The Weekend Quiz – November 19-20, 2016 – answers and discussion

Here are the answers with discussion for this Weekend’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:

When a sovereign government issues debt it logically:

(a) increases the assets that are held by the non-government sector $-for-$.

(b) has no impact on the overall holdings of assets held by the non-government sector $-for-$.

(c) reduces the capacity of the private sector to borrow from banks because they use their deposits to buy the bonds.

The answer is Option (b) – Has no impact on the overall holdings of assets held by the non-government sector $-for-$.

The answer to this question is complementary to the answer in Question 2.

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 and 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 that are not accompanied by corresponding monetary operations (debt-issuance) 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.

National governments have cash operating accounts with their central bank. The specific arrangements vary by country but the principle remains the same. When the government spends it debits these accounts and credits various bank accounts within the commercial banking system. Deposits thus show up in a number of commercial banks as a reflection of the spending. It may issue a cheque and post it to someone in the private sector whereupon that person will deposit the cheque at their bank. It is the same effect as if it had have all been done electronically.

All federal spending happens like this. You will note that:

• Governments do not spend by “printing money”. They spend by creating deposits in the private banking system. Clearly, some currency is in circulation which is “printed” but that is a separate process from the daily spending and taxing flows.
• There has been no mention of where they get the credits and debits come from! The short answer is that the spending comes from no-where but we will have to wait for another blog soon to fully understand that. Suffice to say that the Federal government, as the monopoly issuer of its own currency is not revenue-constrained. This means it does not have to “finance” its spending unlike a household, which uses the fiat currency.
• Any coincident issuing of government debt (bonds) has nothing to do with “financing” the government spending.

All the commercial banks maintain reserve accounts with the central bank within their system. These accounts permit reserves to be managed and allows the clearing system to operate smoothly. The rules that operate on these accounts in different countries vary (that is, some nations have minimum reserves others do not etc). For financial stability, these reserve accounts always have to have positive balances at the end of each day, although during the day a particular bank might be in surplus or deficit, depending on the pattern of the cash inflows and outflows. There is no reason to assume that these flows will exactly offset themselves for any particular bank at any particular time.

The central bank conducts “operations” to manage the liquidity in the banking system such that short-term interest rates match the official target – which defines the current monetary policy stance. The central bank may: (a) Intervene into the interbank (overnight) money market to manage the daily supply of and demand for reserve funds; (b) buy certain financial assets at discounted rates from commercial banks; and (c) impose penal lending rates on banks who require urgent funds, In practice, most of the liquidity management is achieved through (a). That being said, central bank operations function to offset operating factors in the system by altering the composition of reserves, cash, and securities, and do not alter net financial assets of the non-government sectors.

Fiscal policy impacts on bank reserves – government spending (G) adds to reserves and taxes (T) drains them. So on any particular day, if G > T (a fiscal deficit) then reserves are rising overall. Any particular bank might be short of reserves but overall the sum of the bank reserves are in excess. It is in the commercial banks interests to try to eliminate any unneeded reserves each night given they usually earn a non-competitive return. Surplus banks will try to loan their excess reserves on the Interbank market. Some deficit banks will clearly be interested in these loans to shore up their position and avoid going to the discount window that the central bank offeres and which is more expensive.

The upshot, however, is that the competition between the surplus banks to shed their excess reserves drives the short-term interest rate down. These transactions net to zero (a equal liability and asset are created each time) and so non-government banking system cannot by itself (conducting horizontal transactions between commercial banks – that is, borrowing and lending on the interbank market) eliminate a system-wide excess of reserves that the fiscal deficit created.

What is needed is a vertical transaction – that is, an interaction between the government and non-government sector. So bond sales can drain reserves by offering the banks an attractive interest-bearing security (government debt) which it can purchase to eliminate its excess reserves.

However, the vertical transaction just offers portfolio choice for the non-government sector rather than changing the holding of financial assets.

