# Saturday Quiz – August 16, 2014 – 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

A currency-issuing government can always ensure there is first-class services to meet the demands of an ageing population.

The dependency ratio matters but not in the way that is usually assumed.

The standard dependency ratio is normally defined as 100*(population 0-15 years) + (population over 65 years) all divided by the (population between 15-64 years). Historically, people retired after 64 years and so this was considered reasonable. The working age population (15-64 year olds) then were seen to be supporting the young and the old.

The aged dependency ratio is calculated as:

100*Number of persons over 65 years of age divided by the number of persons of working age (15-65 years).

The child dependency ratio is calculated as:

100*Number of persons under 15 years of age divided by the number of persons of working age (15-65 years).

The total dependency ratio is the sum of the two. You can clearly manipulate the “retirement age” and add workers older than 65 into the denominator and subtract them from the numerator.

If we want to actually understand the changes in active workers relative to inactive persons (measured by not producing national income) over time then the raw computations are inadequate.

Then you have to consider the so-called effective dependency ratio which is the ratio of economically active workers to inactive persons, where activity is defined in relation to paid work. So like all measures that count people in terms of so-called gainful employment they ignore major productive activity like housework and child-rearing. The latter omission understates the female contribution to economic growth.

Given those biases, the effective dependency ratio recognises that not everyone of working age (15-64 or whatever) are actually producing. There are many people in this age group who are also “dependent”. For example, full-time students, house parents, sick or disabled, the hidden unemployed, and early retirees fit this description.

I would also include the unemployed and the underemployed in this category although the statistician counts them as being economically active.

If we then consider the way the neo-liberal era has allowed mass unemployment to persist and rising underemployment to occur you get a different picture of the dependency ratios.

The reason that mainstream economists believe the dependency ratio is important is typically based on false notions of the government fiscal constraint.

So a rising dependency ratio suggests that there will be a reduced tax base and hence an increasing fiscal crisis given that public spending is alleged to rise as the ratio rises as well.

So if the ratio of economically inactive rises compared to economically active, then the economically active will have to pay much higher taxes to support the increased spending. So an increasing dependency ratio is meant to blow the deficit out and lead to escalating debt.

These myths have also encouraged the rise of the financial planning industry and private superannuation funds which blew up during the recent crisis losing millions for older workers and retirees. The less funding that is channelled into the hands of the investment banks the better is a good general rule.

But all of these claims are not in the slightest bit true and should be rejected out of hand.

So you get all this hoopla about the fiscal crisis that is emerging. Apparently we have to make people work longer despite this being very biased against the lower-skilled workers who physically are unable to work hard into later life.

We are also encouraged to increase our immigration levels to lower the age composition of the population and expand the tax base. Further, we are told relentlessly that the government will be unable to afford to provide the quality and quantity of the services that we have become used too.

However, all of these remedies miss the point overall. It is not a financial crisis that beckons but a real one. Dependency ratios matter because they tell us how many workers will be available to produce real goods and services at any point in time. So we can make projections about real GDP growth for given projections about productivity once we have an idea of these underlying dependency ratios.

Clearly we want to be sure that the projected real needs of the population are capable of being met with the likely available resources.

So the only question we need to ask about the future population trends relate to whether there will be enough real resources available to provide aged-care, etc at a desirable level in the future? However, that is never the way the debate is framed. The worry is always that public outlays will rise because more real resources will be required “in the public sector” than previously.

However these outlays are irrelevant from a financial point of view. The government can purchase anything that is for sale in the currency it issues at any time. There is never a question that the government cannot afford to buy something that is available.

It is the availability that is the issue. As long as these real resources are available there will be no problem. In this context, the type of policy strategy that is being driven by these myths will probably undermine the future productivity and provision of real goods and services in the future.

It is clear that the goal should be to maintain efficient and effective medical care systems. Clearly the real health care system matters by which I mean the resources that are employed to deliver the health care services and the research that is done by universities and elsewhere to improve our future health prospects. So real facilities and real know how define the essence of an effective health care system.

Further, productivity growth comes from research and development and in Australia the private sector has an abysmal track record in this area. Typically they are parasites on the public research system which is concentrated in the universities and public research centres (for example, CSIRO).

Unfortunately, tackling the problems of the distant future in terms of current “monetary” considerations which have led to the conclusion that fiscal austerity is needed today to prepare us for the future will actually undermine our future.

The irony is that the pursuit of fiscal austerity leads governments to target public education almost universally as one of the first expenditures that are reduced.

Most importantly, maximising employment and output in each period is a necessary condition for long-term growth. The emphasis in mainstream integeneration debate that we have to lift labour force participation by older workers is sound but contrary to current government policies which reduces job opportunities for older male workers by refusing to deal with the rising unemployment.

Anything that has a positive impact on the dependency ratio is desirable and the best thing for that is ensuring that there is a job available for all those who desire to work.

Further encouraging increased casualisation and allowing underemployment to rise is not a sensible strategy for the future. The incentive to invest in one’s human capital is reduced if people expect to have part-time work opportunities increasingly made available to them.

But all these issues are really about political choices rather than government finances. The ability of government to provide necessary goods and services to the non-government sector, in particular, those goods that the private sector may under-provide is independent of government finance.

Any attempt to link the two via fiscal policy “discipline:, will not increase per capita GDP growth in the longer term. The reality is that fiscal drag that accompanies such “discipline” reduces growth in aggregate demand and private disposable incomes, which can be measured by the foregone output that results.

Clearly surpluses help control inflation because they act as a deflationary force relying on sustained excess capacity and unemployment to keep prices under control. This type of fiscal “discipline” is also claimed to increase national savings but this equals reduced non-government savings, which arguably is the relevant measure to focus upon.

So even though the government is not financially constrained it might adopt a policy platform that undermines productivity growth and leaves the economy short of real productive resources at a time in the future when they will be needed to fulfill its socio-economic program.

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Question 2:

For a nation running a small current account deficit (close to balance), the government fiscal balance will always be in deficit if the domestic private sector is spending less than it earns.

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.

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.

So here is the accounting (again). 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. The reference to a “small” external deficit was to place doubt in your mind. In fact, it doesn’t matter how large the external deficit is for this question.

Assume, now that the private domestic sector (households and firms) seeks to increase its saving ratio and is successful in doing so. 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 fiscal balance towards and eventually into deficit via the automatic stabilisers.

If the private sector persists in trying to increase its saving ratio then the contracting income will clearly push the fiscal balance into deficit.

So we would have an external deficit, a private domestic surplus and a fiscal deficit.

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Question 3:

Ignoring laws to the contrary, a central bank currently targetting a 2 per cent short-term policy rate, cannot directly purchase treasury debt to facilitate the national government’s fiscal deficit (that is, “monetise the deficit”) and continue to maintain its policy rate at 2 per cent.

It is false, because the central bank can offer a positive return (say 2 per cent) on excess reserves and circumvent any interbank competition from underining the policy rate.

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, debt is issued as an interest-maintenance strategy by the central bank. It has no correspondence with any need to fund government spending. Debt might also be issued if the government wants the private sector to have less purchasing power.

Further, the idea that governments would 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 federal 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.

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### This Post Has One Comment

1. Totaram says:

Bill,
Somewhat off-topic: I am trying to fit “asset bubbles” into my understanding of MMT but couldn’t find anything by searching your blogs. Any suggestions? Thanks.