The US Federal Reserve could easily directly purchase Treasury debt to facilitate the US Governments budget deficit without compromising its monetary policy settings because its short-term policy rate is already near zero.
Answer: False
The answer is False.
The Federal Reserve could easily directly purchase Treasury debt to facilitate the US Government's budget deficit but not because its short-term policy rate is already so low.
They could also do the same with higher positive policy rates by ensuring they offer a support rate on the excess reserves.
So what is the explanation?
The central bank conducts what are called liquidity management operations for two reasons. First, it has to ensure that all private cheques (that are funded) clear and other interbank transactions occur smoothly as part of its role of maintaining financial stability. Second, it must maintain aggregate bank reserves at a level that is consistent with its target policy setting given the relationship between the two.
So operating factors link the level of reserves to the monetary policy setting under certain circumstances. These circumstances require that the return on "excess" reserves held by the banks is below the monetary policy target rate. In addition to setting a lending rate (discount rate), the central bank also sets a support rate which is paid on commercial bank reserves held by the central bank.
Commercial banks maintain accounts with the central bank which permit reserves to be managed and also the clearing system to operate smoothly. In addition to setting a lending rate (discount rate), the central bank also can set a support rate which is paid on commercial bank reserves held by the central bank (which might be zero).
Many countries (such as Australia, Canada and zones such as the European Monetary Union) maintain a default return on surplus reserve accounts (for example, the Reserve Bank of Australia pays a default return equal to 25 basis points less than the overnight rate on surplus Exchange Settlement accounts). Other countries like Japan and the US have typically not offered a return on reserves until the onset of the current crisis.
If the support rate is zero then persistent excess liquidity in the cash system (excess reserves) will instigate dynamic forces which would drive the short-term interest rate to zero unless the government sells bonds (or raises taxes). This support rate becomes the interest-rate floor for the economy.
The short-run or operational target interest rate, which represents the current monetary policy stance, is set by the central bank between the discount and support rate. This effectively creates a corridor or a spread within which the short-term interest rates can fluctuate with liquidity variability. It is this spread that the central bank manages in its daily operations.
In most nations, commercial banks by law have to maintain positive reserve balances at the central bank, accumulated over some specified period. At the end of each day commercial banks have to appraise the status of their reserve accounts. Those that are in deficit can borrow the required funds from the central bank at the discount rate.
Alternatively banks with excess reserves are faced with earning the support rate which is below the current market rate of interest on overnight funds if they do nothing. Clearly it is profitable for banks with excess funds to lend to banks with deficits at market rates. Competition between banks with excess reserves for custom puts downward pressure on the short-term interest rate (overnight funds rate) and depending on the state of overall liquidity may drive the interbank rate down below the operational target interest rate. When the system is in surplus overall this competition would drive the rate down to the support rate.
The main instrument of this liquidity management is through open market operations, that is, buying and selling government debt. When the competitive pressures in the overnight funds market drives the interbank rate below the desired target rate, the central bank drains liquidity by selling government debt. This open market intervention therefore will result in a higher value for the overnight rate. Importantly, we characterise the debt-issuance as a monetary policy operation designed to provide interest-rate maintenance. This is in stark contrast to orthodox theory which asserts that debt-issuance is an aspect of fiscal policy and is required to finance deficit spending.
So the fundamental principles that arise in a fiat monetary system are as follows.
Accordingly, debt is issued as an interest-maintenance strategy by the central bank. It has no correspondence with any need to fund government spending. Debt might also be issued if the government wants the private sector to have less purchasing power.
Further, the idea that governments would simply get the central bank to "monetise" treasury debt (which is seen orthodox economists as the alternative "financing" method for government spending) is highly misleading. Debt monetisation is usually referred to as a process whereby the central bank buys government bonds directly from the treasury.
In other words, the federal government borrows money from the central bank rather than the public. Debt monetisation is the process usually implied when a government is said to be printing money. Debt monetisation, all else equal, is said to increase the money supply and can lead to severe inflation.