Option (a) “increases the assets that are held by the non-government sector $-for-$” is thus incorrect.

Option (c) “reduces the capacity of the private sector to borrow from banks because they use their deposits to buy the bonds” is clearly not correct.

This is based on the erroneous belief that the banks need deposits and reserves before they can lend. Mainstream macroeconomics wrongly asserts that banks only lend if they have prior reserves. The illusion is that a bank is an institution that accepts deposits to build up reserves and then on-lends them at a margin to make money. The conceptualisation suggests that if it doesn’t have adequate reserves then it cannot lend. So the presupposition is that by adding to bank reserves, quantitative easing will help lending.

But this is a completely incorrect depiction of how banks operate. Bank lending is not “reserve constrained”. Banks lend to any credit worthy customer they can find and then worry about their reserve positions afterwards. If they are short of reserves (their reserve accounts have to be in positive balance each day and in some countries central banks require certain ratios to be maintained) then they borrow from each other in the interbank market or, ultimately, they will borrow from the central bank through the so-called discount window. They are reluctant to use the latter facility because it carries a penalty (higher interest cost).

The point is that building bank reserves will not increase the bank’s capacity to lend. Loans create deposits which generate reserves.

The following blogs may be of further interest to you:

• Quantitative easing 101
• Building bank reserves will not expand credit
• Building bank reserves is not inflationary
• Money multiplier and other myths
• Will we really pay higher interest rates?
• A modern monetary theory lullaby

Question 2:

Only one of the following statements is definitely true when you observe rising government bond yields for new issues:

(a) Government spending is becoming more expensive.

(b) Bond prices are falling in response to falling demand.

(c) Government spending is increasing the cost of borrowing for private investors.

The answer is Option (b) – Bond prices are falling in response to falling demand..

The first option provided “that government spending is becoming more expensive” assumes that there is some revenue constraint on government spending. The interest servicing payments come from the same source as all government spending – its infinite (minus $1!) capacity to issue fiat currency. There is no “cost” – in real terms to the government doing this.

The concept of more or less expensive is therefore inapplicable to government spending.

The third option “that government spending is increasing the cost of borrowing for private investors” is also based on the flawed mainstream concept of crowding out. The normal presentation of the crowding out hypothesis, which is a central plank in the mainstream economics attack on government fiscal intervention, is more accurately called “financial crowding out”.

In this blog – Studying macroeconomics – an exercise in deception – I provide detailed analysis of this hypothesis.

By way of summary, the underpinning of the crowding out hypothesis is the old Classical theory of loanable funds, which is an aggregate construction of the way financial markets are meant to work in mainstream macroeconomic thinking. The original conception was designed to explain how aggregate demand could never fall short of aggregate supply because interest rate adjustments would always bring investment and saving into equality.

Mainstream textbook writer Mankiw assumes that it is reasonable to represent the financial system to his students as the “market for loanable funds” where “all savers go to this market to deposit their savings, and all borrowers go to this market to get their loans. In this market, there is one interest rate, which is both the return to saving and the cost of borrowing.”

This doctrine was a central part of the so-called classical model where perfectly flexible prices delivered self-adjusting, market-clearing aggregate markets at all times. If consumption fell, then saving would rise and this would not lead to an oversupply of goods because investment (capital goods production) would rise in proportion with saving. So while the composition of output might change (workers would be shifted between the consumption goods sector to the capital goods sector), a full employment equilibrium was always maintained as long as price flexibility was not impeded. The interest rate became the vehicle to mediate saving and investment to ensure that there was never any gluts.

The supply of funds comes from those people who have some extra income they want to save and lend out. The demand for funds comes from households and firms who wish to borrow to invest (houses, factories, equipment etc). The interest rate is the price of the loan and the return on savings and thus the supply and demand curves (lines) take the shape they do.

