Quiz #1

• Quantitative easing
• is when the central bank purchases investment maturity bonds in return for bank reserves and involves no change in the net financial assets of the non-government sector.
• is when the central bank floods the banks with new money (new net financial assets) to encourage them to lend in order to ease the credit crunch
• involves the central bank printing new money and is thus the same as government spending which is not financed by debt
• Bonds have to be issued by the national governments
• if taxation revenue falls in a recession and the government wants to introduce a stimulus package.
• if the central bank desires to maintain a constant short-term target interest rate and net government spending is rising. (note comments)
• to finance the budget deficit if the government is worried about "money creation".
• Budget deficits
• put downward pressure on short-term interest rates because they increase bank reserves in aggregate which then stimulate competition in the Interbank market.
• put upward pressure on interest rates because the government is competing for scarce savings that could be invested elsewhere.
• have no implications for interest rates because the ratings agencies basically set the risk rating of public debt.
• Budget surpluses
• allow the Federal government to build sovereign funds which then help it solve problems in the future.
• undermine private wealth and are mirrored $-for-$ in non-government dis-saving.
• assist the economy to save when activity levels are high.
• Federal government budget deficits
• are good during recessions because provide direct stimulus to the spending stream and finance private savings.
• are good during recessions because they put money into bank reserves in exchange for longer-maturing bonds.
• are good during recessions but need to be increased with caution because they increase the public borrowing requirement.
• are good during recessions but ultimately require higher taxation in the future to bring the budget back towards balance.

Quiz #1 answers

• Quantitative easing

Answer: is when the central bank purchases investment maturity bonds in return for bank reserves and involves no change in the net financial assets of the non-government sector.

Explanation: Quantitative easing is when the central bank buys one type of financial asset (private holdings of bonds, company paper) in return for another asset (reserve balances at the central bank). The net financial assets in the private sector are in fact unchanged although the portfolio composition of those assets is altered (maturity substitution) which changes yields and returns. Quantitative easing increases central bank demand for "long maturity" assets held in the private sector which reduces interest rates at the longer end of the yield curve. These are traditionally thought of as the investment rates. This might increase aggregate demand given the cost of investment funds is likely to drop. But on the other hand, the lower rates reduce the interest-income of savers who will reduce consumption (demand) accordingly.

• Bonds have to be issued by the national governments

Answer: if the central bank desires to maintain a constant short-term target interest rate and net government spending is rising. (note comments)

Explanation: Please read Deficit spending 101 - Part 3 if you are still wondering why!

• Budget deficits

Answer: put downward pressure on short-term interest rates because they increase bank reserves in aggregate which then stimulate competition in the Interbank market.

Explanation: Please see Deficit spending 101 - Part 3 if you are still wondering why the correct answer is one.

• Budget surpluses

Answer: undermine private wealth and are mirrored $-for-$ in non-government dis-saving.

Explanation: Please see Deficit spending 101 - Part 1 if you are still wondering why the correct answer is two. Further, when the government is building a sovereign fund by purchasing financial assets in the open markets it is spending. So it is a myth to say they "used" the surplus up to buy the assets.

• Federal government budget deficits

Answer: are good during recessions because provide direct stimulus to the spending stream and finance private savings.

Explanation: Please see Deficit spending 101 - Part 1 if you are still wondering why the correct answer is three.