The Weekend Quiz – May 11-12, 2019 – 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:

In a fixed coupon government bond auction, the higher is the demand for the bonds:

(a) the higher the yields will be at that asset maturity which suggests that higher fiscal deficits will eventually drive short-term interest rates down.

(b) the lower the yields will be at that asset maturity which suggests that higher fiscal deficits will eventually drive short-term interest rates down.

(c) the lower the yields will be at that asset maturity but this tells us nothing about the effect of fiscal deficits on short-term interest rates.

The answer is Option (c) the lower the yields will be at that asset maturity but this tells us nothing about the effect of fiscal deficits on short-term interest rates.

Option (b) might have attracted your attention given that it correctly associates higher demand for bonds will lower yields. You then may have been led by your understanding of the fundamental principles of Modern Monetary Theory (MMT) that include the fact that government spending provides the net financial assets (bank reserves) and fiscal deficits put downward pressure on interest rates (with no accompanying central bank operations), which is contrary to the myths that appear in macroeconomic textbooks about “crowding out”.

But of-course, the central bank sets the short-term interest rate based on its policy aspirations and conducts the necessary liquidity management operations to ensure the actual short-term market interest rate is consistent with the desired policy rate. That doesn’t mean the central bank has a free rein.

It has to either offer a return on reserves equivalent to the policy rate or sell government bonds if it is to maintain a positive target rate. 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.

This situation arises because the central bank essentially lacks control over the quantity of reserves in the system.

So the correct answer is that movements in public bond yields at the primary issue stage, tell us nothing about the intentions of central bank with respect to monetary policy (interest rate setting).

Given that the correct answer includes lower yields the logic developed will tell you why the option “the higher the yields will be at that asset maturity which suggests that higher fiscal deficits will eventually drive short-term interest rates down” was incorrect.

Why are yields inverse to price in a primary issue? The standard bond has three parameters: (a) the face value – say $A1000; (b) the coupon rate – say 5 per cent; and (c) some maturity – say 10 years. Taken together, this public debt instrument will provide the bond holder with $50 dollar per annum in interest income for 10 years whereupon they will get the $1000 face value returned.

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.

Most primary market issuance is 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 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.

Alternatively if the market wanted security and considered the coupon rate on offer was more than competitive then the bonds will be very attractive. Under the auction system they will bid higher than the face value up to the yields that they think are market-based. The yield reflects the last auction bid in the bond issue

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.

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 2:

When the government borrows from the non-government sector it eventually has to pay the bonds back on maturity. This will:

(a) be inflationary if by the time the bonds mature the economy is growing strongly so there will be too much money floating about.

(b) be inflationary if the government payments to bond holders at maturity add more to nominal aggregate demand than the real economy can support given other policy settings.

(c) not be inflationary because the sovereign government just has to credit the bank accounts of those who hold the bonds to repay them.

The answer is Option (b) – be inflationary if the government payments to bond holders at maturity add more to nominal aggregate demand than the real economy can support given other policy settings

Option (c) describes the operational reality that accompanies the repayment of the bonds and all interest payments. So in the first place, the flow of funds ends up in bank reserves.

So as it stands that option is a correct answer. But is it the best answer?

Option (a) makes no real sense and is a typical mainstream response. What does “too much money” mean? Nothing as it stands.

The best answer is defined by the crucial assumption that is provides you with. That the funds that accompany the maturing bonds (whether they be the return of the face value or the final interest payment) are spent – that is flow into aggregate demand rather than stay suspended in bank reserves.

An increase in bank reserves is not inflationary. Outstanding public bonds do form part of the accumulated wealth of the non-government sector. At any time, they choose, non-government agents can convert the stock of wealth into a flow of spending. So the “inflation risk” inherent in the stock of financial assets is independent of maturity of the outstanding bonds.

The spending capacity of private sector is not affected by maturing bonds because bonds by definition represent savings of private sector which can be spent at any moment of time regardless of time to maturity (especially with central bank always standing ready to repo these bonds for reserves).

But that doesn’t negate the validity of the answer in the way I have constructed it. If non-government agents decide to run down some of their financial wealth and start spending then the inflation risk can be realised. I would stress that we should not always focus on that inflation risk as the inevitable outcome. Inflation can result when aggregate demand rises but usually will not.

In this context, it is essential to understand that the analysis of inflation is related to the state of aggregate demand relative to productive capacity. Increased spending, in itself, is not inflationary. Nominal spending growth will stimulate real responses from firms – increased output and employment – if they have available productive capacity. Firms will be reluctant to respond to increased demand for their goods and services by increasing prices because it is expensive to do so (catalogues have to be revised etc) and they want to retain market share and fear that their competitors would not follow suit.

So generalised inflation (as opposed to price bubbles in specific asset classes) is unlikely to become an issue while there is available productive capacity. Even at times of high demand, firms typically have some spare capacity so that they can meet demand spikes. It is only when the economy has been running at high pressure for a substantial period of time that inflationary pressures become evident and government policy to restrain demand are required (including government spending cutbacks, tax rises etc).

Further, spending growth can push the expansion of productive capacity ahead of the nominal demand growth. Investment by firms in productive capacity is an example as is government spending on productive infrastructure (including human capital development). So not all spending closes the gap between nominal spending growth and available productive capacity.

But, ultimately, if nominal demand outstrips the real capacity of the economy to respond to the spending growth then inflation is the result.

The following blog posts may be of further interest to you:

• Building bank reserves is not inflationary
• Will we really pay higher interest rates?
• Hyperdeflation, followed by rampant inflation

Question 3:

When an external deficit and public deficit coincide, there must be a private sector deficit, which means that governments can only really run fiscal deficits safely to support a private sector surplus, when net exports are strong.

The answer is False.

This question relies on your understanding of the sectoral balances that are derived from the national accounts and must hold by definition. The statement of sectoral balances doesn’t tell us anything about how the economy might get into the situation depicted. Whatever behavioural forces were at play, the sectoral balances all have to sum to zero. Once you understand that, then deduction leads to the correct answer.

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) + CAB

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

Conversely, government surpluses (G – T < 0) and current account deficits (CAB < 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) – CAB] = (G – T)

where the term on the left-hand side [(S – I) – CAB] 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.

To help us answer the specific question posed, we can identify three states all involving public and external deficits:

• Case A: Fiscal Deficit (G – T) < Current Account balance (X - M) deficit.
• Case B: Fiscal Deficit (G – T) = Current Account balance (X – M) deficit.
• Case C: Fiscal Deficit (G – T) > Current Account balance (X – M) deficit.

The following Table shows these three cases expressing the balances as percentages of GDP. You can see that it is only in Case A when the external deficit exceeds the public deficit that the private domestic sector is in deficit.

So the answer is false because the coexistence of a fiscal deficit (adding to aggregate demand) and an external deficit (draining aggregate demand) does have to lead to the private domestic sector being in deficit.

With the external balance set at a 2 per cent of GDP, as the fiscal balance moves into larger deficit, the private domestic balance approaches balance (Case B). Then once the fiscal deficit is large enough (3 per cent of GDP) to offset the demand-draining external deficit (2 per cent of GDP) the private domestic sector can save overall (Case C).

The fiscal deficits are underpinning spending and allowing income growth to be sufficient to generate savings greater than investment in the private domestic sector but have to be able to offset the demand-draining impacts of the external deficits to provide sufficient income growth for the private domestic sector to save.

The following blog posts may be of further interest to you:

• Stock-flow consistent macro models
• Norway and sectoral balances
• The OECD is at it again!
• Saturday Quiz – May 22, 2010 – answers and discussion

That is enough for today!

(c) Copyright 2019 William Mitchell. All Rights Reserved.