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…
Many people have written to me asking me to post answers to the Saturday Quiz. I am sympathetic to these requests but on the other hand the Quiz (which takes a few minutes to compile) is my “day off” the blog and so building in extra work would sort of defeat the purpose. But as it happens I was about to announce that from soon I was going to stop posting a regular Sunday blog. I play in a band which takes time and in a few weeks will have regular new commitments on Sunday evenings. If there is something happening that warrants comment I will but in general I was going to extend my “day off” to the whole weekend. But then I thought – I can write the answers up with some discussion on Sundays and so the weekends can become The Quiz Weekend, which should satisfy both the requests for more quiz feedback and my desire to grab some extra free (well non-blog) time. So that is the plan from now on. 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.
Government spending which is accompanied by a bond sale to the private sector adds less to aggregate demand than would be the case if there was no bond sale.
The answer is false.
The mainstream macroeconomic textbooks all have a chapter on fiscal policy (and it is often written in the context of the so-called IS-LM model but not always).
The chapters always introduces the so-called Government Budget Constraint that alleges that governments have to “finance” all spending either through taxation; debt-issuance; or money creation. The writer fails to understand that government spending is performed in the same way irrespective of the accompanying monetary operations.
Anyway, they claim that money creation (borrowing from central bank) is inflationary while the latter (private bond sales) is less so. These conclusions are based on their erroneous claim that “money creation” adds more to aggregate demand than bond sales, because the latter forces up interest rates which crowd out some private spending.
All these claims are without foundation in a fiat monetary system and an understanding of the banking operations that occur when governments spend and issue debt helps to show why.
So what would happen if a sovereign, currency-issuing government (with a flexible exchange rate) ran a budget deficit without issuing debt?
Like all government spending, the Treasury would credit the reserve accounts held by the commercial bank at the central bank. The commercial bank in question would be where the target of the spending had an account. So the commercial bank’s assets rise and its liabilities also increase because a deposit would be made.
The transactions are clear: The commercial bank’s assets rise and its liabilities also increase because a new deposit has been made.
Further, the target of the fiscal initiative enjoys increased assets (bank deposit) and net worth (a liability/equity entry on their balance sheet).
Taxation does the opposite and so a deficit (spending greater than taxation) means that reserves increase and private net worth increases.
This means that there are likely to be excess reserves in the “cash system” which then raises issues for the central bank about its liquidity management. The aim of the central bank is to “hit” a target interest rate and so it has to ensure that competitive forces in the interbank market do not compromise that target.
When there are excess reserves there is downward pressure on the overnight interest rate (as banks scurry to seek interest-earning opportunities), the central bank then has to sell government bonds to the banks to soak the excess up and maintain liquidity at a level consistent with the target.
Some central banks offer a return on overnight reserves which reduces the need to sell debt as a liquidity management operation.
There is no sense that these debt sales have anything to do with “financing” government net spending. The sales are a monetary operation aimed at interest-rate maintenance.
So M1 (deposits in the non-government sector) rise as a result of the deficit without a corresponding increase in liabilities. It is this result that leads to the conclusion that that deficits increase net financial assets in the non-government sector.
What would happen if there were bond sales? All that happens is that the banks reserves are reduced by the bond sales but this does not reduce the deposits created by the net spending. So net worth is not altered. What is changed is the composition of the asset portfolio held in the non-government sector.
The only difference between the Treasury “borrowing from the central bank” and issuing debt to the private sector is that the central bank has to use different operations to pursue its policy interest rate target. If it debt is not issued to match the deficit then it has to either pay interest on excess reserves (which most central banks are doing now anyway) or let the target rate fall to zero (the Japan solution).
There is no difference to the impact of the deficits on net worth in the non-government sector.
Mainstream economists would say that by draining the reserves, the central bank has reduced the ability of banks to lend which then, via the money multiplier, expands the money supply.
However, the reality is that:
- Building bank reserves does not increase the ability of the banks to lend.
- The money multiplier process so loved by the mainstream does not describe the way in which banks make loans.
- Inflation is caused by aggregate demand growing faster than real output capacity. The reserve position of the banks is not functionally related with that process.
So the banks are able to create as much credit as they can find credit-worthy customers to hold irrespective of the operations that accompany government net spending.
This doesn’t lead to the conclusion that deficits do not carry an inflation risk. All components of aggregate demand carry an inflation risk if they become excessive, which can only be defined in terms of the relation between spending and productive capacity.
It is totally fallacious to think that private placement of debt reduces the inflation risk. It does not.
You may wish to read the following blogs for more information:
- Why history matters
- Building bank reserves will not expand credit
- Building bank reserves is not inflationary
- The complacent students sit and listen to some of that
If the external balance is always in surplus, then the government can safely run a surplus and not impede economic growth. However, this option is only available to a few nations because not all nations can run external surpluses.
The answer is false.
I noted several questions in the comments section about this particular problem. The secret to understanding the answer is two-fold.
First, you need to understand the basic relationship between the sectoral flows and the balances that are derived from them. The flows are derived from the National Accounting relationship between aggregate spending and income. So:
(1) Y = C + I + G + (X – M)
where Y is GDP (income), C is consumption spending, I is investment spending, G is government spending, X is exports and M is imports (so X – M = net exports).
Another perspective on the national income accounting is to note that households can use total income (Y) for the following uses:
(2) Y = C + S + T
where S is total saving and T is total taxation (the other variables are as previously defined).
You than then bring the two perspectives together (because they are both just “views” of Y) to write:
(3) C + S + T = Y = C + I + G + (X – M)
You can then drop the C (common on both sides) and you get:
(4) S + T = I + G + (X – M)
Then you can convert this into the familiar sectoral balances accounting relations which allow us to understand the influence of fiscal policy over private sector indebtedness.
So we can re-arrange Equation (4) to get the accounting identity for the three sectoral balances – private domestic, government budget and external:
(S – I) = (G – T) + (X – M)
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)), where net exports represent the net savings of non-residents.
Another way of saying this is that total private savings (S) is equal to private investment (I) plus the public deficit (spending, G minus taxes, T) plus net exports (exports (X) minus imports (M)), where net exports represent the net savings of non-residents.
All these relationships (equations) hold as a matter of accounting and not matters of opinion.
Thus, when an external deficit (X – M < 0) and public surplus (G - T < 0) coincide, there must be a private deficit. While private spending can persist for a time under these conditions using the net savings of the external sector, the private sector becomes increasingly indebted in the process. Second, you then have to appreciate the relative sizes of these balances to answer the question correctly. Consider the following Table which depicts three cases - two that define a state of macroeconomic equilibrium (where aggregate demand equals income and firms have no incentive to change output) and one (Case 2) where the economy is in a disequilibrium state and income changes would occur. Note that in the equilibrium cases, the (S - I) = (G - T) + (X - M) whereas in the disequilibrium case (S - I) > (G – T) + (X – M) meaning that aggregate demand is falling and a spending gap is opening up. Firms respond to that gap by decreasing output and income and this brings about an adjustment in the balances until they are back in equality.
So in Case 1, assume that the private domestic sector desires to save 2 per cent of GDP overall (spend less than they earn) and the external sector is running a surplus equal to 4 per cent of GDP.
In that case, aggregate demand will be unchanged if the government runs a surplus of 2 per cent of GDP (noting a negative sign on the government balance means T > G).
In this situation, the surplus does not undermine economic growth because the injections into the spending stream (NX) are exactly offset by the leakages in the form of the private saving and the budget surplus. This is the Norwegian situation.
In Case 2, we hypothesise that the private domestic sector now wants to save 6 per cent of GDP and they translate this intention into action by cutting back consumption (and perhaps investment) spending.
Clearly, aggregate demand now falls by 4 per cent of GDP and if the government tried to maintain that surplus of 2 per cent of GDP, the spending gap would start driving GDP downwards.
The falling income would not only reduce the capacity of the private sector to save but would also push the budget balance towards deficit via the automatic stabilisers. It would also push the external surplus up as imports fell. Eventually the income adjustments would restore the balances but with lower GDP overall.
So Case 2 is a not a position of rest – or steady growth. It is one where the government sector (for a given net exports position) is undermining the changing intentions of the private sector to increase their overall saving.
In Case 3, you see the result of the government sector accommodating that rising desire to save by the private sector by running a deficit of 2 per cent of GDP.
So the injections into the spending stream are 4 per cent from NX and 2 per cent from the deficit which exactly offset the desire of the private sector to save 6 per cent of GDP. At that point, the system would be in rest.
This is a highly stylised example and you could tell a myriad of stories that would be different in description but none that could alter the basic point.
If the drain on spending outweighs the injections into the spending stream then GDP falls (or growth is reduced).
So even though an external surplus is being run, the desired budget balance still depends on the saving desires of the private domestic sector. Under some situations, these desires could require a deficit even with an external surplus.
You may wish to read the following blogs for more information:
In the same way the spending multiplier indicates the extent to which GDP rises when there is a given rise in government spending, the tax multiplier captures the impact of rising tax rates on GDP as people reduce their labour supply because of the disincentives associated with taxation.
The answer is false.
Mainstream economics analysis does posit that rising marginal tax rates distort the labour supply choice – by increasing the hourly cost of work and providing greater incenctives for workers to choose more leisure. This allegation forms the basis of their case for substantial tax cuts and proportional tax systems; and, as a consequence, reduced budget deficits.
