The change in the net worth of the non-government sector when the government increases its net spending is invariant to government issuing debt which exactly matches ($-for-$) the increase in net public spending.
Answer: True
The answer is True.
This answer is complementary to that provided for Question 3 and relies on the same understanding of reserve operations. So within a fiat monetary system we need to understand the banking operations that occur when governments spend and issue debt. That understanding allows us to appreciate 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 as explained in the answer to Question 3. But at this stage, M1 (deposits in the non-government sector) rise as a result of the deficit without a corresponding increase in liabilities. In other words, budget 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.
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Question 5 - Premium Question:
The government is attempting to stimulate the economy via an expansion in the budget deficit. The private market orientated advisors tell them to cut taxes and "privatise" the expansion whereas the more civic-minded advisers argue that there is a need for improved public infrastructure which requires increases in government spending. So imagine that the government is choosing between a tax cut that will reduce tax revenue at the current level of national income by $x and a spending increase of $x. Which policy option will have the greater initial impact on aggregate demand?
(a) Tax cut
(b) Spending increase
(c) Both will be equivalent
(d) There is not enough information to answer this question
The answer is Spending increase.
The question is only seeking an understanding of the initial injection into the spending stream rather than the fully exhausted multiplied expansion of national income that will result. It is clear that the tax cut approach will have two effects: (a) some initial demand stimulus; and (b) it increases the value of the multiplier, other things equal.
We are only interested in the first effect rather than the total effect. But I will give you some insight also into what the two components of the tax result might imply overall when compared to the stimulus motivated by an increase in government spending.
To give you a concrete example which will consolidate the understanding of what happens, imagine that the marginal propensity to consume out of disposable income is 0.8 and there is only one tax rate set at 0.20. So for every extra dollar that the economy produces the government taxes 20 cents leaving 80 cents in disposable income. In turn, households then consume 0.8 of this 80 cents which means an injection of 64 cents goes into aggregate demand which them multiplies as the initial spending creates income which, in turn, generates more spending and so on.
Government spending increase
An increase in government spending (say of $1000) is what we call an exogenous injection into the spending stream and stimulates aggregate demand by that amount. So it might be an order of $1000 worth of gadget X which advances human welfare immeasurably! The firm that produces gadget X thus increases production of the good or service by the rise in orders ($1000) and as a result incomes of the productive factors rises by $1000. So the initial rise in aggregate demand is $1000.
This initial increase in national output and income then stimulates (induces) further consumption by 64 cents in the dollar so in Period 2, aggregate demand increases by $640. Output and income rises by the same amount to meet this increase in spending. In Period 3, aggregate demand rises by 0.8 x 0.8 x $640 and so on. The induced spending increase gets smaller and smaller because some of each round of income increase is taxed away, some goes to imports and some is saved.
Tax-cut induced stimulus
The stimulus coming from a tax-cut does not directly impact on the spending stream in the same way as the rise in government spending.
First, imagine the government worked out a tax cut that would increase its initial budget deficit by the same amount as would have been the case if it had increased government spending (so in our example, $1000).
In other words, disposable income at each level of GDP rises initially by $1000. What happens next?
Some of the disposable income is saved (20 cents in each dollar that disposable income increases). So immediately some of the tax increase is lost from the spending stream.
In this case the injection into aggregate demand is $800 rather than $1000 in the case of the increase in government spending.
What happens next depends on the parameters of the macroeconomic system. The multiplied rise in national income may be higher or lower depending on these parameters. But it will never be the case that an initial budget equivalent tax cut will be more stimulatory than a government spending increase.
Note in answering this question I am disregarding all the nonsensical notions of Ricardian equivalence that abound among the mainstream doomsayers who have never predicted anything of empirical note! All their predictions come to nought.
You may wish to read the following blogs for more information: