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…
Here are the answers with discussion for yesterday’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.
While the US government is sovereign in its own currency, increased nominal expenditure on health care will still reduce the real resources available for other uses and so political choices have to be made.
The answer is False.
The question was designed to ensure you are careful in articulating each of the concepts mentioned accurately and not drawing quick but false associations.
The first part of the question lures you into thinking about a series of other propositions that follow for such a government. So we know that the following summary features describe a government that is sovereign in its own currency:
- A national government which issues its own currency is not revenue-constrained in its own spending, irrespective of the voluntary (political) arrangements it puts in place which may constrain it in spending in any number of ways.
- The only constraints facing such a government other than the political pressures it has to manage are real – there must be real resources available for sale for government spending to purchase.
- A sovereign government can buy whatever is for sale at any time but should only net spend up to the desire by the non-government sector to save otherwise nominal spending will outstrip the real capacity of the economy to respond in quantity terms and inflation will result.
- A deficiency of spending overall relative to full capacity output will cause output to contract and employment to fall.
- Government net spending funds the private desire to save while at the same ensuring output levels are higher than otherwise.
- A government deficit (surplus) will be exactly equal ($-for-$) to a non-government surplus (deficit).
- Public debt issuance of a sovereign government is about interest-rate maintenance and has nothing to do with “funding” net government spending.
The “knee-jerk” answer would be true if after a careless reading you reasoned that when governments spend they use up real resources in the economy.
But the questioned asked you to relate nominal expenditure to availability of real resources. All spending is nominal but whether it has a real effect depends on state of overall demand in the economy and also on price movements in particular areas of the economy.
You could imagine that with the health care providers holding market power which translates into price setting power that increased demand for health care resources could be met by price adjustments and draw in no further real resources into the sector.
In 2001, Japan defied the ratings agencies who had downgraded their sovereign debt. They refused to alter their fiscal commitments despite constant pressure to cut the deficit. Given that countries such as Greece and Portugal are unlikely to be expelled from the EMU if they continue to exceed the Stability and Growth Pact conditions, they should similarly resist the demands of the ratings agencies for increased fiscal austerity and thus spread their fiscal adjustment over a longer period which would inflict less damage on their nations.
The answer is False.
This tests whether you really understand the dilemma that the Eurozone nations are facing. You cannot say very much about the constraints facing a Eurozone nation from what Japan did. Relating to the dot points describing a sovereign nation (above in Question 1), Japan is fully sovereign.
The Bank of Japan sets the interest rate and can control the yield curve at longer maturities should it want to. The Japanese government also faces no default risk on its sovereign debt because it can never become insolvent in relation to obligations issued in its own currency.
In Japan’s case it also helps (a bit) that they have particular cultural proclivities and the domestic government bond market is seemingly inexhaustible. Further, the Japanese government is smart and does not issue public debt denominated in any foreign currency.
Even if the bond markets were not “loyal” (as some commentators put it) in Japan, ultimately the Japanese government can spend without off-settting bond sales anyway. That is the option available to all sovereign governments in a fiat monetary system.
So the sovereign rating agencies have no real traction in this case. They can downgrade and hector all they like but their interventions will be meaningless.
None of this applies to an EMU nation. While it is clear that the SGP conditions are binding on EMU nations (violation attracts a fine) the discipline is maintained via moral suasion in the main. Bullying! France and Germany in the past have had extended periods where they exceeded the deficit to GDP limits of 3 per cent.
And, clearly, in the current crisis, several nations are well over the limits.
But this could not go on for very long (as we are seeing in the Greek case). An EMU nation does not set interest rates in its country and cannot control the yield curve in any way. The ECB in Frankfurt has that function.
Further, while an EMU nation can run a deficit they have to “fund” it because they do not issue the currency of the zone. They have to fund it via tax revenue, bond issues and/or asset sales (privatisations). In a recession, with tax revenue falling and the automatic stabilisers driving the deficits higher, the call on bond markets increases for a government in this position.
The auction arrangements that underpin the debt issuance functions rely on the attitudes of the private markets to risk and return for there ongoing success.
Given that an EMU nation faces insolvency risk in all obligations denominated in Euros (it is like a foreign currency obligation to a sovereign currency nation), perceptions of risk play an significant role.