However, as long as the central bank has a mandate to maintain a target short-term interest rate, the size of its purchases and sales of government debt are not discretionary. Once the central bank sets a short-term interest rate target, its portfolio of government securities changes only because of the transactions that are required to support the target interest rate.
The central bank's lack of control over the quantity of reserves underscores the impossibility of debt monetisation. The central bank is unable to monetise the federal debt by purchasing government securities at will because to do so would cause the short-term target rate to fall to zero or to the support rate. If the central bank purchased securities directly from the treasury and the treasury then spent the money, its expenditures would be excess reserves in the banking system. The central bank would be forced to sell an equal amount of securities to support the target interest rate.
The central bank would act only as an intermediary. The central bank would be buying securities from the treasury and selling them to the public. No monetisation would occur.
However, the central bank may agree to pay the short-term interest rate to banks who hold excess overnight reserves. This would eliminate the need by the commercial banks to access the interbank market to get rid of any excess reserves and would allow the central bank to maintain its target interest rate without issuing debt.
The following blogs may be of further interest to you:
Question 5 Premium:
Premium Question: Assume the government increases spending by $100 billion from now and maintains that injection for three years. Economists estimate the spending multiplier to be 1.6 and the impact is immediate and exhausted in each year. They also estimate that the import propensity is 0.2 (meaning that imports rise by 20 cents for every dollar generated in the economy) and the current tax rate is equal to 20 per cent. They also estimate that the tax multiplier (impact of tax changes on income) to be equal to 1. Which of the following statements is correct?
(a) The cumulative impact of this fiscal expansion on nominal GDP is $480 billion and the private sector saves 24 cents out of every extra dollar generated.
(b) The cumulative impact of this fiscal expansion on nominal GDP is $480 billion and the private sector saves 28 cents out of every extra dollar generated.
(c) The cumulative impact of this fiscal expansion on nominal GDP is $384 billion and the private sector saves 24 cents out of every extra dollar generated.
(d) The cumulative impact of this fiscal expansion on nominal GDP is $384 billion and the private sector saves 28 cents out of every extra dollar generated.
The answer was Option (b) $480 billion and 28 cents.
The question involves two parts: (a) working out what is relevant to the answer; and (b) reverse engineering some of the relevant data to get the marginal propensity to consume (and hence the saving propensity).
To work out the cumulative impact you need to understand the concept of the spending multiplier which is the easier part of the question.
In Year 1, government spending rises by $100 billion, which leads to a total increase in GDP of $160 billion via the spending multiplier. The multiplier process is explained in the following way. Government spending, say, on some equipment or construction, leads to firms in those areas responding by increasing real output. In doing so they pay out extra wages and other payments which then provide the workers (consumers) with extra disposable income (once taxes are paid).
Higher consumption is thus induced by the initial injection of government spending. Some of the higher income is saved and some is lost to the local economy via import spending. So when the workers spend their higher wages (which for some might be the difference between no wage as an unemployed person and a positive wage), broadly throughout the economy, this stimulates further induced spending and so on, with each successive round of spending being smaller than the last because of the leakages to taxation, saving and imports.
Eventually, the process exhausts and the total rise in GDP is the "multiplied" effect of the initial government injection. In this question we adopt the simplifying (and unrealistic) assumption that all induced effects are exhausted within the same year. In reality, multiplier effects of a given injection usually are estimated to go beyond 4 quarters.
So this process goes on for 3 years so the $300 billion cumulative injection leads to a cumulative increase in GDP of $480 billion.
It is true that total tax revenue rises by $96 billion over the three years but this is just an automatic stabiliser effect. There was no change in the tax structure (that is, tax rates) posited in the question.
That means that the tax multiplier, whatever value it might have been, is irrelevant to this example.
Some might have decided to subtract the $96 billion from the $480 billion to get answer (c) or (d) on the presumption that there was a tax effect. But the automatic stabiliser effect of the tax system is already built into the expenditure multiplier.
So answers (c) and (d) were there to lure you into thinking the tax parameters were important for the first part of the solution.