This framework is then used to analyse fiscal policy impacts and the alleged negative consequences of fiscal deficits – the so-called financial crowding out – is derived.
Mankiw (in his First Principles) says:

One of the most pressing policy issues … has been the government budget deficit … In recent years, the U.S. federal government has run large budget deficits, resulting in a rapidly growing government debt. As a result, much public debate has centred on the effect of these deficits both on the allocation of the economy’s scarce resources and on long-term economic growth.

So what would happen if there is a fiscal deficit? The erroneous mainstream logic is that investment falls because when the government borrows to finance its fiscal deficit, it increases competition for scarce private savings pushes up interest rates. The higher cost of funds crowds thus crowds out private borrowers who are trying to finance investment. This leads to the conclusion that given investment is important for long-run economic growth, government fiscal deficits reduce the economy’s growth rate.

The analysis relies on layers of myths which have permeated the public space to become almost “self-evident truths”. Obviously, national governments are not revenue-constrained so their borrowing is for other reasons – we have discussed this at length. This trilogy of blogs will help you understand this if you are new to my blog – Deficit spending 101 – Part 1 | Deficit spending 101 – Part 2 | Deficit spending 101 – Part 3.

But governments do borrow – for stupid ideological reasons and to facilitate central bank operations – so doesn’t this increase the claim on saving and reduce the “loanable funds” available for investors? Does the competition for saving push up the interest rates?

The answer to both questions is no! Modern Monetary Theory (MMT) does not claim that central bank interest rate hikes are not possible. There is also the possibility that rising interest rates reduce aggregate demand via the balance between expectations of future returns on investments and the cost of implementing the projects being changed by the rising interest rates.

But the Classical claims about crowding out are not based on these mechanisms. In fact, they assume that savings are finite and the government spending is financially constrained which means it has to seek “funding” in order to progress their fiscal plans. The result competition for the “finite” saving pool drives interest rates up and damages private spending.

A related theory which is taught under the banner of IS-LM theory (in macroeconomic textbooks) assumes that the central bank can exogenously set the money supply. Then the rising income from the deficit spending pushes up money demand and this squeezes interest rates up to clear the money market. This is the Bastard Keynesian approach to financial crowding out.

Neither theory is remotely correct and is not related to the fact that central banks push up interest rates up because they believe they should be fighting inflation and interest rate rises stifle aggregate demand.

Further, from a macroeconomic flow of funds perspective, the funds (net financial assets in the form of reserves) that are the source of the capacity to purchase the public debt in the first place come from net government spending. Its what astute financial market players call “a wash”. The funds used to buy the government bonds come from the government!

There is also no finite pool of saving that is competed for. Loans create deposits so any credit-worthy customer can typically get funds. Reserves to support these loans are added later – that is, loans are never constrained in an aggregate sense by a “lack of reserves”. The funds to buy government bonds come from government spending! There is just an exchange of bank reserves for bonds – no net change in financial assets involved. Saving grows with income.

But importantly, deficit spending generates income growth which generates higher saving. It is this way that MMT shows that deficit spending supports or “finances” private saving not the other way around.

Acknowledging the point that increased aggregate demand, in general, generates income and saving, Luigi Passinetti the famous Italian economist had a wonderful sentence I remember from my graduate school days – “investment brings forth its own savings” – which was the basic insight of Keynes and Kalecki – and the insight that knocked out classical loanable funds theory upon which the neo-liberal crowding out theory was originally conceived.

So that leaves the option “that bond prices are falling in response to demand”.

In macroeconomics, we summarise the plethora of public debt instruments with the concept of a bond. The standard bond has a face value – say $A1000 and a coupon rate – say 5 per cent and a maturity – say 10 years. This means that the bond holder will will get $50 dollar per annum (interest) for 10 years and when the maturity is reached they would get $1000 back.

Bonds are issued by government into the primary market, which is simply the institutional machinery via which the government sells debt to “raise funds”. In a modern monetary system with flexible exchange rates it is clear the government does not have to finance its spending so the the institutional machinery is voluntary and reflects the prevailing neo-liberal ideology – which emphasises a fear of fiscal excesses rather than any intrinsic need.