Insolvency could come about via a bank run – where the government could not bail out its banks. Or it might come from the governments being unable to finance on-going spending commitments because the bond markets will no longer buy their debt.
In this case, the assessments of the credit rating agencies matter. They can force the government to pay increasingly onerous interest burdens on newly-issued debt and ultimately influence markets to stop buying the debt.
Further, the national central banks in each EMU country are part of the EMU system with the ECB at the head. The EMU system is largely decentralised with the NCPs performing most of the day to day monetary functions – liquidity management etc. To a some level, the NCBs can buy the debt of their government and cash it in via the ECB.
But the ECB has rules relating to the quality of the assets it will accept as collateral through these arrangements. They use credit rating assessments to determine what is an acceptable asset. So again, the credit rating agencies can render the debt instruments offered by an EMU government worthless.
Defiance is not an option. The options in these cases are either to implement “credible” fiscal austerity packages to the detriment of the citizens of the nation (I use credible in the sense that the corrupt ratings agencies might use it); default on the debt (and then what?); or leave the EMU system altogether and reinstate the currency sovereignty of the nation (which might also require a default on Euro-denominated debt).
The following blogs may be of further interest to you:
- Euro zone’s self-imposed meltdown
- A Greek tragedy …
- España se está muriendo
- Exiting the Euro?
- Doomed from the start
- Europe – bailout or exit?
- Not the EMF … anything but the EMF!
Fiscal rules such as are embodied in the Stability and Growth Pact of the EMU will continually create conditions of slower growth because they deprive the government of fiscal flexibility to support aggregate demand when necessary.
The answer is False.
One word in the question renders this proposition false. I had originally worded the question (following EMU) “will bias the nations to slower growth” etc which is true and I considered that too easy.
The fiscal policy rules that were agreed in the Maastricht Treaty – budget deficits should not exceed 3 per cent of GDP and public debt should not exceed 60 per cent of GDP – clearly constrain EMU governments during periods when private spending (or net exports) are draining aggregate demand.
In those circumstances, if the private spending withdrawal is sufficiently severe, the automatic stabilisers alone will drive the budget deficit above the required limits. Pressure then is immediately placed on the national governments to introduce discretionary fiscal contractions to get the fiscal balance back within the limits.
Further, after an extended recession, the public debt ratios will almost always go beyond the allowable limits which places further pressure on the government to introduce an extended period of austerity to bring the ratio back within the limits. So the bias is towards slower growth overall.
It is also true that the fiscal rules clearly (and by design) “deprive the government of fiscal flexibility to support aggregate demand when necessary”. But that wasn’t the question. The question was will these rules continually create conditions of slower growth. The answer is no they will not.
Imagine a situation where the nation has very strong net exports adding to aggregate demand which supports steady growth and full employment without any need for the government to approach the Maastricht thresholds. In this case, the fiscal rules are never binding unless something happens to exports.
The following is an example of this sort of nation. It will take a while for you to work through but it provides a good learning environment for understanding the basic expenditure-income model upon with Modern Monetary Theory (MMT) builds its monetary insights. You might want to read this blog – Saturday Quiz – March 20, 2010 – answers and discussion – to refresh your understanding of the sectoral balances.
The following table shows the structure of the simple macroeconomic model that is the foundation of the expenditure-income model. This sort of model is still taught in introductory macroeconomics courses before the students get diverted into the more nonsensical mainstream ideas. All the assumptions with respect to behavioural parameters are very standard. You can download the simple spreadsheet if you want to play around with the model yourselves.
The first Table shows the model structure and any behavioural assumptions used. By way of explanation:
- All flows are in real terms with the price level constant (set at whatever you want it to be). So we are assuming that there is capacity within the supply-side of the economy to respond in real terms when nominal demand (which also equals real demand) changes.
- We might assume that the economy is at full employment in period 1 and in a state of excess capacity of varying degrees in each of the subsequent periods.
- Fiscal policy dominates monetary policy and the latter is assumed unchanged throughout. The central bank sets the interest rate and it doesn’t move.
- The tax rate is 0.15 throughout – so for every dollar of national income earned 15 cents is taken out in tax.
- The marginal propensity to consume is 0.8 – so for every dollar of disposable income 80 cents is consumed and 20 cents is saved.
