The Weekend Quiz – March 5-6, 2016 – answers and discussion

Here are the answers with discussion for this week’s Weekend 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 mainstream macroeconomics conception of the banking system characterised by the concept of the money multiplier posits that changes in the monetary base are driven by changes in the money supply.

The answer is False.

Mainstream macroeconomics textbooks provide an incorrect depiction of the monetary system when they discuss the credit-creation capacity of commercial banks. 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 the argument in their undergraduate courses (introductory and intermediate macroeconomics; money and banking; monetary economics etc) 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 blogs 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

Question 2:

If the nation is running a current account deficit which is accompanied by a government sector surplus of equal size, then the private domestic sector will always be spending more than its income.

The answer is True.

This is a question about the sectoral balances – the government fiscal balance, the external balance and the private domestic balance – that have to always add to zero because they are derived as an accounting identity from the national accounts.

To refresh your memory the balances are derived as follows. 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).

Expression (1) tells us that total income in the economy per period will be exactly equal to total spending from all sources of expenditure.

We also have to acknowledge that financial balances of the sectors are impacted by net government taxes (T) which includes all taxes and transfer and interest payments (the latter are not counted independently in the expenditure Expression (1)).

Further, as noted above the trade account is only one aspect of the financial flows between the domestic economy and the external sector. we have to include net external income flows (FNI).

Adding in the net external income flows (FNI) to Expression (2) for GDP we get the familiar gross national product or gross national income measure (GNP):

(2) GNP = C + I + G + (X – M) + FNI

To render this approach into the sectoral balances form, we subtract total taxes and transfers (T) from both sides of Expression (3) to get:

(3) GNP – T = C + I + G + (X – M) + FNI – T

Now we can collect the terms by arranging them according to the three sectoral balances:

(4) (GNP – C – T) – I = (G – T) + (X – M + FNI)

The the terms in Expression (4) are relatively easy to understand now.

The term (GNP – C – T) represents total income less the amount consumed less the amount paid to government in taxes (taking into account transfers coming the other way). In other words, it represents private domestic saving.

The left-hand side of Equation (4), (GNP – C – T) – I, thus is the overall saving of the private domestic sector, which is distinct from total household saving denoted by the term (GNP – C – T).

In other words, the left-hand side of Equation (4) is the private domestic financial balance and if it is positive then the sector is spending less than its total income and if it is negative the sector is spending more than it total income.

The term (G – T) is the government financial balance and is in deficit if government spending (G) is greater than government tax revenue minus transfers (T), and in surplus if the balance is negative.

Finally, the other right-hand side term (X – M + FNI) is the external financial balance, commonly known as the current account balance (CAD). It is in surplus if positive and deficit if negative.

In English we could say that:

The private financial balance equals the sum of the government financial balance plus the current account balance.

We can re-write Expression (6) in this way to get the sectoral balances equation:

(5) (S – I) = (G – T) + CAD

which is interpreted as meaning that government sector deficits (G – T > 0) and current account surpluses (CAD > 0) generate national income and net financial assets for the private domestic sector.

Conversely, government surpluses (G – T < 0) and current account deficits (CAD < 0) reduce national income and undermine the capacity of the private domestic sector to add financial assets.

Expression (5) can also be written as:

(6) [(S – I) – CAD] = (G – T)

where the term on the left-hand side [(S – I) – CAD] is the non-government sector financial balance and is of equal and opposite sign to the government financial balance.

This is the familiar MMT statement that a government sector deficit (surplus) is equal dollar-for-dollar to the non-government sector surplus (deficit).

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)) plus net income transfers.

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

This is also a basic rule derived from the national accounts and has to apply at all times.

The following Table represents three options in percent of GDP terms. To aid interpretation remember that (I-S) > 0 means that the private domestic sector is spending more than they are earning; that (G-T) < 0 means that the government is running a surplus because T > G; and (X-M) < 0 means the external position is in deficit because imports are greater than exports.