Once bonds are issued they are traded in the secondary market between interested parties. Clearly secondary market trading has no impact at all on the volume of financial assets in the system – it just shuffles the wealth between wealth-holders. In the context of public debt issuance – the transactions in the primary market are vertical (net financial assets are created or destroyed) and the secondary market transactions are all horizontal (no new financial assets are created). Please read my blog – Deficit spending 101 – Part 3 – for more discussion on this point.

Further, most primary market issuance is now done via auction. Accordingly, the government would determine the maturity of the bond (how long the bond would exist for), the coupon rate (the interest return on the bond) and the volume (how many bonds) being specified.

The issue would then be put out for tender and the market then would determine the final price of the bonds issued. Imagine a $1000 bond had a coupon of 5 per cent, meaning that you would get $50 dollar per annum until the bond matured at which time you would get $1000 back.

Imagine that the market wanted a yield of 6 per cent to accommodate risk expectations (inflation or something else). So for them the bond is unattractive and they would avoid it under the tap system. But under the tender or auction system they would put in a purchase bid lower than the $1000 to ensure they get the 6 per cent return they sought.

The mathematical formulae to compute the desired (lower) price is quite tricky and you can look it up in a finance book.

The general rule for fixed-income bonds is that when the prices rise, the yield falls and vice versa. Thus, the price of a bond can change in the market place according to interest rate fluctuations.

When interest rates rise, the price of previously issued bonds fall because they are less attractive in comparison to the newly issued bonds, which are offering a higher coupon rates (reflecting current interest rates).

When interest rates fall, the price of older bonds increase, becoming more attractive as newly issued bonds offer a lower coupon rate than the older higher coupon rated bonds.

Further, rising yields may indicate a rising sense of risk (mostly from future inflation although sovereign credit ratings will influence this). But they may also indicated a recovering economy where people are more confidence investing in commercial paper (for higher returns) and so they demand less of the “risk free” government paper.

So you see how an event (yield rises) that signifies growing confidence in the real economy is reinterpreted (and trumpeted) by the conservatives to signal something bad (crowding out). In this case, the reason long-term yields would be rising is because investors were diversifying their portfolios and moving back into private financial assets. The yield reflects the last auction bid in the bond issue. So if diversification is occurring reflecting confidence and the demand for public debt weakens and yields rise this has nothing at all to do with a declining pool of funds being soaked up by the binging government!

The following blogs may be of further interest to you:

• Saturday Quiz – April 17, 2010 – answers and discussion
• Time to outlaw the credit rating agencies
• Studying macroeconomics – an exercise in deception
• Time for a reality check on debt – Part 1
• Will we really pay higher interest rates?

Question 3:

Open market operations as a means of ensuring that levels of bank reserves are consistent with the policy interest rate target becomes redundant if the central bank pays a positive interest rate on overnight reserves held by the commercial banks (ignore any reserve requirements in place when answering).

The answer is Maybe.

This blog – Understanding central bank operations – is good for understanding operational matters as they apply to central banking.

Mainstream macroeconomics textbooks typically try to tell students that monetary policy describes the processes by which the central bank determines “the total amount of money in existence or to alter that amount”.

In Mankiw’s Principles of Economics (Chapter 27 First Edition) he say that the central bank has “two related jobs”. The first is to “regulate the banks and ensure the health of the financial system” and the second “and more important job”:

… is to control the quantity of money that is made available to the economy, called the money supply. Decisions by policymakers concerning the money supply constitute monetary policy (emphasis in original).

How does the mainstream see the central bank accomplishing this task? Mankiw says:

Fed’s primary tool is open-market operations – the purchase and sale of U.S government bonds … If the FOMC decides to increase the money supply, the Fed creates dollars and uses them buy government bonds from the public in the nation’s bond markets. After the purchase, these dollars are in the hands of the public. Thus an open market purchase of bonds by the Fed increases the money supply. Conversely, if the FOMC decides to decrease the money supply, the Fed sells government bonds from its portfolio to the public in the nation’s bond markets. After the sale, the dollars it receives for the bonds are out of the hands of the public. Thus an open market sale of bonds by the Fed decreases the money supply.

This description of the way the central bank interacts with the banking system and the wider economy is totally false. The reality is that monetary policy is focused on determining the value of a short-term interest rate. Central banks cannot control the money supply. To some extent these ideas were a residual of the commodity money systems where the central bank could clearly control the stock of gold, for example. But in a credit money system, this ability to control the stock of “money” is undermined by the demand for credit.

The theory of endogenous money is central to the horizontal analysis in Modern Monetary Theory (MMT). When we talk about endogenous money we are referring to the outcomes that are arrived at after market participants respond to their own market prospects and central bank policy settings and make decisions about the liquid assets they will hold (deposits) and new liquid assets they will seek (loans).

The essential idea is that the “money supply” in an “entrepreneurial economy” is demand-determined – as the demand for credit expands so does the money supply. As credit is repaid the money supply shrinks. These flows are going on all the time and the stock measure we choose to call the money supply, say M3 (Currency plus bank current deposits of the private non-bank sector plus all other bank deposits from the private non-bank sector) is just an arbitrary reflection of the credit circuit.

So the supply of money is determined endogenously by the level of GDP, which means it is a dynamic (rather than a static) concept.

Central banks clearly do not determine the volume of deposits held each day. These arise from decisions by commercial banks to make loans. The central bank can determine the price of “money” by setting the interest rate on bank reserves. Further expanding the monetary base (bank reserves) as we have argued in recent blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – does not lead to an expansion of credit.

With this background in mind, the question is specifically about the dynamics of bank reserves which are used to satisfy any imposed reserve requirements and facilitate the payments system. These dynamics have a direct bearing on monetary policy settings. Given that the dynamics of the reserves can undermine the desired monetary policy stance (as summarised by the policy interest rate setting), the central banks have to engage in liquidity management operations.

What are these liquidity management operations?

Well you first need to appreciate what reserve balances are.

The New York Federal Reserve Bank’s paper – Divorcing Money from Monetary Policy said that:

… reserve balances are used to make interbank payments; thus, they serve as the final form of settlement for a vast array of transactions. The quantity of reserves needed for payment purposes typically far exceeds the quantity consistent with the central bank’s desired interest rate. As a result, central banks must perform a balancing act, drastically increasing the supply of reserves during the day for payment purposes through the provision of daylight reserves (also called daylight credit) and then shrinking the supply back at the end of the day to be consistent with the desired market interest rate.

So the central bank must ensure that all private cheques (that are funded) clear and other interbank transactions occur smoothly as part of its role of maintaining financial stability. But, equally, it must also maintain the bank reserves in aggregate 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.

Many countries (such as Australia and Canada) 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 the US and Japan have historically offered a zero return on reserves which means persistent excess liquidity would drive the short-term interest rate to zero.

The support rate effectively becomes the interest-rate floor for the economy. If 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.

So the issue then becomes – at what level should the support rate be set? To answer that question, I reproduce a version of teh diagram from the FRBNY paper which outlined a simple model of the way in which reserves are manipulated by the central bank as part of its liquidity management operations designed to implement a specific monetary policy target (policy interest rate setting).

I describe the FRBNY model in detail in the blog – Understanding central bank operations so I won’t repeat that explanation.

The penalty rate is the rate the central bank charges for loans to banks to cover shortages of reserves. If the interbank rate is at the penalty rate then the banks will be indifferent as to where they access reserves from so the demand curve is horizontal (shown in red).

