The Weekend Quiz – September 30-October 1, 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:

Assume that a nation is continuously running an external deficit of 2 per cent of GDP. If the private domestic sector successfully spends less than its overall income, then we would always find a public sector deficit.

The answer is True.

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.

Refreshing the balances (again) – 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.

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:

(1) 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 tax revenue minus total 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 net taxes (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.

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 the specific 2 per cent of GDP figure was to place doubt in your mind. In fact, it doesn’t matter how large or small 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 outcome into deficit.

So if there is an external deficit and the private domestic sector saves (a surplus) then there will always be a fiscal deficit. The higher the private saving, the larger the deficit.

The following Graph and related Table shows you the sectoral balances written as (G-T) = (S-I) – (X-M) and how the fiscal deficit rises as the private domestic saving rises.

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 2:

The automatic stabilisers built into fiscal policy operate to return the government’s fiscal balance returns to its appropriate level once growth returns to trend following a downturn.

The answer is False.

The automatic stabilisers operate in a counter-cyclical fashion when economic growth resumes. This is because tax revenue improves given it is typically tied to income generation in some way. Further, most governments provide transfer payment relief to workers (unemployment benefits) and this increases when there is an economic slowdown.

The question is false though because this process while important may not ensure that the government fiscal balance returns to its appropriate level.

The automatic stabilisers just push the fiscal balance towards deficit, into deficit, or into a larger deficit when GDP growth declines and vice versa when GDP growth increases. These movements in aggregate demand play an important counter-cyclical attenuating role. So when GDP is declining due to falling aggregate demand, the automatic stabilisers work to add demand (falling taxes and rising welfare payments). When GDP growth is rising, the automatic stabilisers start to pull demand back as the economy adjusts (rising taxes and falling welfare payments).

We also measure the automatic stabiliser impact against some benchmark or “full capacity” or potential level of output, so that we can decompose the fiscal balance into that component which is due to specific discretionary fiscal policy choices made by the government and that which arises because the cycle takes the economy away from the potential level of output.

This decomposition provides (in modern terminology) the structural (discretionary) and cyclical fiscal balances. The fiscal components are adjusted to what they would be at the potential or full capacity level of output.

So if the economy is operating below capacity then tax revenue would be below its potential level and welfare spending would be above. In other words, the fiscal balance would be smaller at potential output relative to its current value if the economy was operating below full capacity. The adjustments would work in reverse should the economy be operating above full capacity.

If the fiscal outcome is in deficit when computed at the “full employment” or potential output level, then we call this a structural deficit and it means that the overall impact of discretionary fiscal policy is expansionary irrespective of what the actual fiscal outcome is presently. If it is in surplus, then we have a structural surplus and it means that the overall impact of discretionary fiscal policy is contractionary irrespective of what the actual fiscal outcome is presently.

So you could have a downturn which drives the fiscal outcome into a deficit but the underlying structural position could be contractionary (that is, a surplus). And vice versa.

The difference between the actual fiscal outcome and the structural component is then considered to be the cyclical fiscal outcome and it arises because the economy is deviating from its potential.

In some of the blogs listed below I go into the measurement issues involved in this decomposition in more detail. However for this question it these issues are less important to discuss.

The point is that structural fiscal balance has to be sufficient to ensure there is full employment. The only sensible reason for accepting the authority of a national government and ceding currency control to such an entity is that it can work for all of us to advance public purpose.

In this context, one of the most important elements of public purpose that the state has to maximise is employment. Once the private sector has made its spending (and saving decisions) based on its expectations of the future, the government has to render those private decisions consistent with the objective of full employment.

Given the non-government sector will typically desire to net save (accumulate financial assets in the currency of issue) over the course of a business cycle this means that there will be, on average, a spending gap over the course of the same cycle that can only be filled by the national government. There is no escaping that.

So then the national government has a choice – maintain full employment by ensuring there is no spending gap which means that the necessary deficit is defined by this political goal. It will be whatever is required to close the spending gap. However, it is also possible that the political goals may be to maintain some slack in the economy (persistent unemployment and underemployment) which means that the government deficit will be somewhat smaller and perhaps even, for a time, a fiscal surplus will be possible.

But the second option would introduce fiscal drag (deflationary forces) into the economy which will ultimately cause firms to reduce production and income and drive the fiscal outcome towards increasing deficits.

Ultimately, the spending gap is closed by the automatic stabilisers because falling national income ensures that that the leakages (saving, taxation and imports) equal the injections (investment, government spending and exports) so that the sectoral balances hold (being accounting constructs). But at that point, the economy will support lower employment levels and rising unemployment. The fiscal outcome will also be in deficit – but in this situation, the deficits will be what I call “bad” deficits. Deficits driven by a declining economy and rising unemployment.

So fiscal sustainability requires that the government fills the spending gap with “good” deficits at levels of economic activity consistent with full employment – which I define as 2 per cent unemployment and zero underemployment.

Fiscal sustainability cannot be defined independently of full employment. Once the link between full employment and the conduct of fiscal policy is abandoned, we are effectively admitting that we do not want government to take responsibility of full employment (and the equity advantages that accompany that end).

So it will not always be the case that the dynamics of the automatic stabilisers will leave a structural deficit sufficient to finance the saving desire of the non-government sector at an output level consistent with full utilisation of resources.

The following blogs may be of further interest to you:

• A modern monetary theory lullaby
• Saturday Quiz – April 24, 2010 – answers and discussion
• The dreaded NAIRU is still about!
• Structural deficits – the great con job!
• Structural deficits and automatic stabilisers
• Another economics department to close

Question 3:

The government has to issue debt if the central bank is targetting a non-zero policy rate and is reluctant to pay a competitive return on excess bank reserves.

The answer is True.

I am using the term government here in the Modern Monetary Theory (MMT) sense of the consolidation of the central bank and treasury operations.

Central banks conducts what are called liquidity management operations for two reasons. First, they have 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, they must maintain aggregate bank reserves at a level that is consistent with their 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.

The following blogs may be of further interest to you:

• Saturday Quiz – May 1, 2010 – answers and discussion
• Understanding central bank operations
• 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

That is enough for today!

(c) Copyright 2017 William Mitchell. All Rights Reserved.