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Saturday Quiz – December 28, 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:

If the external sector was running a surplus equivalent to 4 per cent of GDP, and the sum of all the private sector spending plans indicated it was desiring to run a surplus overall equivalent to 6 per cent, then the government could safely plan on achieving a budget surplus of 2 per cent of GDP.

The answer is False.

First, you need to understand the basic relationship between the sectoral flows and the balances that are derived from them. The flows are derived from the National Accounting relationship between aggregate spending and income. So:

(1) Y = C + I + G + (X – M)

where Y is GDP (income), C is consumption spending, I is investment spending, G is government spending, X is exports and M is imports (so X – M = net exports).

Another perspective on the national income accounting is to note that households can use total income (Y) for the following uses:

(2) Y = C + S + T

where S is total saving and T is total taxation (the other variables are as previously defined).

You than then bring the two perspectives together (because they are both just “views” of Y) to write:

(3) C + S + T = Y = C + I + G + (X – M)

You can then drop the C (common on both sides) and you get:

(4) S + T = I + G + (X – M)

Then you can convert this into the familiar sectoral balances accounting relations which allow us to understand the influence of fiscal policy over private sector indebtedness.

So we can re-arrange Equation (4) to get the accounting identity for the three sectoral balances – private domestic, government budget and external:

(S – I) = (G – T) + (X – M)

The sectoral balances equation says that total private savings (S) minus private investment (I) has to equal the public deficit (spending, G minus taxes, T) plus net exports (exports (X) minus imports (M)), where net exports represent the net savings of non-residents.

Another way of saying this is that total private savings (S) is equal to private investment (I) plus the public deficit (spending, G minus taxes, T) plus net exports (exports (X) minus imports (M)), where net exports represent the net savings of non-residents.

All these relationships (equations) hold as a matter of accounting and not matters of opinion.

Thus, when an external deficit (X – M < 0) and public surplus (G – T < 0) coincide, there must be a private deficit. While private spending can persist for a time under these conditions using the net savings of the external sector, the private sector becomes increasingly indebted in the process.

Second, you then have to appreciate the relative sizes of these balances to answer the question correctly.

Consider the following Table which depicts three cases – two that define a state of macroeconomic equilibrium (where aggregate demand equals income and firms have no incentive to change output) and one (Case 2) where the economy is in a disequilibrium state and income changes would occur.

You will see that Case 2 corresponds to the data proposed in the question.

Note that in the equilibrium cases, the (S – I) = (G – T) + (X – M) whereas in the disequilibrium case (S – I) > (G – T) + (X – M) meaning that aggregate demand is falling and a spending gap is opening up. Firms will respond to that gap by decreasing output and income and this brings about an adjustment in the balances until they are back in equality.

So in Case 1, assume that the private domestic sector desires to save 2 per cent of GDP overall (spend less than they earn) and the external sector is running a surplus equal to 4 per cent of GDP.

In that case, aggregate demand will be unchanged if the government runs a surplus of 2 per cent of GDP (noting a negative sign on the government balance means T > G).

In this situation, the surplus does not undermine economic growth because the injections into the spending stream (NX) are exactly offset by the leakages in the form of the private saving and the budget surplus. This is the Norwegian situation.

In Case 2, we hypothesise that the private domestic sector now wants to save 6 per cent of GDP and they translate this intention into action by cutting back consumption (and perhaps investment) spending.

Clearly, aggregate demand now falls by 4 per cent of GDP and if the government tried to maintain that surplus of 2 per cent of GDP, the spending gap would start driving GDP downwards.

The falling income would not only reduce the capacity of the private sector to save but would also push the budget balance towards deficit via the automatic stabilisers. It would also push the external surplus up as imports fell. Eventually the income adjustments would restore the balances but with lower GDP overall.

So Case 2 is a not a position of rest – or steady growth. It is one where the government sector (for a given net exports position) is undermining the changing intentions of the private sector to increase their overall saving.

In Case 3, you see the result of the government sector accommodating that rising desire to save by the private sector by running a deficit of 2 per cent of GDP.

So the injections into the spending stream are 4 per cent from NX and 2 per cent from the deficit which exactly offset the desire of the private sector to save 6 per cent of GDP. At that point, the system would be in rest.

This is a highly stylised example and you could tell a myriad of stories that would be different in description but none that could alter the basic point.

If the drain on spending outweighs the injections into the spending stream then GDP falls (or growth is reduced).

So even though an external surplus is being run, the desired budget balance still depends on the saving desires of the private domestic sector. Under some situations, these desires could require a deficit even with an external surplus.