The first two possibilities we might call A and B:

A: A nation can run a current account deficit with an offsetting government sector surplus, while the private domestic sector is spending less than they are earn
B: A nation can run a current account deficit with an offsetting government sector surplus, while the private domestic sector is spending more than they are earning.

So Option A says the private domestic sector is saving overall, whereas Option B say the private domestic sector is dis-saving (and going into increasing indebtedness). These options are captured in the first column of the Table. So the arithmetic example depicts an external sector deficit of 2 per cent of GDP and an offsetting fiscal surplus of 2 per cent of GDP.

You can see that the private sector balance is positive (that is, the sector is spending more than they are earning – Investment is greater than Saving – and has to be equal to 4 per cent of GDP.

Given that the only proposition that can be true is:

B: A nation can run a current account deficit with an offsetting government sector surplus, while the private domestic sector is spending more than they are earning.

Column 2 in the Table captures Option C:

C: A nation can run a current account deficit with a government sector surplus that is larger, while the private domestic sector is spending less than they are earning.

So the current account deficit is equal to 2 per cent of GDP while the surplus is now larger at 3 per cent of GDP. You can see that the private domestic deficit rises to 5 per cent of GDP to satisfy the accounting rule that the balances sum to zero.

The Table data also shows the rule that the sectoral balances add to zero because they are an accounting identity is satisfied in both cases.

So what is the economic rationale for this result?

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 external deficit also means that foreigners are increasing financial claims denominated in the local currency. Given that exports represent a real costs and imports a real benefit, the motivation for a nation running a net exports surplus (the exporting nation in this case) must be to accumulate financial claims (assets) denominated in the currency of the nation running the external deficit.

A fiscal surplus also means the government is spending less than it is “earning” and that puts a drag on aggregate demand and constrains the ability of the economy to grow.

In these circumstances, for income to be stable, the private domestic sector has to spend more than they earn.

You can see this by going back to the aggregate demand relations above. For those who like simple algebra we can manipulate the aggregate demand model to see this more clearly.

Y = GDP = C + I + G + (X – M)

which says that the total national income (Y or GDP) is the sum of total final consumption spending (C), total private investment (I), total government spending (G) and net exports (X – M).

So if the G is spending less than it is “earning” and the external sector is adding less income (X) than it is absorbing spending (M), then the other spending components must be greater than total income

The following blogs may be of further interest to you:

• Barnaby, better to walk before we run
• Stock-flow consistent macro models
• Norway and sectoral balances
• The OECD is at it again!

Question 3:

With the Eurozone nations unable to gain competitive relief via nominal exchange rate adjustments the hope is that by deflating wages and prices real unit labour costs will fall. Assuming other nations do nothing and wages and prices fall at the same rate, then a real exchange rate depreciation (relative to other nations) requires labour productivity and employment growth to rise.

The answer is False.

The EMU countries cannot improve their international competitiveness by exchange rate depreciation, which is the option always available to a fully sovereign nation issuing its own currency and floating it in foreign exchange markets.

Thus, to improve their international competitiveness, the EMU countries have to engage in “internal devaluation” which means they have to cut real unit labour costs – which are the real cost of producing goods and services. Governments setting out on this policy path have to engineer cuts in the wage and price levels (the latter following the former as unit costs fall).

But the question demonstrates that it takes more than just a nominal deflation. The strategy hinges on whether you can also engineer productivity growth (typically).

Given the assumption (wage and prices falling at the same rate), what happens to employment growth is irrelevant.

Some explanatory notes to accompany the analysis that follows:

• Employment is measured in persons (averaged over the period).
• Labour productivity is the units of output per person employment per period.
• The wage and price level are in nominal units; the real wage is the wage level divided by the price level and tells us the real purchasing power of that nominal wage level.
• The wage bill is employment times the wage level and is the total labour costs in production for each period.
• Real GDP is thus employment times labour productivity and represents a flow of actual output per period; Nominal GDP is Real GDP at market value – that is, multiplied by the price level. So real GDP can grow while nominal GDP can fall if the price level is deflating and productivity growth and/or employment growth is positive.
• The wage share is the share of total wages in nominal GDP and is thus a guide to the distribution of national income between wages and profits.
• Unit labour costs are in nominal terms and are calculated as total labour costs divided by nominal GDP. So they tell you what each unit of output is costing in labour outlays; Real unit labour costs just divide this by the price level to give a real measure of what each unit of output is costing. RULC is also the ratio of the real wage to labour productivity and through algebra I would be able to show you (trust me) that it is equivalent to the Wage share measure (although I have expressed the latter in percentage terms and left the RULC measure in raw units).