As an aside there is no empirical evidence to support this claim. Most of the credible studies find very little evidence of a negative tax elasticity within normal ranges that these variables shift. The most significant tax effect is found at the intersection of the welfare system and the wage system where workers who work an extra hour while on benefits often face 100 per cent marginal taxes (loss of benefit equal to earnings). But that is another story again.
However, in terms of this question, the trick was in understanding what the tax multiplier is trying to conceptualise.
First, it is a macroeconomic rather than a microeconomic concept. Households are assumed to pay some tax out of gross income and the tax rate (keeping it simple) specifies that proportion. In reality, there are a myriad of tax rates but the total effect can be summarised by a single (weighted-average!) tax rate.
Households consume out of disposable income. Assume the overall propensity to consume is 0.80 – which means that overall consumers will spend 80 cents for every extra dollar of disposable income received.
So, if the tax rate rises, then disposable income falls. If nothing else changes, then this fall in disposable income will lead to a reduction in consumption (equal to the propensity to consume times the fall in disposable income). The resulting fall in GDP is defined as the tax multiplier.
Similarly, when tax rates falls and increase disposable income, the reverse occurs.
You should not confuse the hypothesised tax multiplier effect with the increase in tax revenue that occurs as a result of the automatic stabilisers. This effect occurs with no discretionary change in the tax regime. It is a common mistake to assume that because tax revenue is rising that tax policy is becoming contractionary.
Further, at the individual level, as GDP growth recovers most people will not be paying higher taxes at all while others will be paying a substantial increase – why? Because they move from unemployment (zero taxes paid) to earning an income (some taxes paid).
You may wish to read the following blog for more information:
- Pushing the fantasy barrow
- Will we really pay higher taxes?
- Structural deficits and automatic stabilisers
Assume the government increases spending by $100 billion in the each of the next three years from now. Economists estimate the spending multiplier to be 1.5 and the impact is immediate and exhausted in each year. They also estimate the tax multiplier to be equal to 1 and the current tax rate is equal to 30 per cent (30 cents in the $). What is the cumulative impact of this fiscal expansion on GDP after three years?
(a) $135 billion
(b) $150 billion
(c) $315 billion
(d) $450 billion
The answer was $450 billion. In Year 1, government spending rises by $100 billion, which leads to a total increase in GDP of $150 billion via the spending multiplier. The multiplier process is explained in the following way. Government spending, say, on some equipment or construction, leads to firms in those areas responding by increasing real output. In doing so they pay out extra wages and other payments which then provide the workers (consumers) with extra disposable income (once taxes are paid).
Higher consumption is thus induced by the initial injection of government spending. Some of the higher income is saved and some is lost to the local economy via import spending. So when the workers spend their higher wages (which for some might be the difference between no wage as an unemployed person and a positive wage), broadly throughout the economy, this stimulates further induced spending and so on, with each successive round of spending being smaller than the last because of the leakages to taxation, saving and imports.
Eventually, the process exhausts and the total rise in GDP is the “multiplied” effect of the initial government injection. In this question we adopt the simplifying (and unrealistic) assumption that all induced effects are exhausted within the same year. In reality, multiplier effects of a given injection usually are estimated to go beyond 4 quarters.
So this process goes on for 3 years so the $300 billion cumulative injection leads to a cumulative increase in GDP of $450 billion.
It is true that total tax revenue rises by $135 billion but this is just an automatic stabiliser effect. There was no change in the tax structure (that is, tax rates) posited in the question.
That means that the tax multiplier, whatever value it might have been, is irrelevant to this example.
Some might have decided to subtract the $135 billion from the $450 billion to get answer (c) on the presumption that there was a tax effect. But the automatic stabiliser effect of the tax system is already built into the expenditure multiplier.
Some might have just computed $135 billion and said (a). Clearly, not correct.
Some might have thought it was a total injection of $100 billion and multiplied that by 1.5 to get answer (b). Clearly, not correct.
You may wish to read the following blogs for more information:
In a stock-flow consistent macroeconomics, we have to always trace the impact of flows during a period on the relevant stocks at the end of the period. Accordingly, government and private investment spending are two examples of flows that adds to the stock of aggregate demand which in turn impacts on GDP.
The answer is false.
This is a very easy test of the difference between flows and stocks. All expenditure aggregates – such as government spending and investment spending are flows. They add up to total expenditure or aggregate demand which is also a flow rather than a stock. Aggregate demand (a flow) in any period) determines the flow of income and output in the same period (that is, GDP).
So while flows can add to stock – for example, the flow of saving adds to wealth or the flow of investment adds to the stock of capital – flows can also be added together to form a “larger” flow.