It’s Wednesday and I just finished a ‘Conversation’ with the Economics Society of Australia, where I talked about Modern Monetary Theory (MMT) and its application to current policy issues. Some of the questions were excellent and challenging to answer, which is the best way. You can view an edited version of the discussion below and…
Today I am departing from usual practice. I have decided to use Friday’s blog space to provide draft versions of the Modern Monetary Theory textbook that I am writing with my colleague and friend Randy Wray. We expect to complete the text by the end of this year. So each Friday I will publish the work I have been doing on it during the previous week in between the other work that I am pursuing. Comments are always welcome. Remember this is a textbook aimed at undergraduate students and so the writing will be different from my usual blog free-for-all. Note also that the text I post is just the work I am doing by way of the first draft so the material posted will not represent the complete text. Further it will change once the two of us have edited it. Anyway, this is what I wrote today.
Chapter 1 Introduction
Basic Outline of Chapter
- What is macroeconomics?
- Stylised facts of macroeconomics
- Hard core hypotheses of the model: macroeconomics must recognize government as by far and away the most important actor in the modern economy.
- Macro foundations versus micro foundations
- Stocks and flows
- Flows: income, consumption, investment, government spending and taxing, imports and exports, saving
- Stocks: wealth, financial and real, domestic and external, private and public
- Basics of sectoral accounting, relations to stock and flow concepts
- Deficits, savings and debts, wealth.
- Measuring the economy – essential tools
- GDP and alternative measures of output
- Measures of inflation
- Employment indicators: labour force, employment, unemployment
- Measures of growth
1.1 What is macroeconomics?
In macroeconomics we study the aggregate outcomes of economic behaviour. The word Macro is derived from the Greek word makro, which means large and so we take an economy-wide perspective.
Macroeconomics is not concerned with analysing how each individual person, household or business firm behaves or what they produce or earn – that is the terrain of the other major branch of economic analysis, microeconomics. Macroeconomics focuses on a selected few outcomes at the aggregate level and is rightly considered to be the study of employment, output and inflation in an international context. A coherent macroeconomic theory will provide consistent insights into how each of these aggregates are determined and change.
In this regard, there are some key macroeconomics questions that we seek to explore:
1. What factors determines the flow of total output produced in the economy over a given period and its growth over time?
2. What factors determine total employment and why does mass unemployment occur?
3. What factors determines the evolution of prices in the economy (inflation)?
4. How does the domestic economy interact with the rest of the world and what are the implications of that interaction?
A central idea in economics whether it is microeconomics or macroeconomics is efficiency – getting the best out of what you have available. The concept is extremely loaded and is the focus of many disputes – some more arcane than others. But there is a general consensus among economists that at the macroeconomic level, the “efficiency frontier” (which defines the best outcome achievable from an array of possible outcomes) is normally summarised in terms of full employment. The hot debate that has occupied economist for years is the exact meaning of the term – full employment. We will consider that issue in full in Chapters 10 and 11. But definitional disputes aside; it is a fact that the concept of full employment is a central focus of macroeconomic theory. Using the available macroeconomic resources including labour to the limit is a key goal of macroeconomics. The debate is over what the actual limit is.
The related macroeconomic challenge is how to maintain full employment but at the same time simultaneously achieve price stability. MMT develops a macroeconomic framework that exploits the unique features of the monetary system to achieve these two important goals. Those issues are brought together in Chapter 11 after the earlier chapters have developed the essential understandings of how employment and inflation is generated.
The clear point is that if you achieve that then you will be contributing to the prosperity and welfare of the population by ensuring real output levels are high within an environment of a nominal anchor (inflation control).
What this book seeks to develop is a framework for understanding the key determinants of these aggregate outcomes – the level and growth in output; the rate of unemployment; and the rate of inflation – within the context of what we call a monetary system. All economies use currencies as a way to facilitate transactions. The arrangements that pertain to the way the currency enters the economy and the role that the currency issuer, the national government has in influencing the outcomes at the aggregate level is a crucial part of macroeconomics.
Modern Monetary Theory (MMT) is distinguished from other approaches to macroeconomics because it places these arrangements at the centre of the analysis. Learning macroeconomics from an MMT perspective requires you to understand how money “works” in the modern economy and developing a conceptual structure or analysing the economy as it actually exists.
It is thus essential to understand the notion of a currency regime, which can range through a continuum from fixed exchange rate systems to floating exchange rate systems with varying degrees of exchange rate management in between. Understanding the way the exchange rate is set is important because it allows us to appreciate the various policy options that the currency issuer – the government – has in relation to influencing the objects of our study – employment, output and inflation.
At the heart of macroeconomics is the notion that at the aggregate level, total spending equals total income and total output. In turn, total employment is determined by the total output in the economy. So to understand employment and output determination we need to understand what drives total spending and how that generates income, output and the demand for labour.
In this context, we will consider the behaviour and interactions of the broad economic sectors – first, the government and non-government dichotomy; and, second, we will broaden the non-government into its component sectors – the private domestic sector (consumption and investment) and the external sector (trade and capital flows). The emphasis on the broad macroeconomic sectors leads directly to a particular approach being taken to the way we view the so-called National Accounts, which we analysis in detail in Chapter 5. This approach is called the sectoral balance approach which is build on the accounting rule that the deficits of one sector must be offset by surpluses of another in the case of the government-non-government dichotomy or that the sum of the balances nets to zero in the case of the government, private domestic, external sector variant.
If one of these spends more than its income, at least one of the others must spend less than its income because for the economy as a whole, total spending must equal total receipts or income. While there is no reason why any one sector has to run a balanced budget, the MMT framework shows that the system as a whole must. Often, though not always, the private domestic sector runs a surplus – spending less than its income. This is how it accumulates net financial wealth. Overall private domestic sector saving (or surplus) is a leakage from the overall expenditure cycle that must be matched by an injection of spending from another sector. The current account deficit (the so-called external sector account) is another leakage that drains domestic demand. That is the domestic economy is spending more overseas than foreigners are spending in the domestic economy. These concepts are developed in full in Chapter 6.
To organise the way of thinking in this regard we use a conceptual structure sometimes referred in the economics literature as a model – in this case a macroeconomic model. A model is just an organising framework and is typically a simplification of the system that is being investigated. In this textbook we will develop a macroeconomic model, which combines narrative and some formal language (mathematics) to advance your understanding of how the real world economy operates. We will necessarily stylise where complexity hinders clarity but always we will focus on the real world rather than an assumed world that has not application to the actual economy.
All disciplines develop their own language as a way of communicating. One might think that this just makes it harder to understand the ideas and we have sympathy for that view. But we also understand that students of a specific discipline – in this case macroeconomics – should be somewhat conversant with the language of the discipline they are studying.
In the Appendix to this Chapter, we present some analytical terminology that is used in the specification of macroeconomic models and which you will find throughout this book.
A macroeconomic model thus comprises the tools and theoretical connections to advance study of the main aggregates. This textbook is designed unique because it specifically develops the MMT macroeconomic model, which will be applicable to the real-world issues including economic policy debates. The application to policy is important because macroeconomics is what might be termed a policy science.
By placing government as the currency issuer at the centre of the monetary system we immediately focus on how it spends and how that spending influences the major macroeconomic aggregates that we seek to explain. The framework will, at first, provide a general analysis of government spending that applies to all currency-exchange rate systems before explaining the constraints (policy options) that apply to governments as we move from a fixed exchange rate to a flexible exchange rate system. We will consider how the design of the monetary system impacts on the domestic policy choices open to government and the outcomes of specific policy choices in terms of employment, output and inflation.
The two main policy choices that seek to influence what is termed the demand or spending side of the economy are monetary and fiscal policy. Fiscal policy is represented by the spending and taxation choices made by the government (the “treasury”) and the net financial accounting outcomes of these decisions are summarised periodically by the by government budget. Fiscal policy is one of the major means that the government seeks to influence overall spending in the economy and achieve its aims.
The textbook shows that a nation will have maximum fiscal space:
- If it operates with a sovereign currency; that is, a currency that is issued by the sovereign government and that is not pegged to foreign currencies; and
- If it avoids incurring debt in foreign currencies, and avoids guaranteeing the foreign currency debt of domestic entities (firms, households, or state, province, or city debts).
Under these conditions, the national government can always afford to purchase anything that is available for sale in its own currency. This means that if there are unemployed resources, the government can always mobilise them – putting them to productive use – through the use of fiscal policy. Such a government is not revenue-constrained, which means it does not face the financing constraints that a private household or firm faces in framing their expenditure decision.
To put it as simply as possible – this means that if there are unemployed workers who are willing to work, a sovereign government can afford to hire them to perform useful work in the public interest. From a macroeconomic efficiency argument, a primary aim of public policy is to fully utilise available resources.