Once the price of reserves falls below the penalty rate, banks will then demand reserves according to their requirments (the legal and the perceived). The higher the market rate of interest, the higher is the opportunity cost of holding reserves and hence the lower will be the demand. As rates fall, the opportunity costs fall and the demand for reserves increases. But in all cases, banks will only seek to hold (in aggregate) the levels consistent with their requirements.

At low interest rates (say zero) banks will hold the legally-required reserves plus a buffer that ensures there is no risk of falling short during the operation of the payments system.

Commercial banks choose to hold reserves to ensure they can meet all their obligations with respect to the clearing house (payments) system. Because there is considerable uncertainty (for example, late-day payment flows after the interbank market has closed), a bank may find itself short of reserves. Depending on the circumstances, it may choose to keep a buffer stock of reserves just to meet these contingencies.

So central bank reserves are intrinsic to the payments system where a mass of interbank claims are resolved by manipulating the reserve balances that the banks hold at the central bank. This process has some expectational regularity on a day-to-day basis but stochastic (uncertain) demands for payments also occur which means that banks will hold surplus reserves to avoid paying any penalty arising from having reserve deficiencies at the end of the day (or accounting period).

To understand what is going on not that the diagram is representing the system-wide demand for bank reserves where the horizontal axis measures the total quantity of reserve balances held by banks while the vertical axis measures the market interest rate for overnight loans of these balances

In this diagram there are no required reserves (to simplify matters). We also initially, abstract from the deposit rate for the time being to understand what role it plays if we introduce it.

Without the deposit rate, the central bank has to ensure that it supplies enough reserves to meet demand while still maintaining its policy rate (the monetary policy setting.

So the model can demonstrate that the market rate of interest will be determined by the central bank supply of reserves. So the level of reserves supplied by the central bank supply brings the market rate of interest into line with the policy target rate.

At the supply level shown as Point A, the central bank can hit its monetary policy target rate of interest given the banks’ demand for aggregate reserves. So the central bank announces its target rate then undertakes monetary operations (liquidity management operations) to set the supply of reserves to this target level.

So contrary to what Mankiw’s textbook tells students the reality is that monetary policy is about changing the supply of reserves in such a way that the market rate is equal to the policy rate.

The central bank uses open market operations to manipulate the reserve level and so must be buying and selling government debt to add or drain reserves from the banking system in line with its policy target.

If there are excess reserves in the system and the central bank didn’t intervene then the market rate would drop towards zero and the central bank would lose control over its target rate (that is, monetary policy would be compromised).

As explained in the blog – Understanding central bank operations – the introduction of a support rate payment (deposit rate) whereby the central bank pays the member banks a return on reserves held overnight changes things considerably.

It clearly can – under certain circumstances – eliminate the need for any open-market operations to manage the volume of bank reserves.

In terms of the diagram, the major impact of the deposit rate is to lift the rate at which the demand curve becomes horizontal (as depicted by the new horizontal red segment moving up via the arrow).

This policy change allows the banks to earn overnight interest on their excess reserve holdings and becomes the minimum market interest rate and defines the lower bound of the corridor within which the market rate can fluctuate without central bank intervention.

So in this diagram, the market interest rate is still set by the supply of reserves (given the demand for reserves) and so the central bank still has to manage reserves appropriately to ensure it can hit its policy target.

If there are excess reserves in the system in this case, and the central bank didn’t intervene, then the market rate will drop to the support rate (at Point B).

So if the central bank wants to maintain control over its target rate it can either set a support rate below the desired policy rate (as in Australia) and then use open market operations to ensure the reserve supply is consistent with Point A or set the support (deposit) rate equal to the target policy rate.

The answer to the question is thus Maybe because it all depends on where the support rate is set. Only if it set equal to the policy rate will there be no need for the central bank to manage liquidity via open market operations.

The following blogs may be of further interest to you:

• Understanding central bank operations
• Building bank reserves will not expand credit
• Building bank reserves is not inflationary