The Weekend Quiz – August 25-26, 2018

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1. Two out of three! Got no 1 wrong! But got no 3! Talk about a stab in the dark!

2. Does question 1 refer to the specific circumstances of the present (the United States domestic private sector spends more on the rest of the world’s output than the rest of the world spends on the US domestic private sector’s output)? Or is the question a general hypothetical that assumes no knowledge of what the external sector is doing?

3. I suppose for question 3 we are to assume the economists’ estimation is correct on the multiplier effect? Which is kind of a rare thing for this blog for us to assume that. Anyways, I have to admit that even with that assumption, I can’t figure out how you know how much will be saved. I await the answers that will be coming tomorrow.

   And for question 2, I am fairly sure I could devise an increased deficit that does not impact the local productive resources available to the private domestic sector. It might not be very realistic- but what if the government spent the entire deficit increase on imported goods and the exporting country decided to save the receipts rather than spend it back into the importing country’s economy? How would that reduce the resources available to the private domestic sector?

   Obviously, I flunked this quiz… But thanks for the quiz as always. Hoping to learn from the answers.

4. Oh dear.

   1/3.

   Doom. I fear some time spent with the maths is my Sunday morning tomorrow.

5. Dear Bill, question 3 is just bothering me intensely. How can an economist come up with an estimate of the fiscal multiplier effect if they don’t have an estimate of the propensity to consume of the targets of that fiscal policy? I guess I will find out soon enough and join ‘cs’ spending time with the maths.

   In my futile attempts to answer this question, I noticed that your chart from answers and discussion April 21-22 question 3 is wrong. The savings column does not add up to 64. Well, at this point I better just say that I think it is wrong.

6. I don’t know how to answer Question 3 without knowing the private sector’s Marginal Propensity to Consume (the percentage of each extra dollar of disposable income that is used for consumption). Isn’t saving considered a residual for accounting purposes? How can you calculate the saving percentage without knowing the MPC?

7. Question 3 is also causing me so bother. There must be a “red herring” somewhere but I can`t find it.
   If the multiplier is 1.6, the MPM is .2, the tax rate is .2 , then The MPC must be .7…(or so I calculate)
   The Tax multiplier ( supposedly 1 is probably the red herring) given a .7 MPC, I calculate that multiplier at -1.1…..I have no idea what to do with that.

   So far with only the first 100b increase I have a GDP increase over ten periods of 156.2b and a total saving of 37.5 or .38 cents per dollar….. Trying to get the other two years in gets me nowhere close to the correct answer. Surely it can`t be as simple as 300 * 1.6 = 480 ?

8. I surmise that for Question 3 we need to understand that demand generates output, and output generates income.

   There are three demand injections into the output-income cycle:
   1. government spending
   2. private sector investment (the private sector allocating previously accumulated savings to output-producing activities)
   3. exports

   There are three demand leakages from the output-income cycle:
   1. government taxation
   2. private sector saving
   3. imports

   The combination of injections and leakages has an induced spending effect over a given period.

   When you calculate the induced spending effect for the next period, you need to realize that if the injections are the same as the previous period, the induced spending effect in the second period will be less because of the effect of the leakages during the first period.

   Therefore in order to maintain the same induced spending effect year after year, the government would need to increase its spending each year. If it maintains the same amount of spending each period (like the scenario in Question 3), the induced spending effect diminishes over time. Eventually the leakages would completely offset the injections, causing the induced spending effect to wear off completely.

   But I don’t see how to solve Question 3 without knowing the private sector’s Marginal Propensity to Consume.

9. Question 2 is what Gollum would describe as “tricksy”. Whether the increasing government deficit is reducing the amount of real resources available to the domestic private sector depends on whether the deficit increase is discretionary or the result of automatic stabilizers.

   If output is falling, income is falling, demand is falling, and the federal government deliberately adds some spending that is targeted at mobilizing unused real resources into socially valuable use, then yes, the increasing deficit involves reducing the amount of real resources available for the private sector’s use.

   But if the deficit is rising merely because tax receipts are falling and welfare spending is rising, and there are still ample unused real resources available but the private sector won’t spend on them because their income is falling or stagnating and they want to hang on to their savings for a rainier day, then the rising deficit isn’t depriving the private sector of real resources. The real resources are there but the private sector lacks the confidence to spend them into socially valuable use. The private sector might have some savings that it could spend down now, but it is choosing not to do that because it wants that money to be available for the future.

10. Question 2 appears obviously to be asking about the immediate effects of an increasing deficit.

    In the long term, if the federal government makes active use of discretionary fiscal policy to maintain full employment and make other productivity-enhancing investments, then the rising government deficit (more accurately termed a rising private sector surplus) will eventually add to the real resources available to the private sector.

    Full employment adds productive capacity because employed workers develop knowledge, skills, confidence, social networks, and enjoy better health than the involuntarily unemployed.

    Discretionary fiscal policy that invests heavily in education, training, scientific discovery, technological advancement, socially valuable infrastructure, and services that promote public health and wellbeing will also have productivity-enhancing effects.

11. And for question 2, I am fairly sure I could devise an increased deficit that does not impact the local productive resources available to the private domestic sector. It might not be very realistic- but what if the government spent the entire deficit increase on imported goods and the exporting country decided to save the receipts rather than spend it back into the importing country’s economy? How would that reduce the resources available to the private domestic sector?

    Hi Jerry, interesting scenario. My hunch (yet to be confirmed by an expert) is that for accounting purposes a federal government fiscal deficit by definition refers to the federal government’s financial balance with respect to the domestic private sector only. The federal government’s fiscal balance is the nominal value of tax receipts from the domestic private sector minus the nominal value of government spending into the domestic private sector.

    If the federal government spends on imports, wouldn’t that be counted in the current account balance rather than the fiscal balance?

    I’m not sure.

12. I did question 3 by solving for the marginal propensity to consume (MPC) given the other parameters supplied. The equation is: MPC = [M(1 + MPI) – 1] / [M(1 – T)] where M = multiplier (1.6), MPI = marginal propensity to import (0.2), and T = tax rate (0.2).
    That returns MPC = 0.72. So there is $0.28 saved out of every extra disposable dollar.

    Nominal GDP is $100 billion * multiplier (1.6) * number of years (3) = $480 billion

13. Yes Allan, thank you. I figured there was a way to derive a MPC from the suppositions supplied, but my algebra is very rusty and it is really, really not the way any economist should figure this out. Start with the estimate of the multiplier and then derive the MPC from that? I would think you need to estimate the MPC first in order to estimate the multiplier.

14. Thanks for providing the MPC formula, Allan!

    Why is the full government spending injection plus the spending multiplier added to nominal GDP?

    Why aren’t the leakage to savings and the leakage to tax subtracted from that amount?

15. Hi Nicholas. I’m pretty sure a fiscal deficit occurs whenever the government spends more than it taxes for any given period. Would not matter where the government spent that money. But in my scenario, the spending would also count (as a negative) towards the current account balance. I don’t believe they are mutually exclusive- they count in both.

16. Jerry, The question provides two possible MPC values: 0.72 and 0.76, so you could try solving the multiplier M with each of those and see if it matches the given multiplier of 1.6.

17. “what if the government spent the entire deficit increase on imported goods”

    or on intangible goods? Kind of sounds like the Troubled Assets Relief Program.