- The marginal propensity to import is 0.2 – so for every dollar of national income (Y) 20 cents is lost from the expenditure stream into imports.
You might want to right-click the images to bring them up into a separate window and the print them (on recycled paper) to make it easier to follow the evolution of this economy over the 10 periods shown.
The next table quantifies the ten-period cycle and the graph below it presents the same information graphically for those who prefer pictures to numbers. The description of events is in between the table and the graph for those who do not want to print.
The graph below shows the sectoral balances – budget deficit (red line), external balance (blue line) and private domestic balance (green line) over the 10-period cycle as a percentage of GDP (Y) in addition to the period-by-period GDP growth (y) in percentage terms (grey bars).
Above the zero line means positive GDP growth, a budget deficit (G > T), an external surplus (X > M) and a private domestic deficit (I > S) and vice-versa for below the zero line.
This is an economy that is enjoying steady GDP growth (1.4 per cent) courtesy of a strong and growing export sector (surpluses in each of the first three periods). It is able to maintain strong growth via the export sector which permits a budget surplus (in each of the first three periods) and the private domestic sector is spending less than they are earning.
The budget parameters (and by implication the public debt ratio) is well within the Maastricht rules and not preventing strong (full employment growth) from occurring. You might say this is a downward bias but from in terms of an understanding of functional finance it just means that the government sector is achieving its goals (full employment) and presumably enough services and public infrastructure while being swamped with tax revenue as a result of the strong export sector.
Then in Period 4, there is a global recession and export markets deteriorate up and governments delay any fiscal stimulus. GDP growth plunges and the private domestic balance moves towards deficit. Total tax revenue falls and the budget deficit moves into balance all due to the automatic stabilisers. There has been no discretionary change in fiscal policy.
In Period 5, we see investment expectations turn sour as a reaction to the declining consumption from Period 4 and the lost export markets. Exports continue to decline and the external balance moves towards deficit (with some offset from the declining imports as a result of lost national income). Together GDP growth falls further and we have a technical recession (two consecutive periods of negative GDP growth).
With unemployment now rising (by implication) the government reacts by increasing government spending and the budget moves into deficit but still within the Maastricht rules. Taxation revenue continues to fall. So the increase in the deficit is partly due to the automatic stabilisers and partly because discretionary fiscal policy is now expanding.
Period 6, exports and investment spending decline further and the government now senses a crisis is on their hands and they accelerate government spending. This starts to reduce the negative GDP growth but pushes the deficit beyond the Maastricht limits of 3 per cent of GDP. Note the rising deficits allows for an improvement in the private domestic balance, although that is also due to the falling investment.
In Period 7, even though exports continue to decline (and the external balance moves into deficit), investors feel more confident given the economy is being supported by growth in the deficit which has arrested the recession. We see a return to positive GDP growth in this period and by implication rising employment, falling unemployment and better times. But the deficit is now well beyond the Maastricht rules and rising even further.
In Period 8, exports decline further but the domestic recovery is well under way supported by the stimulus package and improving investment. We now have an external deficit, rising budget deficit (4.4 per cent of GDP) and rising investment and consumption.
At this point the EMU bosses take over and tell the country that it has to implement an austerity package to get their fiscal parameters back inside the Maastricht rules. So in Period 9, even though investment continues to grow (on past expectations of continued growth in GDP) and the export rout is now stabilised, we see negative GDP growth as government spending is savaged to fit the austerity package agree with the EMU bosses. Net exports moves towards surplus because of the plunge in imports.
Finally, in period 10 the EMU bosses are happy in their warm cosy offices in Brussels or Frankfurt or wherever they have their secure, well-paid jobs because the budget deficit is now back inside the Maastricht rules (2.9 per cent of GDP). Pity about the economy – it is back in a technical recession (a double-dip). Investment spending has now declined again courtesy of last period’s stimulus withdrawal, consumption is falling, government support of saving is in decline, and we would see employment growth falling and unemployment rising.
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!
It is clear that EMU nations cannot use the exchange rate mechanism to adjust for trading imbalances arising from a lack of competitiveness within the Eurozone. With fiscal and monetary policy tied by the EMU arrangements, the only adjustment mechanism left is to reduce wages and prices to restore competitiveness. While harsh this will ultimately improve the competitive position of Greece, Portugal, Ireland and other nations currently in external deficit.