If the private sector was able to realise their spending plans, the the government would have to run a deficit equivalent of 2 per cent of GDP, given the other data.

You may wish to read the following blogs for more information:

Question 2:

If governments allowed the automatic stabilisers built into the government balance to work counter-cyclically and avoided discretionary shifts in fiscal policy, the fiscal balance would return to its appropriate level after a cyclical disturbance.

The answer is False.

The factual statement in the proposition is that the automatic stabilisers do operate in a counter-cyclical fashion when economic growth resumes. This is because tax revenue improves given it is typically tied to income generation in some way. Further, most governments provide transfer payment relief to workers (unemployment benefits) and this increases when there is an economic slowdown.

The question is false though because this process while important may not ensure that the government budget balance returns to its appropriate level.

The automatic stabilisers just push the budget 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 budget 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 budget balances. The budget 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 budget 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 budget 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 budget 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 budget outcome is presently.

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

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

In some of the blogs 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 budget 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 budget 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 budget 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 budget 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 it will not always be the case that the dynamics of the automatic stabilisers will leave a structural deficit sufficient to finance the saving desire of the non-government sector at an output level consistent with full utilisation of resources.

The following blogs may be of further interest to you:

Question 3:

If austerity led to all national governments simultaneously running public surpluses (which is the aim) then it would be impossible for all their respective private domestic sectors to save overall.

The answer is True.

The question tests a knowledge of the sectoral balances and their interactions, the behavioural relationships that generate the flows which are summarised by decomposing the national accounts into these balances, and the constraints that is placed on the behaviour within the three sectors that is evident in the requirement that the balances must add up to zero as a matter of accounting.

Refer to answer above for derivation.

The private domestic sector is only one part of the non-government sector – the other being the external sector.

Most countries currently run external deficits. This means that if the government sector is in surplus the private domestic sector has to be in deficit.

However, some countries have to run external surpluses if there is at least one country running an external deficit. That country can depending on the relative magnitudes of the external balance and private domestic balance, run a public surplus while maintaining strong economic growth. For example, Norway.

In this case an increasing desire to save by the private domestic sector in the face of fiscal drag coming from the budget surplus can be offset by a rising external surplus with growth unimpaired. So the decline in domestic spending is compensated for by a rise in net export income.

So if all governments (in all nations) are running public surpluses and some nations are running external deficits (the majority), public surpluses have to be associated (given the underlying behaviour that generates these aggregates) with private domestic deficits.

Even if the external sector balance was zero, the proposition would still be true. At least one private domestic sector would be unable to save overall.

These deficits can keep spending going for a time but the increasing indebtedness ultimately unwinds and households and firms (whoever is carrying the debt) start to reduce their spending growth to try to manage the debt exposure. The consequence is a widening spending gap which pushes the economy into recession and, ultimately, pushes the budget into deficit via the automatic stabilisers.

So you can sustain economic growth with a private domestic surplus and government surplus if the external surplus is large enough. So a growth strategy can still be consistent with a public surplus.

Clearly not every country can adopt this strategy given that the external positions net out to zero themselves across all trading nations. So for every external surplus recorded there has to be equal deficits spread across other nations.

You might like to read these blogs for further information:

This Post Has 13 Comments

  1. “… If the external sector was running a surplus equivalent to 4 per cent of GDP …”
    “… where net exports represent the net savings of non-residents. …”

    I think this needs more clarification. When you say the “external sector” (non-residents) is “running a surplus”, you seem to mean they are getting an excess of your real goods (X – M) as opposed to holding on to your currency (M – X), but when you say the private sector is saving they are really saving up your currency (S – I). This can be confusing, even if in that particular example mixing this up still gets you the right answer.

  2. Bill,

    “total private savings (S) is equal to private investment (I) plus the public deficit (spending, G minus taxes, T) plus net exports (exports (X) minus imports (M)), where net exports represent the net savings of non-residents”.

    So, S = I + (G – T) + (X – M)

    Say the public deficit/surplus is zero, and the current account deficit/ surplus is zero, and domestic private investment = 10

    so: S = 10 + (0) + (0)

    In this case private saving (S) = 10

    So is it correct in this case to say that the private sector is not saving overall?


  3. Philippe

    If I’ve understood your point properly, it is correct to say the private sector is not saving overall because the definition of the private sector balance includes what is happening to private investment.

    So in your example savings due perhaps to foregone consumption of 10 units might result in a build up of stocks of 10 units all other things being equal. in any event by definition the two would have to be equal given the results for the other sectors.

