{"id":12142,"date":"2010-10-31T04:00:21","date_gmt":"2010-10-30T17:00:21","guid":{"rendered":"https:\/\/billmitchell.org\/blog\/?p=12142"},"modified":"2010-10-31T04:00:21","modified_gmt":"2010-10-30T17:00:21","slug":"saturday-quiz-october-30-2010-answers-and-discussion","status":"publish","type":"post","link":"https:\/\/billmitchell.org\/blog\/?p=12142","title":{"rendered":"Saturday Quiz – October 30, 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

\nQuite apart from whether they understand that they do not face any financial constraints, governments are now trying to reduce their budget deficits because they correctly understand that additional fiscal stimulus would increase the public debt ratios which would worsen their political positions.\n<\/p><\/blockquote>\n

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

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.<\/p>\n

So the two concepts are not commensurate although they are related in some way.<\/p>\n

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<\/a>.<\/p>\n

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.<\/p>\n

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.<\/p>\n

The mainstream framework for analysing the so-called “financing” choices faced by a government (taxation, debt-issuance, money creation) is written as:
\n\"gbc\"<\/a><\/p>\n

<\/div>\n

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.<\/p>\n

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.<\/p>\n

So in terms of MMT, the previous equation is just an ex post<\/em> accounting identity that has to be true by definition and has not real economic importance.<\/p>\n

For the mainstream economist, the equation represents an ex ante<\/em> (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).<\/p>\n

That interpretation is inapplicable (and wrong) when applied to a sovereign government that issues its own currency.<\/p>\n

But the accounting relationship can be manipulated to provide an expression linking deficits and changes in the public debt ratio.<\/p>\n

The following equation expresses the relationships above as proportions of GDP:<\/p>\n

\"debt_gdp_ratio\"<\/a><\/p>\n

<\/div>\n

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<\/em>) and the GDP growth rate (g<\/em>) times the initial debt ratio; and (b) the ratio of the primary deficit (G-T<\/em>) to GDP. A primary budget balance is the difference between government spending (excluding interest rate servicing) and taxation revenue.<\/p>\n

The real interest rate is the difference between the nominal interest rate and the inflation rate.<\/p>\n

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<\/em> – g<\/em>.<\/p>\n

So a nation running a primary deficit<\/strong> 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.<\/p>\n

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.<\/p>\n

The following blog may be of further interest to you:<\/p>\n