{"id":12044,"date":"2010-10-24T02:00:44","date_gmt":"2010-10-23T15:00:44","guid":{"rendered":"https:\/\/billmitchell.org\/blog\/?p=12044"},"modified":"2010-10-24T02:00:44","modified_gmt":"2010-10-23T15:00:44","slug":"saturday-quiz-october-23-2010-answers-and-discussion","status":"publish","type":"post","link":"https:\/\/billmitchell.org\/blog\/?p=12044","title":{"rendered":"Saturday Quiz – October 23, 2010 – answers and discussion"},"content":{"rendered":"

\t\t\t\tHere 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.
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\nQuestion 1:<\/strong><\/p>\n

\nA budget deficit equivalent to 3 per cent of GDP signals that the government is adopting a less expansionary policy than if the budget deficit outcome was equivalent to 5 per cent of GDP.\n<\/p><\/blockquote>\n

The answer is Maybe<\/strong>.<\/p>\n

The question probes an understanding of the forces (components) that drive the budget balance that is reported by government agencies at various points in time.<\/p>\n

In outright terms, a budget deficit that is equivalent to 5 per cent of GDP is more expansionary than a budget deficit outcome that is equivalent to 3 per cent of GDP. But that is not what the question asked. The question asked whether that signalled that the government is adopting a less expansionary policy – that is, whether its discretionary fiscal intent<\/strong> was expansionary.<\/p>\n

In other words, what does the budget outcome signal about the discretionary fiscal stance adopted by the government.<\/p>\n

To see the difference between these statements we have to explore the issue of decomposing the observed budget balance into the discretionary (now called structural) and cyclical components. The latter component is driven by the automatic stabilisers that are in-built into the budget process.<\/p>\n

The federal (or national) government budget balance is the difference between total federal revenue and total federal outlays. So if total revenue is greater than outlays, the budget is in surplus and vice versa. It is a simple matter of accounting with no theory involved. However, the budget balance is used by all and sundry to indicate the fiscal stance of the government.<\/p>\n

So if the budget is in surplus it is often concluded that the fiscal impact of government is contractionary (withdrawing net spending) and if the budget is in deficit we say the fiscal impact expansionary (adding net spending).<\/p>\n

Further, a rising deficit (falling surplus) is often considered to be reflecting an expansionary policy stance and vice versa. What we know is that a rising deficit may, in fact, indicate a contractionary fiscal stance – which, in turn, creates such income losses that the automatic stabilisers start driving the budget back towards (or into) deficit.<\/p>\n

So the complication is that we cannot conclude that changes in the fiscal impact reflect discretionary policy changes. The reason for this uncertainty clearly relates to the operation of the automatic stabilisers.<\/p>\n

To see this, the most simple model of the budget balance we might think of can be written as:<\/p>\n

Budget Balance = Revenue – Spending.<\/p>\n

Budget Balance = (Tax Revenue + Other Revenue) – (Welfare Payments + Other Spending)<\/p>\n

We know that Tax Revenue and Welfare Payments move inversely with respect to each other, with the latter rising when GDP growth falls and the former rises with GDP growth. These components of the budget balance are the so-called automatic stabilisers.<\/p>\n

In other words, without any discretionary policy changes, the budget balance will vary over the course of the business cycle. When the economy is weak – tax revenue falls and welfare payments rise and so the budget balance moves towards deficit (or an increasing deficit). When the economy is stronger – tax revenue rises and welfare payments fall and the budget balance becomes increasingly positive. Automatic stabilisers attenuate the amplitude in the business cycle by expanding the budget in a recession and contracting it in a boom.<\/p>\n

So just because the budget goes into deficit or the deficit increases as a proportion of GDP doesn’t allow us to conclude that the Government has suddenly become of an expansionary mind. In other words, the presence of automatic stabilisers make it hard to discern whether the fiscal policy stance (chosen by the government) is contractionary or expansionary at any particular point in time.<\/p>\n

To overcome this uncertainty, economists devised what used to be called the Full Employment or High Employment Budget. In more recent times, this concept is now called the Structural Balance. The Full Employment Budget Balance was a hypothetical construct of the budget balance that would be realised if the economy was operating at potential or full employment. In other words, calibrating the budget position (and the underlying budget parameters) against some fixed point (full capacity) eliminated the cyclical component – the swings in activity around full employment.<\/p>\n

So a full employment budget would be balanced if total outlays and total revenue were equal when the economy was operating at total capacity. If the budget was in surplus at full capacity, then we would conclude that the discretionary structure of the budget was contractionary and vice versa if the budget was in deficit at full capacity.<\/p>\n

The calculation of the structural deficit spawned a bit of an industry in the past with lots of complex issues relating to adjustments for inflation, terms of trade effects, changes in interest rates and more.<\/p>\n

Much of the debate centred on how to compute the unobserved full employment point in the economy. There were a plethora of methods used in the period of true full employment in the 1960s. All of them had issues but like all empirical work – it was a dirty science – relying on assumptions and simplifications. But that is the nature of the applied economist’s life.<\/p>\n

As I explain in the blogs cited below, the measurement issues have a long history and current techniques and frameworks based on the concept of the Non-
\nAccelerating Inflation Rate of Unemployment (the NAIRU) bias the resulting analysis such that actual discretionary positions which are contractionary are seen as being less so and expansionary positions are seen as being more expansionary.<\/p>\n

The result is that modern depictions of the structural deficit systematically understate the degree of discretionary contraction coming from fiscal policy.<\/p>\n

So the data provided by the question could indicate a more expansionary fiscal intent from government but it could also indicate a large automatic stabiliser (cyclical) component.<\/p>\n

Therefore the best answer is Maybe<\/strong> because there are circumstances where the proposition will not hold. It doesn’t always hold.<\/p>\n

You might like to read these blogs for further information:<\/p>\n