    That’s how i see it anyway.

  4. Dear hamstray (at 2013/12/29 at 19:25)

    All the sectoral balances are specified in terms of flows of dollars (or whatever the relevant currency is). They are in nominal terms and usually expressed as a percentage of GDP (also in nominal terms).

    Once you realise that you will find that there is no confusion.

    best wishes

  5. Dear Philippe (at 2013/12/30 at 4:14)

    You noted:

    Say the public deficit/surplus is zero, and the current account deficit/ surplus is zero, and domestic private investment = 10

    so: S = 10 + (0) + (0)

    In this case private saving (S) = 10

    So is it correct in this case to say that the private sector is not saving overall?

    Your arithmetic is correct but your conclusion in incorrect.

    To avoid confusion the terminology in Modern Monetary Theory is “saving” (by a household out of disposable income) and “saving overall” (referring to the private domestic sector as an aggregate).

    In your example, there is saving (equal to 10) but not “saving overall” because Investment equals saving, which means (once you take into account the implicit consumption) that the private domestic sector (which consumes and invests) is spending all their income.

    I hope that clarifies the situation for you.

    best wishes

  6. Bill,

    Thank you for the explanation. I get your point that the private sector is spending all of its income.

    However, isn’t saving defined as income not spent on consumption?

    In other words, isn’t income spent on investment defined as saving?

    I looked up the subject in the General Theory, and in it Keynes defines saving as follows:

    “Having now defined both income and consumption, the definition of saving, which is the excess of income over consumption, naturally follows. Since income is equal to A – U and consumption is equal to A – A1, it follows that saving is equal to A1 – U. Similarly, we have net saving for the excess of net income over consumption, equal to A1 – U – V.”

    “In short-

    Income = value of output = consumption + investment.
    Saving = income − consumption.
    Therefore saving = investment.”

    (GT, Chapter 6, part 2)

    By this definition, what you refer to as “saving overall” is called “net saving” by Keynes.

    Wynne Godley uses the same definition as Keynes:

    “0 = [G – T] + [X – M] – PNS

    where PNS is private net saving-that is, private disposable income less total private expenditure, including both consumption and investment… private net saving is always identically equal to the government’s budget deficit plus the current account surplus.”

    Do any other economists use the term ‘saving overall’ to refer to ‘net saving’ or is this particular to MMT?


  7. “Once you realise that you will find that there is no confusion.”

    So why do we say the external sector is running a surplus when there is money flowing from it rather than to it (X > M)?
    rearranging the balance equation to:
    (S – I) + (M – X) – (T – G) = 0
    money flowing to private sector + money flowing to external sector – money flowing to government sector = 0

    so if (S > I) we call that private surplus,
    and if (T > G) we call that government surplus,
    but when (M < X) why do we call that an external surplus?

  8. Last I checked the goods and services Australia sell to other countries were called exports and the goods and services Australians buy from other countries were called imports.

    The Current Account equals [exports minus imports] plus net income + net current transfers.

    In the above examples I think Bill is using X-M to cover CA = [X – M] + NY + NCT

    With respect to Hamstrays post we would call (M < X) an external surplus because we are receiving more income than we are giving ? Or have I had another brain fade ?

  9. “Once you realise that you will find that there is no confusion.”

    No, there is. Really, there is. I went through this exercise once with heteonomist’s help (resembling a scene straight out of Green Acres), and I was sure I could answer this question. Now I’m all confused again. Just so that we’re clear, I ended up using pictures to represent each sector in my version of sector balances. That works too.


  10. Hamstray,

    “… If the external sector was running a surplus equivalent to 4 per cent of GDP …”

    I think what Bill means here is that the domestic country is running an external trade surplus, i.e its exports are greater than its imports.

    “… where net exports represent the net savings of non-residents. …”

    Net exports can be negative, or alternatively they can be called ‘net imports’.

    If your country’s ‘net exports’ equal -2 (i.e. you are importing more than you are exporting), the country you are importing from is net saving. Hence your (negative) net exports represent their net saving. I think this is what is meant.

  11. Hence your (negative) net exports represent their net saving.

    Burn everything.

    Hence your trade deficit represents foreign saving in your currency.

    Fixed, thx!

  12. 1) Wasnt the Lisbon Treaty signed to stop govts. from using the central bank in this manner that youve mentioned
    2) MMT needs an advertising (propaganda) machine equal to that of what the neo liberals have used to get society to believe that thier garbage is the best way to go – even after all the disasters that neo liberalism has caused.

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