit.
So when there is an external deficit and the private domestic sector is spending less than it earns (ex post) then there will always be a budget deficit. Government attempts to avoid that will drive aggregate demand lower and their deficit higher.
The following blogs may be of further interest to you:
- Barnaby, better to walk before we run
- Stock-flow consistent macro models
- Norway and sectoral balances
- The OECD is at it again!
Question 4:
It would be impossible for a government to avoid issuing debt to the private sector when running a budget deficit while the central bank was targeting a positive short-term policy rate.
The answer is False.
The ignoring specific legal considerations qualification refers to the fact that some legislatures have banned central banks from directly purchasing treasury debt as an ideological act to limit the possibilities available to government.
The central bank conducts what are called liquidity management operations for two reasons. First, it has to ensure that all private cheques (that are funded) clear and other interbank transactions occur smoothly as part of its role of maintaining financial stability. Second, it must maintain aggregate bank reserves at a level that is consistent with its target policy setting given the relationship between the two.
So operating factors link the level of reserves to the monetary policy setting under certain circumstances. These circumstances require that the return on “excess” reserves held by the banks is below the monetary policy target rate. In addition to setting a lending rate (discount rate), the central bank also sets a support rate which is paid on commercial bank reserves held by the central bank.
Commercial banks maintain accounts with the central bank which permit reserves to be managed and also the clearing system to operate smoothly. In addition to setting a lending rate (discount rate), the central bank also can set a support rate which is paid on commercial bank reserves held by the central bank (which might be zero).
Many countries (such as Australia, Canada and zones such as the European Monetary Union) maintain a default return on surplus reserve accounts (for example, the Reserve Bank of Australia pays a default return equal to 25 basis points less than the overnight rate on surplus Exchange Settlement accounts). Other countries like Japan and the US have typically not offered a return on reserves until the onset of the current crisis.
If the support rate is zero then persistent excess liquidity in the cash system (excess reserves) will instigate dynamic forces which would drive the short-term interest rate to zero unless the government sells bonds (or raises taxes). This support rate becomes the interest-rate floor for the economy.
The short-run or operational target interest rate, which represents the current monetary policy stance, is set by the central bank between the discount and support rate. This effectively creates a corridor or a spread within which the short-term interest rates can fluctuate with liquidity variability. It is this spread that the central bank manages in its daily operations.
In most nations, commercial banks by law have to maintain positive reserve balances at the central bank, accumulated over some specified period. At the end of each day commercial banks have to appraise the status of their reserve accounts. Those that are in deficit can borrow the required funds from the central bank at the discount rate.
Alternatively banks with excess reserves are faced with earning the support rate which is below the current market rate of interest on overnight funds if they do nothing. Clearly it is profitable for banks with excess funds to lend to banks with deficits at market rates. Competition between banks with excess reserves for custom puts downward pressure on the short-term interest rate (overnight funds rate) and depending on the state of overall liquidity may drive the interbank rate down below the operational target interest rate. When the system is in surplus overall this competition would drive the rate down to the support rate.
The main instrument of this liquidity management is through open market operations, that is, buying and selling government debt. When the competitive pressures in the overnight funds market drives the interbank rate below the desired target rate, the central bank drains liquidity by selling government debt. This open market intervention therefore will result in a higher value for the overnight rate. Importantly, we characterise the debt-issuance as a monetary policy operation designed to provide interest-rate maintenance. This is in stark contrast to orthodox theory which asserts that debt-issuance is an aspect of fiscal policy and is required to finance deficit spending.
So the fundamental principles that arise in a fiat monetary system are as follows.
- The central bank sets the short-term interest rate based on its policy aspirations.
- Government spending is independent of borrowing which the latter best thought of as coming after spending.
- Government spending provides the net financial assets (bank reserves) which ultimately represent the funds used by the non-government agents to purchase the debt.
- Budget deficits put downward pressure on interest rates contrary to the myths that appear in macroeconomic textbooks about ‘crowding out’.
- The “penalty for not borrowing” is that the interest rate will fall to the bottom of the “corridor” prevailing in the country which may be zero if the central bank does not offer a return on reserves.
- Government debt-issuance is a “monetary policy” operation rather than being intrinsic to fiscal policy, although in a modern monetary paradigm the distinctions between monetary and fiscal policy as traditionally defined are moot.
