{"id":26626,"date":"2013-12-29T04:00:41","date_gmt":"2013-12-28T18:00:41","guid":{"rendered":"https:\/\/billmitchell.org\/blog\/?p=26626"},"modified":"2013-12-29T04:00:41","modified_gmt":"2013-12-28T18:00:41","slug":"saturday-quiz-december-28-2013-answers-and-discussion","status":"publish","type":"post","link":"https:\/\/billmitchell.org\/blog\/?p=26626","title":{"rendered":"Saturday Quiz – December 28, 2013 – 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

\nIf the external sector was running a surplus equivalent to 4 per cent of GDP, and the sum of all the private sector spending plans indicated it was desiring to run a surplus overall equivalent to 6 per cent, then the government could safely plan on achieving a budget surplus of 2 per cent of GDP.\n<\/p><\/blockquote>\n

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

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:<\/p>\n

(1)\tY = C + I + G + (X – M)<\/p>\n

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).<\/p>\n

Another perspective on the national income accounting is to note that households can use total income (Y) for the following uses:<\/p>\n

(2)\tY = C + S + T<\/p>\n

where S is total saving and T is total taxation (the other variables are as previously defined).<\/p>\n

You than then bring the two perspectives together (because they are both just “views” of Y) to write:<\/p>\n

(3)\tC + S + T = Y = C + I + G + (X – M)<\/p>\n

You can then drop the C (common on both sides) and you get:<\/p>\n

(4)\tS + T = I + G + (X – M)<\/p>\n

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.<\/p>\n

So we can re-arrange Equation (4) to get the accounting identity for the three sectoral balances – private domestic, government budget and external:<\/p>\n

(S – I) = (G – T) + (X – M)<\/p>\n

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.<\/p>\n

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.<\/p>\n

All these relationships (equations) hold as a matter of accounting and not matters of opinion.<\/p>\n

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.<\/p>\n

Second, you then have to appreciate the relative sizes of these balances to answer the question correctly.<\/p>\n

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.<\/p>\n

You will see that Case 2 corresponds to the data proposed in the question.<\/p>\n

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 will respond to that gap by decreasing output and income and this brings about an adjustment in the balances until they are back in equality.<\/p>\n

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

<\/div>\n

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.<\/p>\n

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).<\/p>\n

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.<\/p>\n

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.<\/p>\n

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.<\/p>\n

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.<\/p>\n

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.<\/p>\n

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.<\/p>\n

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.<\/p>\n

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.<\/p>\n

If the drain on spending outweighs the injections into the spending stream then GDP falls (or growth is reduced).<\/p>\n

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.<\/p>\n

If the private sector was able to realise their spending plans, the the government would have to run a deficit equivalent of 2 per cent of GDP, given the other data.<\/p>\n

You may wish to read the following blogs for more information:<\/p>\n