The answer is False.
The temptation is to accept the rhetoric after understanding the constraints that the EMU places on member countries and conclude that the only way that competitiveness can be restored is to cut wages and prices. That is what the dominant theme emerging from the public debate is telling us.
However, deflating an economy under these circumstance is only part of the story and does not guarantee that a nations competitiveness will be increased.
We have to differentiate several concepts: (a) the nominal exchange rate; (b) domestic price levels; (c) unit labour costs; and (d) the real or effective exchange rate.
It is the last of these concepts that determines the “competitiveness” of a nation. This Bank of Japan explanation of the real effective exchange rate is informative. Their English-language services are becoming better by the year.
Nominal exchange rate (e)
The nominal exchange rate (e) is the number of units of one currency that can be purchased with one unit of another currency. There are two ways in which we can quote a bi-lateral exchange rate. Consider the relationship between the $A and the $US.
- The amount of Australian currency that is necessary to purchase one unit of the US currency ($US1) can be expressed. In this case, the $US is the (one unit) reference currency and the other currency is expressed in terms of how much of it is required to buy one unit of the reference currency. So $A1.60 = $US1 means that it takes $1.60 Australian to buy one $US.
- Alternatively, e can be defined as the amount of US dollars that one unit of Australian currency will buy ($A1). In this case, the $A is the reference currency. So, in the example above, this is written as $US0.625= $A1. Thus if it takes $1.60 Australian to buy one $US, then 62.5 cents US buys one $A. (i) is just the inverse of (ii), and vice-versa.
So to understand exchange rate quotations you must know which is the reference currency. In the remaining I use the first convention so e is the amount of $A which is required to buy one unit of the foreign currency.
Are Australian goods and services becoming more or less competitive with respect to goods and services produced overseas? To answer the question we need to know about:
- movements in the exchange rate, ee; and
- relative inflation rates (domestic and foreign).
Clearly within the EMU, the nominal exchange rate is fixed between nations so the changes in competitiveness all come down to the second source and here foreign means other nations within the EMU as well as nations beyond the EMU.
There are also non-price dimensions to competitiveness, including quality and reliability of supply, which are assumed to be constant.
We can define the ratio of domestic prices (P) to the rest of the world (Pw) as Pw/P.
For a nation running a flexible exchange rate, and domestic prices of goods, say in the USA and Australia remaining unchanged, a depreciation in Australia’s exchange means that our goods have become relatively cheaper than US goods. So our imports should fall and exports rise. An exchange rate appreciation has the opposite effect.
But this option is not available to an EMU nation so the only way goods in say Greece can become cheaper relative to goods in say, Germany is for the relative price ratio (Pw/P) to change:
- If Pw is rising faster than P, then Greek goods are becoming relatively cheaper within the EMU; and
- If Pw is rising slower than P, then Greek goods are becoming relatively more expensive within the EMU.
The inverse of the relative price ratio, namely (P/Pw) measures the ratio of export prices to import prices and is known as the terms of trade.
The real exchange rate
Movements in the nominal exchange rate and the relative price level (Pw/P) need to be combined to tell us about movements in relative competitiveness. The real exchange rate captures the overall impact of these variables and is used to measure our competitiveness in international trade.
The real exchange rate (R) is defined as:
R = (e.Pw/P) (2)
where P is the domestic price level specified in $A, and Pw is the foreign price level specified in foreign currency units, say $US.
The real exchange rate is the ratio of prices of goods abroad measured in $A (ePw) to the $A prices of goods at home (P). So the real exchange rate, R adjusts the nominal exchange rate, e for the relative price levels.
For example, assume P = $A10 and Pw = $US8, and e = 1.60. In this case R = (8×1.6)/10 = 1.28. The $US8 translates into $A12.80 and the US produced goods are more expensive than those in Australia by a ratio of 1.28, ie 28%.
A rise in the real exchange rate can occur if:
- the nominal e depreciates; and/or
- Pw rises more than P, other things equal.
A rise in the real exchange rate should increase our exports and reduce our imports.
A fall in the real exchange rate can occur if:
- the nominal e appreciates; and/or
- Pw rises less than P, other things equal.
A fall in the real exchange rate should reduce our exports and increase our imports.
In the case of the EMU nation we have to consider what factors will drive Pw/P up and increase the competitive of a particular nation.
If prices are set on unit labour costs, then the way to decrease the price level relative to the rest of the world is to reduce unit labour costs faster than everywhere else.
Unit labour costs are defined as cost per unit of output and are thus ratios of wage (and other costs) to output. If labour costs are dominant (we can ignore other costs for the moment) so total labour costs are the wage rate times total employment = w.L. Real output is Y.
So unit labour costs (ULC) = w.L/Y.
L/Y is the inverse of labour productivity(LP) so ULCs can be expressed as the w/(Y/L) = w/LP.
So if the rate of growth in wages is faster than labour productivity growth then ULCs rise and vice-versa. So one way of cutting ULCs is to cut wage levels which is what the austerity programs in the EMU nations (Ireland, Greece, Portugal etc) are attempting to do.
But LP is not constant. If morale falls, sabotage rises, absenteeism rises and overall investment falls in reaction to the extended period of recession and wage cuts then productivity is likely to fall as well. Thus there is no guarantee that ULCs will fall by any significant amount.
If the US budget deficit keeps rising to meet the need for more fiscal stimulus, it would have to bear the political costs of a rising public debt ratio. This is one of the reasons the US government is talking about reducing net spending.
The answer is False.
Again, this question requires a careful reading and a careful association of concepts to make sure they are commensurate. There are two concepts that are central to the question: (a) a rising budget deficit – which is a flow and not scaled by GDP in this case; and (b) a rising public debt ratio which by construction (as a ratio) is scaled by GDP.
So the two concepts are not commensurate although they are related in some way.
A rising budget deficit does not necessary lead to a rising public debt ratio. You might like to refresh your understanding of these concepts by reading this blog – Saturday Quiz – March 6, 2010 – answers and discussion.
While the mainstream macroeconomics thinks that a sovereign government is revenue-constrained and is subject to the government budget constraint, MMT places no particular importance in the public debt to GDP ratio for a sovereign government, given that insolvency is not an issue.
However, the framework that the mainstream use to illustrate their erroneous belief in the government budget constraint is just an accounting statement that links relevant stocks and flows.
The mainstream framework for analysing the so-called “financing” choices faced by a government (taxation, debt-issuance, money creation) is written as:
which you can read in English as saying that Budget deficit = Government spending + Government interest payments – Tax receipts must equal (be “financed” by) a change in Bonds (B) and/or a change in high powered money (H). The triangle sign (delta) is just shorthand for the change in a variable.
Remember, this is merely an accounting statement. In a stock-flow consistent macroeconomics, this statement will always hold. That is, it has to be true if all the transactions between the government and non-government sector have been corrected added and subtracted.
So in terms of MMT, the previous equation is just an ex post accounting identity that has to be true by definition and has not real economic importance.
For the mainstream economist, the equation represents an ex ante (before the fact) financial constraint that the government is bound by. The difference between these two conceptions is very significant and the second (mainstream) interpretation cannot be correct if governments issue fiat currency (unless they place voluntary constraints on themselves to act as if it is).
That interpretation is inapplicable (and wrong) when applied to a sovereign government that issues its own currency.
But the accounting relationship can be manipulated to provide an expression linking deficits and changes in the public debt ratio.
The following equation expresses the relationships above as proportions of GDP:
So the change in the debt ratio is the sum of two terms on the right-hand side: (a) the difference between the real interest rate (r) and the GDP growth rate (g) times the initial debt ratio; and (b) the ratio of the primary deficit (G-T) to GDP. A primary budget balance is the difference between government spending (excluding interest rate servicing) and taxation revenue.
The real interest rate is the difference between the nominal interest rate and the inflation rate.
A growing economy can absorb more debt and keep the debt ratio constant or falling. From the formula above, if the primary budget balance is zero, public debt increases at a rate r but the public debt ratio increases at r – g.
So a nation running a primary deficit can obviously reduce its public debt ratio over time. Further, you can see that even with a rising primary deficit, if output growth (g) is sufficiently greater than the real interest rate (r) then the debt ratio can fall from its value last period.
Furthermore, depending on contributions from the external sector, a nation running a deficit will more likely create the conditions for a reduction in the public debt ratio than a nation that introduces an austerity plan aimed at running primary surpluses.