Saturday Quiz – February 2, 2013 – answers and discussion

Here are the answers with discussion for yesterday’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 Monetary Theory (MMT) and its application to macroeconomic thinking. Comments as usual welcome, especially if I have made an error.

Question 1:

The automatic stabilisers always support growth when the economic growth is slowing.

The answer is True.

The automatic stabilisers do operate in a counter-cyclical fashion and so when economic growth is slowing they provide stimulus that would otherwise not be there. The declining tax revenue and rising welfare payments force the fiscal position into a more expansionary phase (even if discretionary government policy is unchanged).

The automatic stabilisers push the fiscal balance towards deficit, into deficit, or into a larger deficit when GDP growth declines and vice versa when GDP growth increases. These movements in aggregate demand play an important counter-cyclical attenuating role. So when GDP is declining due to falling aggregate demand, the automatic stabilisers work to add demand (falling taxes and rising welfare payments). When GDP growth is rising, the automatic stabilisers start to pull demand back as the economy adjusts (rising taxes and falling welfare payments).

We also measure the automatic stabiliser impact against some benchmark or “full capacity” or potential level of output, so that we can decompose the fiscal balance into that component which is due to specific discretionary fiscal policy choices made by the government and that which arises because the cycle takes the economy away from the potential level of output.

This decomposition provides (in modern terminology) the structural (discretionary) and cyclical fiscal balances. The fiscal components are adjusted to what they would be at the potential or full capacity level of output.

So if the economy is operating below capacity then tax revenue would be below its potential level and welfare spending would be above. In other words, the fiscal balance would be smaller at potential output relative to its current value if the economy was operating below full capacity. The adjustments would work in reverse should the economy be operating above full capacity.

If the fiscal position is in deficit when computed at the “full employment” or potential output level, then we call this a structural deficit and it means that the overall impact of discretionary fiscal policy is expansionary irrespective of what the actual fiscal outcome is presently. If it is in surplus, then we have a structural surplus and it means that the overall impact of discretionary fiscal policy is contractionary irrespective of what the actual fiscal outcome is presently.

So you could have a downturn which drives the fiscal position into a deficit but the underlying structural position could be contractionary (that is, a surplus). And vice versa.

The difference between the actual fiscal outcome and the structural component is then considered to be the cyclical fiscal outcome and it arises because the economy is deviating from its potential.

In some of the blog posts listed below I go into the measurement issues involved in this decomposition in more detail. However for this question it these issues are less important to discuss.

The point is that structural fiscal balance has to be sufficient to ensure there is full employment. The only sensible reason for accepting the authority of a national government and ceding currency control to such an entity is that it can work for all of us to advance public purpose.

In this context, one of the most important elements of public purpose that the state has to maximise is employment. Once the private sector has made its spending (and saving decisions) based on its expectations of the future, the government has to render those private decisions consistent with the objective of full employment.

Given the non-government sector will typically desire to net save (accumulate financial assets in the currency of issue) over the course of a business cycle this means that there will be, on average, a spending gap over the course of the same cycle that can only be filled by the national government. There is no escaping that.

So then the national government has a choice – maintain full employment by ensuring there is no spending gap which means that the necessary deficit is defined by this political goal. It will be whatever is required to close the spending gap. However, it is also possible that the political goals may be to maintain some slack in the economy (persistent unemployment and underemployment) which means that the government deficit will be somewhat smaller and perhaps even, for a time, a fiscal surplus will be possible.

But the second option would introduce fiscal drag (deflationary forces) into the economy which will ultimately cause firms to reduce production and income and drive the fiscal outcome towards increasing deficits.

Ultimately, the spending gap is closed by the automatic stabilisers because falling national income ensures that that the leakages (saving, taxation and imports) equal the injections (investment, government spending and exports) so that the sectoral balances hold (being accounting constructs). But at that point, the economy will support lower employment levels and rising unemployment. The fiscal position will also be in deficit – but in this situation, the deficits will be what I call “bad” deficits. Deficits driven by a declining economy and rising unemployment.

So fiscal sustainability requires that the government fills the spending gap with “good” deficits at levels of economic activity consistent with full employment – which I define as 2 per cent unemployment and zero underemployment.

Fiscal sustainability cannot be defined independently of full employment. Once the link between full employment and the conduct of fiscal policy is abandoned, we are effectively admitting that we do not want government to take responsibility of full employment (and the equity advantages that accompany that end).

So while the automatic stabilisers act to provide some floor in the collapse in aggregate demand they may still leave a structural deficit that is insufficient to finance the saving desire of the non-government sector at an output level consistent with full utilisation of resources.

The following blog posts may be of further interest to you:

• A modern monetary theory lullaby
• Saturday Quiz – April 24, 2010 – answers and discussion
• The dreaded NAIRU is still about!
• Structural deficits – the great con job!
• Structural deficits and automatic stabilisers
• Another economics department to close

Question 2:

Continuous fiscal deficits are more likely to present an inflation risk than one-off deficits designed to meet a short-term private spending decline.

The answer is False.

This question tests whether you understand that fiscal deficits are just the outcome of two flows which have a finite lifespan. Flows typically feed into stocks (increase or decrease them) and in the case of deficits, under current institutional arrangements, they increase public debt holdings.

So the expenditure impacts of deficit exhaust each period and underpin production and income generation and saving. Aggregate saving is also a flow but can add to stocks of financial assets when stored.

Under current institutional arrangements (where governments unnecessarily issue debt to match its net spending $-for-$) the deficits will also lead to a rise in the stock of public debt outstanding. But of-course, the increase in debt is not a consequence of any “financing” imperative for the government. A sovereign government is never revenue constrained because it is the monopoly issuer of the currency.