Accordingly, while a fiat-issuing government has no need to “fund” its spending, public debt still has to be sold to the private sector (to match the public deficit) as an interest-maintenance strategy.
This means that the idea that governments could simply get the central bank to “monetise” treasury debt (which is seen orthodox economists as the alternative “financing” method for government spending) is highly misleading.
Debt monetisation is usually referred to as a process whereby the central bank buys government bonds directly from the treasury.
In other words, the government borrows money from the central bank rather than the public. Debt monetisation is the process usually implied when a government is said to be printing money. Debt monetisation, all else equal, is said to increase the money supply and can lead to severe inflation.
However, as long as the central bank has a mandate to maintain a target short-term interest rate, the size of its purchases and sales of government debt are not discretionary. Once the central bank sets a short-term interest rate target, its portfolio of government securities changes only because of the transactions that are required to support the target interest rate.
The central bank’s lack of control over the quantity of reserves underscores the impossibility of debt monetisation. The central bank is unable to monetise the federal debt by purchasing government securities at will because to do so would cause the short-term target rate to fall to zero or to the support rate. If the central bank purchased securities directly from the treasury and the treasury then spent the money, its expenditures would be excess reserves in the banking system. The central bank would be forced to sell an equal amount of securities to support the target interest rate.
The central bank would act only as an intermediary. The central bank would be buying securities from the treasury and selling them to the public. No monetisation would occur.
However, the central bank may agree to pay the short-term interest rate to banks who hold excess overnight reserves. This would eliminate the need by the commercial banks to access the interbank market to get rid of any excess reserves and would allow the central bank to maintain its target interest rate without issuing debt.
The following blogs may be of further interest to you:
- The consolidated government – treasury and central bank
- Saturday Quiz – May 1, 2010 – answers and discussion
- Understanding central bank operations
- Building bank reserves will not expand credit
- Building bank reserves is not inflationary
- Deficit spending 101 – Part 1
- Deficit spending 101 – Part 2
- Deficit spending 101 – Part 3
Premium Question 5:
Assume that the government increases spending by $100 billion at the start of each year and maintains this policy for the next three years from now. Economists estimate the spending multiplier to be 1.5 and the impact is exhausted within each year (all induced consumption is completed within 12 months). The tax multiplier is estimated to be equal to 1 and the current tax rate is equal to 30 per cent (so tax revenue rises by 30 cents for every extra dollar of GDP produced ). What is the cumulative impact of this fiscal expansion on GDP after three years?
(a) $135 billion
(b) $150 billion
(c) $315 billion
(d) $450 billion
The answer is $450 billion.
In Year 1, government spending rises by $100 billion, which leads to a total increase in GDP of $150 billion via the spending multiplier. The multiplier process is explained in the following way. Government spending, say, on some equipment or construction, leads to firms in those areas responding by increasing real output. In doing so they pay out extra wages and other payments which then provide the workers (consumers) with extra disposable income (once taxes are paid).
Higher consumption is thus induced by the initial injection of government spending. Some of the higher income is saved and some is lost to the local economy via import spending. So when the workers spend their higher wages (which for some might be the difference between no wage as an unemployed person and a positive wage), broadly throughout the economy, this stimulates further induced spending and so on, with each successive round of spending being smaller than the last because of the leakages to taxation, saving and imports.
Eventually, the process exhausts and the total rise in GDP is the “multiplied” effect of the initial government injection. In this question we adopt the simplifying (and unrealistic) assumption that all induced effects are exhausted within the same year. In reality, multiplier effects of a given injection usually are estimated to go beyond 4 quarters.
So this process goes on for 3 years so the $300 billion cumulative injection leads to a cumulative increase in GDP of $450 billion.
It is true that total tax revenue rises by $135 billion but this is just an automatic stabiliser effect. There was no change in the tax structure (that is, tax rates) posited in the question.
That means that the tax multiplier, whatever value it might have been, is irrelevant to this example.
Some might have decided to subtract the $135 billion from the $450 billion to get answer (c) on the presumption that there was a tax effect. But the automatic stabiliser effect of the tax system is already built into the expenditure multiplier.
Some might have just computed $135 billion and said (a). Clearly, not correct.
Some might have thought it was a total injection of $100 billion and multiplied that by 1.5 to get answer (b). Clearly, not correct.
You may wish to read the following blogs for more information:
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