The Weekend Quiz – March 25-26, 2017 – 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:

Imagine that macroeconomic policy is geared towards keeping real GDP growth on trend. Assume this rate of growth is 3 per cent per annum. If labour productivity is growing at 2 per cent per annum and the labour force is growing at 1.5 per cent per annum and the average working week is constant in hours, then this policy regime will result in:

(a) A declining unemployment rate.

(b) An unchanged unemployment rate.

(c) A rising unemployment rate.

The answer is Option (c) A rising unemployment rate.

The facts were:

• Real GDP growth to be maintained at its trend growth rate of 3 per cent annum.
• Labour productivity growth (that is, growth in real output per person employed) growing at 2 per cent per annum. So as this grows less employment in required per unit of output.
• The labour force is growing by 1.5 per cent per annum. Growth in the labour force adds to the employment that has to be generated for unemployment to stay constant (or fall).
• The average working week is constant in hours. So firms are not making hours adjustments up or down with their existing workforce. Hours adjustments alter the relationship between real GDP growth and persons employed.

Of-course, the trend rate of real GDP growth doesn’t relate to the labour market in any direct way. The late Arthur Okun is famous (among other things) for estimating the relationship that links the percentage deviation in real GDP growth from potential to the percentage change in the unemployment rate – the so-called Okun’s Law.

The algebra underlying this law can be manipulated to estimate the evolution of the unemployment rate based on real output forecasts.

From Okun, we can relate the major output and labour-force aggregates to form expectations about changes in the aggregate unemployment rate based on output growth rates. A series of accounting identities underpins Okun’s Law and helps us, in part, to understand why unemployment rates have risen.

Take the following output accounting statement:

(1) Y = LP*(1-UR)LH

where Y is real GDP, LP is labour productivity in persons (that is, real output per unit of labour), H is the average number of hours worked per period, UR is the aggregate unemployment rate, and L is the labour-force. So (1-UR) is the employment rate, by definition.

Equation (1) just tells us the obvious – that total output produced in a period is equal to total labour input [(1-UR)LH] times the amount of output each unit of labour input produces (LP).

Using some simple calculus you can convert Equation (1) into an approximate dynamic equation expressing percentage growth rates, which in turn, provides a simple benchmark to estimate, for given labour-force and labour productivity growth rates, the increase in output required to achieve a desired unemployment rate.

Accordingly, with small letters indicating percentage growth rates and assuming that the average number of hours worked per period is more or less constant, we get:

(2) y = lp + (1 – ur) + lf

Re-arranging Equation (2) to express it in a way that allows us to achieve our aim (re-arranging just means taking and adding things to both sides of the equation):

(3) ur = 1 + lp + lf – y

Equation (3) provides the approximate rule of thumb – if the unemployment rate is to remain constant, the rate of real output growth must equal the rate of growth in the labour-force plus the growth rate in labour productivity.

It is an approximate relationship because cyclical movements in labour productivity (changes in hoarding) and the labour-force participation rates can modify the relationships in the short-run. But it provides reasonable estimates of what happens when real output changes.

The sum of labour force and productivity growth rates is referred to as the required real GDP growth rate – required to keep the unemployment rate constant.

Remember that labour productivity growth (real GDP per person employed) reduces the need for labour for a given real GDP growth rate while labour force growth adds workers that have to be accommodated for by the real GDP growth (for a given productivity growth rate).

So in the example, the required real GDP growth rate is 3.5 per cent per annum and if policy only aspires to keep real GDP growth at its trend growth rate of 3 per cent annum, then the output gap that emerges is 0.5 per cent per annum.

The unemployment rate will rise by this much (give or take) and reflects the fact that real output growth is not strong enough to both absorb the new entrants into the labour market and offset the employment losses arising from labour productivity growth.

Please read my blog – What do the IMF growth projections mean? – for more discussion on this point.

The question has practical relevance in Australia at present with the recent statement by the RBA that its was hiking rates further because real GDP growth was nearly back on trend. The fact is that the trend growth rate is below the required growth rate and so the monetary policy stance is really locking in higher than necessary unemployment.

Question 2:

Students are taught that the macroeconomic income determination system can be thought of as a bath tub with the current GDP being the water level. The drain plug can be thought of as saving, imports and taxation payments (the so-called leakages from the expenditure system) while the taps can be thought of as investment, government spending and exports (the so-called exogenous injections into the spending system). This analogy is valid because GDP will be unchanged as long as the flows into the bath are equal to the flows out of it which is tantamount to saying the the spending gap left by the leakages is always filled by the injections.

The answer is False.

This is actually an example that has been used in the past by macroeconomics teachers to try to teach students the so-called circular expenditure models with leakages and injections.

The basic flaw is that it confuses stocks and flows. As part of an economics education one has to clearly be able to articulate the distinction between the two concepts.

The taps and the drains reference are conceptually accurate because they relate to flows – all expenditure components, saving and taxation payments are flows which are measures as so many $s per period.

A stock has no such time dimension and the only way we can measure it is to take a snapshot at some point in time.

The flaw then relates to the construction of GDP as the level of water in the bath. This is a stock rather than a flow. In the same way as a reservoir is a storage of water which might be 70 or 80 percent full.

But GDP is just the summation of the expenditure flows and is thus a flow itself.

When then national statistician releases the National Accounts and says that GDP was $x billion in the December quarter, they are referring to the sum total of the flow of component expenditure over the 3 month period (October, November, December). They are not referring to a stock of output (which would be inventories or something like that).

The aspect of the question that is true, however, relates to the statement that GDP will be unchanged as long as the flows into the bath are equal to the flows out of it which is tantamount to saying the the spending gap left by the leakages is always filled by the injections.

However the nuance is that it will be the flow of GDP that will be unchanged. The water level is a poor construction of this flow concept.

Question 3:

In 1998, Russia defaulted on its outstanding domestic debt because it temporarily ran out of rubles due to the currency peg it was running with the US dollar.

The answer is False.

The question was a relatively straight-forward test of whether you understood what actually happened in Russia in 1997-98, given that more and more mainstream economists are (erroneously) using it as an example of sovereign default that is applicable to other nations at present – especially those that are sovereign in their own currency.

The question had correct details embedded with on major falsehood.

First, in late 1997 Russia did face a major collapse of oil and non-ferrous metal prices, upon which they heavily depended on to earn them foreign exchange.

Second, they did strongly rely on the export earnings from this sector to get foreign currency to repay the foreign currency-denominated loans that they had taken out in during the liberalism frenzy that followed the breakdown of the Soviet system. There was considerable optimism in Russia at the time and all sorts of opportunists were set loose and their foreign currency exposure rose dramatically.

Third, the defaults, in part were driven by the fact that they had chosen to peg the ruble within tight range to US dollar (a fairly hard peg) and thereby surrendered their currency sovereignty. Once the government pegged the currency and allowed wide-scale financialisation of its economy to occur with foreign-currency loans and foreign banks dominating, they were at risk of insolvency on any foreign currency debts they took out.

Under these circumstances, the economy – both government and non-government sectors – were are risk of any major decline in their export earnings and/or some other exogenous international event that would provoke speculative attacks on the ruble.

The latter came in November 1997 with the Asian crisis which led to speculative attacks on the Russian currency. The speculators knew that the Russian government would try to maintain the peg and was heavily indebted in foreign currencies. So by selling the Russian currency short the speculators knew they could profit.

The problem was that the Russian government played right into their hands and instructed the central bank (CBR) to defend the rouble (that is, maintain the peg) and they lost around $US6 billion in reserves in doing so.

Then in late 1997 oil and non-ferrous metal prices collapsed which reduced their capacity to replenish the lost foreign currency reserves.

The demise was fast and by April 1998 more attacks on its currency led to further foreign exchange reserves being lost in the futile attempt by the CBR to defend the hard peg. Further, oil prices kept dropping.

During this time, the CBR was hiking interest rates in a vein attempt to attract enough foreign investment to help defend the currency. The major impact of this policy was to scorch the domestic economy. The CBR however did not stop bleeding US dollars in its currency defence.

By August 1998 with the collapse of prices on Russian share and bond markets as investors sold off in the face of major fears of devaluation, the Russian government devalued the ruble, defaulted on domestic debt, and pronounced a moratorium on payments to foreign creditors (effectively a default). On September 2, 1998, the government floated the rouble.

So the crisis was the direct result of the currency peg and the massive exposure to foreign-denominated debt.

So why is the answer false?

Quite simply because the government not only suspended payments on all foreign-currency loans but also defaulted on its public debt denominated in rubles.

Even with the peg and the loss of foreign currency reserves, the government could have still always made the payments owing and the repurchases due on its domestic debt.

The fact they defaulted on their own debt was an act of sheer stupidity and the poor advice they were getting. There was never a solvency risk in their own currency. The IMF among others (including a bevy of mainstream economists) were telling the Russian government that they had to implement an austerity plan and convincing them that they needed to “raise money” to fund the deficit – both erroneous propositions.

They could have simply floated and become sovereign and then there was no solvency risk in all debts denominated in that currency.