The inflation risk is inherent in each period that the deficit runs. The continuous nature doesn’t change that. As long as the government is filling a spending gap then it can safely run non-inflationary deficits forever.

It may be argued that political forces (lobby group) capture rise after a long-period of government deficits and this makes it hard for governments to adjust net spending when there are fluctuations in private spending that warrant a cut back in public stimulus.

That might be true but one wouldn’t advocate entrenched unemployment to avoid the capture of government by lobby groups. The political problem of capture would be better dealt with via strict campaign funding rules and disclosures.

The following blog posts may be of further interest to you:

• Deficit spending 101 – Part 1
• Deficit spending 101 – Part 2
• Deficit spending 101 – Part 3
• Fiscal sustainability 101 – Part 1
• Fiscal sustainability 101 – Part 2
• Fiscal sustainability 101 – Part 3

Question 3:

To maintain financial stability, the monetary base has to be driven by changes in the money supply.

The answer is True.

The standard textbook treatment of this relationship is backwards – courtesy of the belief that orthodox economists have in the money multiplier. As a a results, students are misled by the way in which the credit-creation capacity of commercial banks is discussed.

The concept of the money multiplier is at the centre of this analysis and posits that the multiplier m transmits changes in the so-called monetary base (MB) (the sum of bank reserves and currency at issue) into changes in the money supply (M). The chapters on money usually present some arcane algebra which is deliberately designed to impart a sense of gravitas or authority to the students who then mindlessly ape what is in the textbook.

They rehearse several times in their undergraduate courses (introductory and intermediate macroeconomics; money and banking; monetary economics etc) the mantra that the money multiplier is usually expressed as the inverse of the required reserve ratio plus some other novelties relating to preferences for cash versus deposits by the public.

Accordingly, the students learn that if the central bank told private banks that they had to keep 10 per cent of total deposits as reserves then the required reserve ratio (RRR) would be 0.10 and m would equal 1/0.10 = 10. More complicated formulae are derived when you consider that people also will want to hold some of their deposits as cash. But these complications do not add anything to the story.

The formula for the determination of the money supply is: M = m x MB. So if a $1 is newly deposited in a bank, the money supply will rise (be multiplied) by $10 (if the RRR = 0.10). The way this multiplier is alleged to work is explained as follows (assuming the bank is required to hold 10 per cent of all deposits as reserves):

• A person deposits say $100 in a bank.
• To make money, the bank then loans the remaining $90 to a customer.
• They spend the money and the recipient of the funds deposits it with their bank.
• That bank then lends 0.9 times $90 = $81 (keeping 0.10 in reserve as required).
• And so on until the loans become so small that they dissolve to zero

None of this is remotely accurate in terms of depicting how the banks make loans. It is an important device for the mainstream because it implies that banks take deposits to get funds which they can then on-lend. But prudential regulations require they keep a little in reserve. So we get this credit creation process ballooning out due to the fractional reserve requirements.

The money multiplier myth also leads students to think that as the central bank can control the monetary base then it can control the money supply. Further, given that inflation is allegedly the result of the money supply growing too fast then the blame is sheeted hometo the “government”. This leads to claims that if the government runs a fiscal deficit then it has to issue bonds to avoid causing hyperinflation. Nothing could be further from the truth.

That is nothing like the way the banking system operates in the real world. The idea that the monetary base (the sum of bank reserves and currency) leads to a change in the money supply via some multiple is not a valid representation of the way the monetary system operates.

First, the central bank does not have the capacity to control the money supply in a modern monetary system. In the world we live in, bank loans create deposits and are made without reference to the reserve positions of the banks. The bank then ensures its reserve positions are legally compliant as a separate process knowing that it can always get the reserves from the central bank. The only way that the central bank can influence credit creation in this setting is via the price of the reserves it provides on demand to the commercial banks.

Second, this suggests that the decisions by banks to lend may be influenced by the price of reserves rather than whether they have sufficient reserves. They can always get the reserves that are required at any point in time at a price, which may be prohibitive.

Third, the money multiplier story has the central bank manipulating the money supply via open market operations. So they would argue that the central bank might buy bonds to the public to increase the money base and then allow the fractional reserve system to expand the money supply. But a moment’s thought will lead you to conclude this would be futile unless (as in Question 3 a support rate on excess reserves equal to the current policy rate was being paid).

Why? The open market purchase would increase bank reserves and the commercial banks, in lieu of any market return on the overnight funds, would try to place them in the interbank market. Of-course, any transactions at this level (they are horizontal) net to zero so all that happens is that the excess reserve position of the system is shuffled between banks. But in the process the interbank return would start to fall and if the process was left to resolve, the overnight rate would fall to zero and the central bank would lose control of its monetary policy position (unless it was targetting a zero interest rate).

In lieu of a support rate equal to the target rate, the central bank would have to sell bonds to drain the excess reserves. The same futility would occur if the central bank attempted to reduce the money supply by instigating an open market sale of bonds.

In all cases, the central bank cannot influence the money supply in this way.

Fourth, given that the central bank adds reserves on demand to maintain financial stability and this process is driven by changes in the money supply as banks make loans which create deposits.

So the operational reality is that the dynamics of the monetary base (MB) are driven by the changes in the money supply which is exactly the reverse of the causality presented by the monetary multiplier.

So in fact we might write MB = M/m.

You might like to read these blog posts for further information:

• Teaching macroeconomics students the facts
• Lost in a macroeconomics textbook again
• Lending is capital- not reserve-constrained
• Oh no … Bernanke is loose and those greenbacks are everywhere
• Building bank reserves will not expand credit
• Building bank reserves is not inflationary
• 100-percent reserve banking and state banks
• Money multiplier and other myths