Saturday Quiz – April 5, 2014 – 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:

Recent press reports indicate that the European Central Bank is considering introducing quantitative easing to ease the aggregate demand losses associated with the implementation of fiscal austerity programs as deflation threatens. If calibrated correctly, this strategy will replace the net financial assets destroyed by the fiscal austerity.

The answer is False.

Quantitative easing involves the central bank buying assets from the private sector – government bonds and high quality corporate debt. So what the central bank is doing is swapping financial assets with the banks – they sell their financial assets and receive back in return extra reserves.

The central bank is thus buying one type of financial asset (private holdings of bonds, company paper) and exchanging it for another (reserve balances at the central bank). The net financial assets in the private sector are in fact unchanged although the portfolio composition of those assets is altered (maturity substitution) which changes yields and returns.

In terms of changing portfolio compositions, quantitative easing increases central bank demand for “long maturity” assets held in the private sector which reduces interest rates at the longer end of the yield curve. These are traditionally thought of as the investment rates. This might increase aggregate demand given the cost of investment funds is likely to drop. But on the other hand, the lower rates reduce the interest-income of savers who will reduce consumption (demand) accordingly.

How these opposing effects balance out is unclear but the evidence suggests there is not very much impact at all.

You should read the answer to Question 2 to reflect on how fiscal policy adds net financial assets to the non-government sector by way of contradistinction to QE.

The following blogs may be of further interest to you:

• Money multiplier and other myths
• Islands in the sun
• Operation twist – then and now
• Quantitative easing 101
• 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

Question 2:

The expansionary impact of deficit spending on aggregate demand is lower when the government matches the deficit with debt-issuance than if it just instructed the central bank to fund its spending account. This is because debt-issuance drains excess reserves resulting from the deficits and purchasing power is accordingly withdrawn from the monetary system.

The answer is False.

The mainstream macroeconomic textbooks all have a chapter on fiscal policy (and it is often written in the context of the so-called IS-LM model but not always).

The chapters always introduces the so-called Government Budget Constraint that alleges that governments have to “finance” all spending either through taxation; debt-issuance; or money creation. The writer fails to understand that government spending is performed in the same way irrespective of the accompanying monetary operations.

They claim that money creation (borrowing from central bank) is inflationary while the latter (private bond sales) is less so. These conclusions are based on their erroneous claim that “money creation” adds more to aggregate demand than bond sales, because the latter forces up interest rates which crowd out some private spending.

All these claims are without foundation in a fiat monetary system and an understanding of the banking operations that occur when governments spend and issue debt helps to show why.

So what would happen if a sovereign, currency-issuing government (with a flexible exchange rate) ran a fiscal deficit without issuing debt?

Like all government spending, the Treasury would credit the reserve accounts held by the commercial bank at the central bank. The commercial bank in question would be where the target of the spending had an account. So the commercial bank’s assets rise and its liabilities also increase because a deposit would be made.

The transactions are clear: The commercial bank’s assets rise and its liabilities also increase because a new deposit has been made. Further, the target of the fiscal initiative enjoys increased assets (bank deposit) and net worth (a liability/equity entry on their balance sheet). Taxation does the opposite and so a deficit (spending greater than taxation) means that reserves increase and private net worth increases.

This means that there are likely to be excess reserves in the “cash system” which then raises issues for the central bank about its liquidity management. The aim of the central bank is to “hit” a target interest rate and so it has to ensure that competitive forces in the interbank market do not compromise that target.

When there are excess reserves there is downward pressure on the overnight interest rate (as banks scurry to seek interest-earning opportunities), the central bank then has to sell government bonds to the banks to soak the excess up and maintain liquidity at a level consistent with the target. Some central banks offer a return on overnight reserves which reduces the need to sell debt as a liquidity management operation.

There is no sense that these debt sales have anything to do with “financing” government net spending. The sales are a monetary operation aimed at interest-rate maintenance. So M1 (deposits in the non-government sector) rise as a result of the deficit without a corresponding increase in liabilities. It is this result that leads to the conclusion that that deficits increase net financial assets in the non-government sector.

What would happen if there were bond sales? All that happens is that the banks reserves are reduced by the bond sales but this does not reduce the deposits created by the net spending. So net worth is not altered. What is changed is the composition of the asset portfolio held in the non-government sector.