MMT provides a broad theoretical macroeconomic framework based on the recognition that fiat currency systems are in fact public monopolies per se, and introduce imperfect competition to the monetary system itself, and that the imposition of taxes coupled with insufficient government spending generates unemployment in the private sector.
An understanding of this point will be developed to allow the student to appreciate the role that government can play in maintaining its near universal dual mandates of price stability and full employment. The student will learn that there are two broad approaches to control inflation available to government in designing its fiscal policy choices. The concept of buffer stocks are involved in each and the textbook will examine the differences between the use of:
- Unemployment buffer stocks: The mainstream approach, which describes the current policy orthodoxy), seeks to control inflation through the use of higher interest rates (tighter monetary) and supportive fiscal policy (austerity), which leads to a buffer stock of unemployment. In Chapters 10 and 11, students will learn that this approach is very costly and provides an unreliable target for policy makers to pursue as a means for inflation proofing; and
- Employment buffer stocks: Under this approach the government exploits its fiscal capacity, inherent in its currency issuing status to create an employment buffer stock approach. In MTT, this is called the Job Guarantee (JG) approach to full employment and price stability and the model, which is central to MMT is explained in full in Chapter 10.
The MMT macroeconomic framework shows that a superior use of the labour slack necessary to generate price stability is to implement an employment program for the otherwise unemployed as an activity floor in the real output sector, which both anchors the general price level to the price of employed labour of this (currently unemployed) buffer and can produce useful output with positive supply side effects.
As a further addition to the framework, you will learn the difference between a stock and a flow and relate that to the accumulation of financial assets in the non-government sector. We explain stocks and flows in more detail in Chapters 4 and 6, but for now we note that spending is always a flow of currency per period (for example, households might spend $100 billion dollars in the first three months of 2012).
We will develop the sectoral balances framework to show that a sectoral deficit accumulates, as a matter of accounting to financial debt while sectoral surpluses accumulate to financial assets. MMT is thus based on what is known as a stock-flow consistent approach to macroeconomics where all flows and resulting stocks are accounted for in an exhaustive fashion. The failure to adhere to a stock-flow consistent approach can lead to erroneous analytical conclusions and poor policy design.
From the perspective of fiscal policy choices, an important aspect of the stock-flow consistent approach that will be explained in Chapter 6, is that one sector’s spending flow must equal its income flow plus changes to its financial balance (stock of assets). This implies that a particular sector can spend more than its income, but this implies a deduction from its net financial assets. Likewise, the deficit spending of one sector implies that at least one other sector must be spending less than its income, accumulating net financial assets.
The textbook will show that a country can only run a current account deficit if the rest of the world wishes to accumulate financial claims on the nation. For the most part, these claims are in the form of government debt, which is issued as the government runs deficits. The MMT framework shows that for most governments, there is no default risk on government debt, and therefore such a situation is “sustainable” and should not be interpreted to be necessarily undesirable. Any assessment of the fiscal position of a nation must be taken in the light of the usefulness of the government’s spending program in achieving its national socio-economic goals. This is what Abba Lerner (1943) called the “functional finance” approach: rather than adopting some desired budgetary outcome, government ought to spend and tax with a view to achieving “functionally” defined outcomes.
The consequences of a budget surplus – the government spending less than they are taking out of the economy by way of taxation – when a nation runs an external deficit will also be outlined. In summary, budget surpluses force the non-government sector into deficit and the domestic private sector is forced to accumulate ever-increasing levels of indebtedness to maintain expenditure. The textbook will explain why this is an unsustainable growth strategy and how eventually the private domestic sector is forced to reduce its risky debt levels by saving more and the resulting drop in aggregate spending will reinforce the deflationary impact of the budget surplus.
The central bank in the economy is responsible for the conduct of monetary policy, which typically involves the setting of a short-term policy target interest rate. In the recent global economic crisis the ambit of monetary policy has broadened considerably and these developments will be considered in Chapter 14. MMT considers the treasury and central bank functions to be part of what is termed the consolidated government sector. In many textbooks, students are told that the central bank is independent from government. The MMT macroeconomic model will demonstrate how it is impossible for the two parts of government to work independently if the monetary system is to operate smoothly.
The Saturday Quiz will be back tomorrow as usual – trickier than you can imagine!
That is enough for today!