The following table models the constant and growing productivity cases but holds employment constant for five periods. We assume that the nominal wage and the price level deflate by 10 per cent per period over Period 2 to 5. In the productivity growth case, we assume it grows by 10 per cent per period over Period 2 to 5.

It is quite clear that under the assumptions employed, RULC cannot fall without productivity growth. The only other way to accomplish this is to ensure that nominal wages fall faster than the price level falls. In the historical debate, this was a major contention between Keynes and Pigou (an economist in the neo-classical tradition who best represented the so-called “British Treasury View” in the 1930s. The Treasury View thought the cure to the Great Depression was to cut the real wage because according to their erroneous logic, unemployment could only occur if the real wage was too high.

Keynes argued that if you tried to cut nominal wages as a way of cutting the real wage (given there is no such thing as a real wage that policy can directly manipulate), firms will be forced by competition to cut prices to because unit labour costs would be lower. He hypothesised that there is no reason not to believe that the rate of deflation in nominal wage and price level would be similar and so the real wage would be constant over the period of the deflation. So that is the operating assumption here.

The following table models the constant and growing productivity cases as above but allows employment to grow by 10 per cent per period. All four scenarios in the Table are them modelled in the following graph with the Real Unit Labour Costs converted into index number form equal to 100 in Period 1. As you can see what happens to employment makes no difference at all.

I could have also modelled employment falling with the same results.

The following graph shows the four scenarios shown in the last two tables. I have dashed some scenarios to make the lines visible (given that Case A and Case C) are equivalent as are Case B and Case D. What you learn is that if wages and prices fall at the same rate and labour productivity does not rise there can be no reduction in unit or real unit labour costs.

So the internal devaluation strategy relies heavily on productivity growth occurring. The literature on organisational psychology and industrial relations is replete of examples where worker morale is an important ingredient in accomplishing productivity growth. In a climate of austerity characteristic of an internal devaluation strategy it is highly likely that productivity will not grow and may even fall over time. Then the internal devaluation strategy is useless.

This graph compares the two scenarios in the first Table with the more realistic one that labour productivity actually falls as the government ravages the economy in pursuit of its internal devaluation. As you can see real unit labour costs rise as labour productivity falls and the economy’s competitiveness (given the exchange rate is fixed) falls.

Of-course, this “supply-side” scenario does not take into account the overwhelming reality that for an economy to realise this level of output over an extended period aggregate demand would have to be supportive. The internal devaluation strategy relies heavily on the external sector providing the demand impetus.

Given that Eurozone trade is heavily internal, it seems far fetched to assume that the trade impact arising from any successful internal devaluation will be sufficient to overcome the devastating domestic contraction in demand that will almost certainly occur. This is why commentators are calling for a domestic expansion in Germany to boost aggregate demand throughout the EMU, given the dominance of the German economy in the overall European trade.

That is clearly unlikely to happen given Germany has been engaged in a lengthy process of internal devaluation itself and the Government is resistant to any stimulus packages that might improve things within Germany and beyond via the trade impacts.

The following blogs may be of further interest to you:

• Euro zone’s self-imposed meltdown
• A Greek tragedy …
• España se está muriendo
• Exiting the Euro?
• Doomed from the start
• Europe – bailout or exit?
• Not the EMF … anything but the EMF!
• EMU posturing provides no durable solution
• Protect your workers for the sake of the nation
• The bullies and the bullied
• Modern monetary theory in an open economy

That is enough for today!

(c) Copyright 2016 William Mitchell. All Rights Reserved.