The only difference between the Treasury “borrowing from the central bank” and issuing debt to the private sector is that the central bank has to use different operations to pursue its policy interest rate target. If it debt is not issued to match the deficit then it has to either pay interest on excess reserves (which most central banks are doing now anyway) or let the target rate fall to zero (the Japan solution).

There is no difference to the impact of the deficits on net worth in the non-government sector.

Mainstream economists would say that by draining the reserves, the central bank has reduced the ability of banks to lend which then, via the money multiplier, expands the money supply.

However, the reality is that:

• Building bank reserves does not increase the ability of the banks to lend.
• The money multiplier process so loved by the mainstream does not describe the way in which banks make loans.
• Inflation is caused by aggregate demand growing faster than real output capacity. The reserve position of the banks is not functionally related with that process.

So the banks are able to create as much credit as they can find credit-worthy customers to hold irrespective of the operations that accompany government net spending.

This doesn’t lead to the conclusion that deficits do not carry an inflation risk. All components of aggregate demand carry an inflation risk if they become excessive, which can only be defined in terms of the relation between spending and productive capacity.

It is totally fallacious to think that private placement of debt reduces the inflation risk. It does not.

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

• Why history matters
• Building bank reserves will not expand credit
• Building bank reserves is not inflationary
• The complacent students sit and listen to some of that
• Saturday Quiz – February 27, 2010 – answers and discussion

Question 3:

Imagine that the government is choosing between a tax cut that will reduce tax revenue at the current level of national income by $x and a spending increase of $x. Which policy option will have the greater initial impact on aggregate demand?

(a) Tax cut
(b) Spending increase
(c) Both will be equivalent
(d) There is not enough information to answer this question

The answer is Spending increase.

The question is only seeking an understanding of the initial injection into the spending stream rather than the fully exhausted multiplied expansion of national income that will result. It is clear that the tax cut approach will have two effects: (a) some initial demand stimulus; and (b) it increases the value of the multiplier, other things equal.

We are only interested in the first effect rather than the total effect. But I will give you some insight also into what the two components of the tax result might imply overall when compared to the stimulus motivated by an increase in government spending.

To give you a concrete example which will consolidate the understanding of what happens, imagine that the marginal propensity to consume out of disposable income is 0.8 and there is only one tax rate set at 0.20. So for every extra dollar that the economy produces the government taxes 20 cents leaving 80 cents in disposable income. In turn, households then consume 0.8 of this 80 cents which means an injection of 64 cents goes into aggregate demand which them multiplies as the initial spending creates income which, in turn, generates more spending and so on.

Government spending increase

An increase in government spending (say of $1000) is what we call an exogenous injection into the spending stream and stimulates aggregate demand by that amount. So it might be an order of $1000 worth of gadget X which advances human welfare immeasurably! The firm that produces gadget X thus increases production of the good or service by the rise in orders ($1000) and as a result incomes of the productive factors rises by $1000. So the initial rise in aggregate demand is $1000.

This initial increase in national output and income then stimulates (induces) further consumption by 64 cents in the dollar so in Period 2, aggregate demand increases by $640. Output and income rises by the same amount to meet this increase in spending. In Period 3, aggregate demand rises by 0.8 x 0.8 x $640 and so on. The induced spending increase gets smaller and smaller because some of each round of income increase is taxed away, some goes to imports and some is saved.

Tax-cut induced stimulus

The stimulus coming from a tax-cut does not directly impact on the spending stream in the same way as the rise in government spending.

First, imagine the government worked out a tax cut that would increase its initial fiscal deficit by the same amount as would have been the case if it had increased government spending (so in our example, $1000).

In other words, disposable income at each level of GDP rises initially by $1000. What happens next?

Some of the disposable income is saved (20 cents in each dollar that disposable income increases). So immediately some of the tax increase is lost from the spending stream.

In this case the injection into aggregate demand is $800 rather than $1000 in the case of the increase in government spending.

What happens next depends on the parameters of the macroeconomic system. The multiplied rise in national income may be higher or lower depending on these parameters. But it will never be the case that an initial fiscal equivalent tax cut will be more stimulatory than a government spending increase.

Note in answering this question I am disregarding all the nonsensical notions of Ricardian equivalence that abound among the mainstream doomsayers who have never predicted anything of empirical note! All their predictions come to nought.

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

• Spending multipliers