However, the second part of the question required you to reverse engineer the multiplier. In mathematics the general rule is that you can only solve for unknown parameters if you have as many equations as unknowns. So if you have y = 2x. You cannot solve for y because you don't know what x is. If I tell you x = 2 then you have one equation (y = 2x) and one unknown (y) so it becomes trivial y = 4.
Similar reasoning applies in this question.
The expenditure multiplier is defined as the change in real income that results from a dollar change in exogenous aggregate demand (so one of G, I or X). We could complicate this by having autonomous consumption as well but the principle is not altered.
Consumption and Saving
So the starting point is to define the consumption relationship. The most simple is a proportional relationship to disposable income (Yd). So we might write it as C = c*Yd - where little c is the marginal propensity to consume (MPC) or the fraction of every dollar of disposable income consumed. The marginal propensity to consume is just equal to 1 minus the marginal propensity to save.
The * sign denotes multiplication. You can do this example in an spreadsheet if you like.
Taxes
Our tax relationship is already defined above - so T = tY. The little t is the marginal tax rate which in this case is the proportional rate - 0.2 in the question. Note here taxes are taken out of total income (Y) which then defines disposable income.
So Yd = (1-t) times Y or Yd = (1-0.3)*Y = 0.2*Y
Imports
If imports (M) are 20 per cent of total income (Y) then the relationship is M = m*Y where little m is the marginal propensity to import or the economy will increase imports by 20 cents for every real GDP dollar produced.
Multiplier
If you understand all that then the explanation of the multiplier follows logically. Imagine that government spending went up by $100 and the change in real national income is $160. Then the multiplier is the ratio (denoted k) of the
Change in Total Income to the Change in government spending.
Thus k = $160/$100 = 1.60
That is the value assumed in the question. This says that for every dollar the government spends total real GDP will rise by $1.60 after taking into account the leakages from taxation, saving and imports.
When we conduct this thought experiment we are assuming the other autonomous expenditure components (I and X) are unchanged.
But the important point is to understand why the process generates a multiplier value of 1.60.
The formula for the spending multiplier is given as (see blogs listed below for a complete explanation):
k = 1/(1 - c*(1-t) + m)
where c is the MPC, t is the tax rate so c(1-t) is the extra spending per dollar of disposable income and m is the MPM. The * denotes multiplication as before.
This formula is derived as follows:
The national income identity is:
GDP = Y = C + I + G + (X - M)
Where C = consumption, I is investment, G is government spending, X is exports and M is imports (so (X - M) is net exports).
A simple model of these expenditure components taking the information above is:
GDP = Y = c*Yd + I + G + X - m*Y
Yd = (1 - t)*Y
We consider (in this model for simplicity) that the expenditure components I, G and X are autonomous and do not depend on the level of income (GDP) in any particular period. So we can aggregate them as all autonomous expenditure A.
Thus:
GDP = Y = c*(1- t)*Y -m*Y + A
While I am not trying to test one's ability to do algebra, and in that sense the answer can be worked out conceptually, to get the multiplier formula we re-arrange the previous equation as follows:
Y - c*(1-t)*Y + m*Y - A
Then collect the like terms and simplify:
Y[1- c*(1-t) + m] = A
So a change in A will generate a change in Y according to this formula:
Change in Y = k = 1/(1 - c*(1-t) + m)*Change in A
or if k = 1/(1 - c*(1-t) + m)
Change in Y = k*Change in A.
So in the question you have one equation (the multiplier) and one unknown (c). This is because of the 3 behaviorial parameters (c, t and m) two are known (t and m) and you also know the value of the left-hand side of the equation (1.5). So in effect you can solve for c:
k = 1/(1 - c*(1-t) + m)
Thus k*[1 - c*(1-t) + m] = 1
Thus k - c*k*(1-t) + k*m = 1
Thus k + k*m -1 = c*k*(1-t)
Thus c = (k + k*m - 1)/(k*(1-t))
Then you plug in the values of the knowns and the result is:
c = (1.6 + 0.32 - 1)/(1.6*0.8)
c = 0.92/1.28 = 0.71875
So the MPS (marginal propensity to save) = (1 - c) = approximately 28 cents.
You may wish to read the following blogs for more information: