Saturday Quiz – August 20, 2011 – answers and discussion

Here 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.

Question 1:

Issuing government debt reduces the risk of inflation arising from deficit spending because the private sector has less money to spend.

The answer is False.

The mainstream macroeconomic textbooks all have a chapter on fiscal policy (and it is often written in the context of the so-called IS-LM model but not always).

The chapters always introduces the so-called Government Budget Constraint that alleges that governments have to “finance” all spending either through taxation; debt-issuance; or money creation. The writer fails to understand that government spending is performed in the same way irrespective of the accompanying monetary operations.

They claim that money creation (borrowing from central bank) is inflationary while the latter (private bond sales) is less so. These conclusions are based on their erroneous claim that “money creation” adds more to aggregate demand than bond sales, because the latter forces up interest rates which crowd out some private spending.

All these claims are without foundation in a fiat monetary system and an understanding of the banking operations that occur when governments spend and issue debt helps to show why.

So 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. The aim of the central bank is to “hit” a target interest rate and so it has to ensure that competitive forces in the interbank market do not compromise that target.

When there are excess reserves there is downward pressure on the overnight interest rate (as banks scurry to seek interest-earning opportunities), the central bank then has to sell government bonds to the banks to soak the excess up and maintain liquidity at a level consistent with the target. Some central banks offer a return on overnight reserves which reduces the need to sell debt as a liquidity management operation.

There is no sense that these debt sales have anything to do with “financing” government net spending. The sales are a monetary operation aimed at interest-rate maintenance. So M1 (deposits in the non-government sector) rise as a result of the deficit without a corresponding increase in liabilities. It is this result that leads to the conclusion that that 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.

Mainstream economists would say that by draining the reserves, the central bank has reduced the ability of banks to lend which then, via the money multiplier, expands the money supply.

However, the reality is that:

  • Building bank reserves does not increase the ability of the banks to lend.
  • The money multiplier process so loved by the mainstream does not describe the way in which banks make loans.
  • Inflation is caused by aggregate demand growing faster than real output capacity. The reserve position of the banks is not functionally related with that process.

So the banks are able to create as much credit as they can find credit-worthy customers to hold irrespective of the operations that accompany government net spending.

This doesn’t lead to the conclusion that deficits do not carry an inflation risk. All components of aggregate demand carry an inflation risk if they become excessive, which can only be defined in terms of the relation between spending and productive capacity.

It is totally fallacious to think that private placement of debt reduces the inflation risk. It does not.

You may wish to read the following blogs for more information:

Question 2:

When the government matches it deficit with new debt issues the non-government sector wealth rises.

The answer is True.

This answer is complementary to that provided for Question 1 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?

The question lures you into thinking it is the bond-issuance that drives the rise in non-government wealth when, in fact, it is the budget deficit that adds to non-government wealth irrespective of whether bonds are issued or not.

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 1. 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.

You may wish to read the following blogs for more information:

Question 3:

If net exports are running at 2 per cent of GDP, and the private domestic sector overall is saving an equivalent of 3 per cent of GDP, the government must be running a surplus equal to 1 per cent of GDP.

The answer is False.

The correct answer is that the government must be running a deficit equal to 1 per cent of GDP.

This question tests your knowledge of the sectoral balances that are derived from the National Accounts.

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:

(1) Y = C + I + G + (X – M)

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).

Another perspective on the national income accounting is to note that households can use total income (Y) for the following uses:

(2) Y = C + S + T

where S is total saving and T is total taxation (the other variables are as previously defined).

You than then bring the two perspectives together (because they are both just “views” of Y) to write:

(3) C + S + T = Y = C + I + G + (X – M)

You can then drop the C (common on both sides) and you get:

(4) S + T = I + G + (X – M)

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.

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

(S – I) = (G – T) + (X – M)

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.

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.

All these relationships (equations) hold as a matter of accounting and not matters of opinion.

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.

Second, you then have to appreciate the relative sizes of these balances to answer the question correctly.

The rule is that the sectoral balances have to sum to zero. So if we write the condition above as:

(S – 1) – (G – T) – (X – M) = 0

And substitute the values of the question we get:

3 – (G – T) – 2 = 0

We can solve this for (G – T) as

(G – T) = 3 – 2 = 1

Given the construction (G – T) a positive number (1) is a deficit.

The outcome is depicted in the following graph.

This tells us that even if the external sector is growing strongly and is in surplus there may still be a need for public deficits. This will occur if the private domestic sector seek to save at a proportion of GDP higher than the external surplus.

The economics of this situation might be something like this. The external surplus would be adding to overall aggregate demand (the injection from exports exceeds the drain from imports). However, if the drain from private sector spending (S > I) is greater than the external injection then the only way output and income can remain constant is if the government is in deficit.

National income adjustments would occur if the private domestic sector tried to push for higher saving overall – income would fall (because overall spending fell) and the government would be pushed into deficit whether it liked it or not via falling revenue and rising welfare payments.

You may wish to read the following blogs for more information:

Question 4:

Only one of the following propositions is possible (with all balances expressed as a per cent of GDP):

  • A nation can export less than the sum of imports, net factor income (such as interest and dividends) and net transfer payments (such as foreign aid) and run a government surplus of equal proportion to GDP, while the private domestic sector is spending less than they are earning.
  • A nation can export less than the sum of imports, net factor income (such as interest and dividends) and net transfer payments (such as foreign aid) and run a government sector surplus of equal proportion to GDP, while the private domestic sector is spending more than they are earning.
  • A nation can export less than the sum of imports, net factor income (such as interest and dividends) and net transfer payments (such as foreign aid) and run a government sector surplus that is larger, while the private domestic sector is spending less than they are earning.
  • None of the above are possible as they all defy the sectoral balances accounting identity.

The correct answer is the second option – “A nation can run a current account deficit accompanied by a government sector surplus of equal proportion to GDP, while the private domestic sector is spending more than they are earning”.

Note that the the current account is equal to the trade balance plus invisibles. The trade balance is exports minus imports and the invisibles are equal to the sum of net factor income (such as interest and dividends) and net transfer payments (such as foreign aid). So the question is asking about a current account deficit.

This is a question about the sectoral balances – the government budget balance, the external balance and the private domestic balance – that have to always add to zero because they are derived as an accounting identity from the national accounts.

See the explanation in Question 3 for background.

The following Table represents the three options in percent of GDP terms. To aid interpretation remember that (I-S) > 0 means that the private domestic sector is spending more than they are earning; that (G-T) < 0 means that the government is running a surplus because T > G; and (X-M) < 0 means the external position is in deficit because imports are greater than exports.

The first two possibilities we might call A and B:

A: A nation can run a current account deficit with an offsetting government sector surplus, while the private domestic sector is spending less than they are earn

B: A nation can run a current account deficit with an offsetting government sector surplus, while the private domestic sector is spending more than they are earning.

So Option A says the private domestic sector is saving overall, whereas Option B say the private domestic sector is dis-saving (and going into increasing indebtedness). These options are captured in the first column of the Table. So the arithmetic example depicts an external sector deficit of 2 per cent of GDP and an offsetting budget surplus of 2 per cent of GDP.

You can see that the private sector balance is positive (that is, the sector is spending more than they are earning – Investment is greater than Saving – and has to be equal to 4 per cent of GDP.

Given that the only proposition that can be true is:

B: A nation can run a current account deficit with an offsetting government sector surplus, while the private domestic sector is spending more than they are earning.

Column 2 in the Table captures Option C:

C: A nation can run a current account deficit with a government sector surplus that is larger, while the private domestic sector is spending less than they are earning.

So the current account deficit is equal to 2 per cent of GDP while the surplus is now larger at 3 per cent of GDP. You can see that the private domestic deficit rises to 5 per cent of GDP to satisfy the accounting rule that the balances sum to zero.

The final option available is:

D: None of the above are possible as they all defy the sectoral balances accounting identity.

It cannot be true because as the Table data shows the rule that the sectoral balances add to zero because they are an accounting identity is satisfied in both cases.

So if the G is spending less than it is “earning” and the external sector is adding less income (X) than it is absorbing spending (M), then the other spending components must be greater than total income

The following blogs may be of further interest to you:

Question 5 – Premium question

To reduce the public debt ratio, the government has to eventually run primary budget surpluses (that is, spend less than they raise in taxes).

The answer is False.

This question requires you to understand the key parameters and relationships that determine the dynamics of the public debt ratio. An understanding of these relationships allows you to debunk statements that are made by those who think fiscal austerity will allow a government to reduce its public debt ratio.

It also requires you to differentiate between the level of outstanding public debt and the ratio of public debt to GDP. The question is focusing on the latter concept.

While Modern Monetary Theory (MMT) places no particular importance in the public debt to GDP ratio for a sovereign government, given that insolvency is not an issue, the mainstream debate is dominated by the concept.

The unnecessary practice of fiat currency-issuing governments of issuing public debt $-for-$ to match public net spending (deficits) ensures that the debt levels will rise when there are deficits.

Rising deficits usually mean declining economic activity (especially if there is no evidence of accelerating inflation) which suggests that the debt/GDP ratio may be rising because the denominator is also likely to be falling or rising below trend.

Further, historical experience tells us that when economic growth resumes after a major recession, during which the public debt ratio can rise sharply, the latter always declines again.

It is this endogenous nature of the ratio that suggests it is far more important to focus on the underlying economic problems which the public debt ratio just mirrors.

Mainstream economics starts with the flawed analogy between the household and the sovereign government such that any excess in government spending over taxation receipts has to be “financed” in two ways: (a) by borrowing from the public; and/or (b) by “printing money”.

Neither characterisation is remotely representative of what happens in the real world in terms of the operations that define transactions between the government and non-government sector.

Further, the basic analogy is flawed at its most elemental level. The household must work out the financing before it can spend. The household cannot spend first. The government can spend first and ultimately does not have to worry about financing such expenditure.

However, the mainstream framework for analysing these so-called “financing” choices is called the government budget constraint (GBC). The GBC says that the budget deficit in year t is equal to the change in government debt over year t plus the change in high powered money over year t. So in mathematical terms it is written as:

gbc

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.

However, 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.

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

But for the mainstream economist, the equation represents an ex ante (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).

Further, in mainstream economics, money creation is erroneously depicted as the government asking the central bank to buy treasury bonds which the central bank in return then prints money. The government then spends this money.

This is called debt monetisation and you can find out why this is typically not a viable option for a central bank by reading the Deficits 101 suite – Deficit spending 101 – Part 1Deficit spending 101 – Part 2Deficit spending 101 – Part 3.

Anyway, the mainstream claims that if governments increase the money growth rate (they erroneously call this “printing money”) the extra spending will cause accelerating inflation because there will be “too much money chasing too few goods”! Of-course, we know that proposition to be generally preposterous because economies that are constrained by deficient demand (defined as demand below the full employment level) respond to nominal demand increases by expanding real output rather than prices. There is an extensive literature pointing to this result.

So when governments are expanding deficits to offset a collapse in private spending, there is plenty of spare capacity available to ensure output rather than inflation increases.

But not to be daunted by the “facts”, the mainstream claim that because inflation is inevitable if “printing money” occurs, it is unwise to use this option to “finance” net public spending.

Hence they say as a better (but still poor) solution, governments should use debt issuance to “finance” their deficits. Thy also claim this is a poor option because in the short-term it is alleged to increase interest rates and in the longer-term is results in higher future tax rates because the debt has to be “paid back”.

Neither proposition bears scrutiny – you can read these blogs – Will we really pay higher taxes? and Will we really pay higher interest rates? – for further discussion on these points.

The mainstream textbooks are full of elaborate models of debt pay-back, debt stabilisation etc which all claim (falsely) to “prove” that the legacy of past deficits is higher debt and to stabilise the debt, the government must eliminate the deficit which means it must then run a primary surplus equal to interest payments on the existing debt.

A primary budget balance is the difference between government spending (excluding interest rate servicing) and taxation revenue.

The standard mainstream framework, which even the so-called progressives (deficit-doves) use, focuses on the ratio of debt to GDP rather than the level of debt per se. The following equation captures the approach:

debt_gdp_ratio

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) and the real GDP growth rate (g) times the initial debt ratio; and (b) the ratio of the primary deficit (G-T) to GDP.

The real interest rate is the difference between the nominal interest rate and the inflation rate. Real GDP is the nominal GDP deflated by the inflation rate. So the real GDP growth rate is equal to the Nominal GDP growth minus the inflation rate.

An appreciation of the elements of the public debt ratio immediately tells us that a currency-issuing government running a deficit can reduce the debt ratio. There is no need to run primary surpluses and unnecessarily reduce growth. The standard formula above can easily demonstrate that a nation running a primary deficit can reduce its public debt ratio over time.

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.

Here is why that is the case.

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 rg.

The following Table simulates the two years in question. To make matters simple, assume a public debt ratio at the start of the Year 1 of 100 per cent (so B/Y(-1) = 1) which is equivalent to the statement that “outstanding public debt is equal to the value of the nominal GDP”.

Also the nominal interest rate is 1 per cent and the inflation rate is 1 per cent then the current real interest rate (r) is 0 per cent.

If the nominal GDP is growing at -1 per cent and there is an inflation rate of 1 per cent then real GDP is growing (g) at minus 2 per cent.

Under these conditions, the primary budget surplus would have to be equal to 2 per cent of GDP to stabilise the debt ratio (check it for yourself). So, the question suggests the primary budget deficit is actually 1 per cent of GDP we know by computation that the public debt ratio rises by 3 per cent.

The calculation (using the formula in the Table) is:

Change in B/Y = (0 – (-2))*1 + 1 = 3 per cent.

The data in Year 2 is given in the last column in the Table below. Note the public debt ratio has risen to 1.03 because of the rise from last year. You are told that the budget deficit doubles as per cent of GDP (to 2 per cent) and nominal GDP growth shoots up to 4 per cent which means real GDP growth (given the inflation rate) is equal to 3 per cent.

The corresponding calculation for the change in the public debt ratio is:

Change in B/Y = (0 – 3)*1.03 + 2 = -1.1 per cent.

So the growth in the economy is strong enough to reduce the public debt ratio even though the primary budget deficit has doubled.

It is a highly stylised example truncated into a two-period adjustment to demonstrate the point. In the real world, if the budget deficit is a large percentage of GDP then it might take some years to start reducing the public debt ratio as GDP growth ensures.

So even with an increasing (or unchanged) deficit, real GDP growth can reduce the public debt ratio, which is what has happened many times in past history following economic slowdowns.

The best way to reduce the public debt ratio is to stop issuing debt. A sovereign government doesn’t have to issue debt if the central bank is happy to keep its target interest rate at zero or pay interest on excess reserves.

The discussion also demonstrates why tightening monetary policy makes it harder for the government to reduce the public debt ratio – which, of-course, is one of the more subtle mainstream ways to force the government to run surpluses.

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    19 Responses to Saturday Quiz – August 20, 2011 – answers and discussion

    1. Fed Up says:

      Q2 (&Q1 I think):

      “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).”

      What about raising the reserve requirement?

    2. Fed Up says:

      Q2 (&Q1 I think):

      “There is no difference to the impact of the deficits on net worth in the non-government sector.”

      Should that be in the present vs. possibly not in the future?

      I’d rather think about it this way. Apple saves $100 for one year in a checking account. The gov’t deficit spends $100 with no bond attached. At one year and one day, there could be $200 in circulation of medium of exchange. I assumed the fed funds rate went to zero and no other reactions to that. That is somewhat unrealistic, but trying to keep it simple.

      Apple saves $100 for one year in a checking account. The gov’t deficit spends $100 with a bond attached. Apple buys the bond. At one year and one day, there could be $100 in circulation of medium of exchange. I assumed both interest payments and principal payments on the gov’t bond to pay it off (no rollover risk). I ignored the interest payment transfer between borrower and lender.

      Notice the $200 vs. $100 in circulation of medium of exchange.

    3. Fed Up says:

      Q1 & Q2, do most people assume gov’t debt is less price inflationary in the future because they assume most instances of price deflation and/or negative real GDP growth are aggregate demand shocks?

    4. Andy says:

      Bill, I know you can be sneaky with your wording but it seems to me that, in Question 2, by your own explanation, the answer should be false. It is the deficit that increases non-government sector wealth not the matching of it with bonds.

    5. begruntled says:

      @Fed Up

      1. “What about raising the reserve requirement?”

      The government has no power to set the overal level of bank reserves independent of its spending, taxing, and borrowing.

      Reserves are created when the government spends money, and destroyed when the government taxes or issues bonds. The private sector (including the banks) has no power to change the overal level of reserves (except by sticking suitcases of money under one’s mattress) since any time you make a withdrawal to buy something, the seller has no choice but to deposit the money you gave them in a bank, and hence straight back into the total reserves. Attempting to legislate something that people have no control over is pointless.

      The government can (and does) legislate minimum per-bank reserve requirements, but this is only to keep the payments system running smoothly. Such legislation can only affect the distribution of reserves between banks and not their overal level. Consequently, such legislation could not affect aggregate demand even if bank lending was constrained by reserves, which it isn’t. Bank lending is constrained by the availability of credit-worthy borrowers, and by the capital-qualiy requirements of the Basel Accords.

      2. “Notice the $200 vs. $100 in circulation of medium of exchange.”

      The quantity of the medium of exchange in circulation has no effect on anything whatsoever. For MMTers, this is a statement of fact based on historical analysis, and theoretical models that claim that it should when it clearly doesn’t ( “QV=MP”. “rational expectations”, “loanable funds”) are just so much hot air.

      This is not to say that government actions cannot produce inflation or other effects; of course they can. It is just that it isn’t the “quantity of the medium of exchange” that matters. For example, inflation occurs when a government through its net spending adds more to aggregate demand than the economy can expand to produce, regardless of the ‘quantity’ of money around.

      You are of course free to disagree with this or any other assertion of historical fact, but you need to then provide an explanation for why the historical record supports it so strongly. Purely theoretical justifications for why the facts should be other than what they are are not very interesting.

      3. ‘funding deficits with debt issuing is less inflationary in the future”

      The mainstream believes this on the basis of a plethora of elaborate and purely theoretical models that bluntly contradict the actual historical record, and range from the ridiculous to the truly bizzare.

      If you want, you can spend the time to come to grips with these models and pinpoint their errors, but I don’t reccomend it. Leave that neccessay but pointless work to poor suffering professional MMTers like Bill who are obliged to and at least get paid for it. Do something more productive instead – like watching Get Smart re-runs.

    6. begruntled says:

      @Andy

      The question is sneaky (although not by Bill’s standards) but quite correct. Consider the equivalent statement

      “When you eat too much food that you have stolen your weight rises”

      The stealing is irrelevant, but the assertion never claimed it was. It’s still true.

    7. Fed Up says:

      begruntled, so you are saying raising the reserve requirement (which might have to be by a lot) would not affect the fed funds rate and therefore the demand for credit/debt?

      I’m not going thru the rest. Some of it I agree with. Some of it I don’t.

      I’d like to hear what bill has to say about it.

    8. begruntled says:

      @Fed Up

      More or less.

      The government cannot change the level of reserves by changing the reserve requirement. Doing so can only shift reserves around between banks, and would have no effect on interest rates.

      It may help to think of bank reserves as just cash (paper money) that banks are legally required to keep in their vaults. The government can require that banks each keep a certain amount in their vaults, but it cannot – except by printing more – change the total amount that is in all the vaults. The government prints money and spends it, at which point – apart from the tiny amount in your wallet – it sits in bank vaults – where we call it ‘reserves’ – until the government taxes or borrows it back. I like to think of my wallet as my own, personal ‘bank reserves’ account with the central bank, which in effect it is.

      The overal level of reserves is determined by the government’s spending, taxing, and borrowing. Assuming it didn’t change its spending and taxing, the only way the government could raise the level of reserves would be to buy its bonds back; the cash it printed to do so would become new reserves. By raising the demand for bonds this could be expected to raise their price, and consequently lower their rate of return; buying and selling bonds to preserve their market price at a chosen level is how the central bank sets the interest rate.

      So raising the level of bank reserves (by selling bonds, which is the only way to do so) would, in effect, mean lowering the fed rate. This is what is called ‘monetizing the debt’, or ‘quantative easing’.

    9. begruntled says:

      Last paragraph should have read “by buying bonds”, obviously :)

    10. begruntled says:

      It has just occurred to me that you might be thinking of the government setting a reserve requirement as a percentage of the banks deposits and at a level sufficient to be a constraint on the banks lending, like they once sort-of did (and as many economics textbooks still describe in their section on the ‘money multiplier’). Nobody does this anymore, but I suppose it could be re-introduced.

      In such a case, the government still couldn’t affect the level of reserves by setting the reserve requirement, but it could make the level of reserves a constraint on total bank lending. Such a regime would still have no effect on the fed rate (which is set by the government buying and selling of bonds), and I can’t see any reason it would affect interest rates in general, which would still be determined by the bank’s cost of funds. It might lead to banks being more careful in who they chose as borrowers, however!

    11. begruntled says:

      You’ve got me thinking here FedUp – thanks!

      I suppose a government could:

      1. Re-introduce a reserve requirment as a percentage of bank deposits
      2. Control the level of bank reserves by buying and selling bonds to keep reserves at a set level (and give up control over the federal interest rate)

      3. Choose a level of reserves (and a reserve requirement) that was such that they constrained bank lending to less than what eligible borrowers wanted to borrow.

      In such a scenario – far, far different to the world we live in – I imagine something like this would happen

      1. Because of the limited availability of bank credit, bank lending rates would rise to whatever level the economy could withstand (ie at whatever level there were still credit-worthy risks to take).
      2. Competing for depositors (to gain reserves and allow them to make more highly profitable loans) bank interest on savings would rise to almost the level of lending rates.
      3. Asset prices would collapse (real estate, shares) since everyone would want their money in those high-return savings accounts and not in anything real.
      4. If the government wanted to issue bonds it would have to offer a return (the fed rate) at least equal to what the banks did.

      This would continue until the economy collapsed, there were no longer borrowers who were a good risk for banks to take, and the reserve requirements stopped being a constraint on bank lending. Or, more likely, the government got voted out by irate home owners who couldn’t afford their mortgages anymore. I suspect that is why governments don’t adopt such a policy!

    12. Fed Up says:

      begruntled, I was thinking that raising the reserve requirement (on bank deposits) would convert excess reserves to required reserves. Depending on conditions, that could affect the fed funds rate (raise it) and therefore other interest rates.

    13. begruntled says:

      @FedUp

      I don’t see that there is any meaningful difference between ‘excess reserves’ and ‘required reserves’, and no reason why making reserves that a bank already has ‘required’ would affect interest rates. Let me try and give an example.

      For simplicity, imagine there were just have two banks with reserve accounts, A and B. A has $100 in reserves, and B has $200. Lets say the reserve requirement for each bank is $50.
      A B
      Req 50 50
      Exc 50 150

      What happens if we raise the reserve requirement? The total level of reserves – $300 – can only change if the government changes its spending, taxing or borrowing, so that will stay the same. Lets say the government raises it to $100
      A B
      Req 100 100
      Exc 0 100

      Nobody needs to do anything. Now lets say the government raised it to $150. Bank A doesnt have enough, so it will nip over to bank B and borrow $50. Bank B isn’t earning any interest on its reserves, so it is quite happy to lend them. The situation is now

      Req 150 150
      Exc 0 0
      Loans (50) 50

      Now what if the government raised the requirement to $200? Basically the banks are stuffed – there is nowhere to get more reserves from (by definition nobody else has a reserve account), and there aren’t enough reserves for both banks to meet the requirement. If the government attempted to prosecute them for ‘failing to meet the reserve requirements’ they would be well able to argue in court “But it’s impossible to do so!”

      Do you see what I mean about the reserve requirement just shifting reserves around?

    14. Fed Up says:

      “Now what if the government raised the requirement to $200? Basically the banks are stuffed – there is nowhere to get more reserves from (by definition nobody else has a reserve account), and there aren’t enough reserves for both banks to meet the requirement. If the government attempted to prosecute them for ‘failing to meet the reserve requirements’ they would be well able to argue in court “But it’s impossible to do so!””

      That shortage of (central bank) reserves would show up in the fed funds market as a rising fed funds rate. One thing that could happen is that the central bank can now supply (central bank) reserves at the price (interest rate) it wants. Therefore, they “regain” control of the fed funds rate at the higher rate they want.

    15. begruntled says:

      Aha! I think I get where you are coming from.

      But the government doesn’t want to raise the interest rate; in fact it has set it to an all-time low. It does this by buying bonds whenever the rate goes up, and can do so – and achieve any (non-negative) interest rate it wants – regardless of what the demand for reserves (or bonds) is, simply by changing how many bonds it buys and sells.

      Another way of thinking of bank reserves is that they are just treasury bonds with a 0% interest rate. So what your suggestion (I think) really amounts to is that the government could, for a given desired non-zero fed rate, incur a lower interest bill by legally requiring some people (in this case banks) to purchase a given quantity of 0% bonds, regardless of what the actual market rate was. This is quite true, and is not a bad way of making the point that the governments choice to pay ‘interest’ on its debt is essentially voluntary.

      The government can, of course, stop paying interest on its ‘debt’ simply by printing money. But your suggestion is an intriguing way of maintaining a non-zero fed rate while not actually paying any interest. However I think the banks might complain – why, they would say, do we have to buy interest-free bonds when other people can buy interest-bearing ones? And I suspect there would be all sorts of unpleasant side effects.

      In general, however, the challange for governments is to lower the interest rate, not raise it. This was one of Keynes’s fundamental points; the market tends to set interest rates too high, not too low..

    16. Fed Up says:

      begruntled said: “But your suggestion is an intriguing way of maintaining a non-zero fed rate while not actually paying any interest.”

      Which was the whole point of asking why not raise the reserve requirement. It seems to me that is possible.

      And, “However I think the banks might complain – why, they would say, do we have to buy interest-free bonds when other people can buy interest-bearing ones?”

      It seems to me that is true. I can just hear jamie dimon complaining at a fed press conference about that lowering his bank’s profitability and that constraining lending.

    17. Frank Restly says:

      “Inflation is caused by aggregate demand growing faster than real output capacity. The reserve position of the banks is not functionally related with that process.”

      Inflation (defined as a rise in the price level) is not caused by excess aggregate demand. If that were the case then interest rate increases coupled with budget deficits would make the inflation problem worse instead of better.

      Inflation is caused by the non-productive use of debt. This is why wars tend to be inflationary – because governments fail to raise taxes to pay its employees to embark on a destructive endeavor. Instead they turn to the monetary authority to chip in.

    18. bill says:

      Dear Frank (at 2011/09/03 at 13:53)

      Inflation is not a rise in the price level. Inflation is the continuous rise in the price level. A once-off increase in the price level is not inflation.

      We should get our definitions correct before we start making assertions.

      best wishes
      bill

    19. Frank Restly says:

      From the description above:

      “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.”

      But the commercial banks net position would be zero in this case because the current and future value of its assets and liabilities would always be equal. What you failed to include is that no commercial bank would participate in this arrangement because it would be nonprofitable.

      In the case of bond issuance, as long as the yield curve is sloped positively, a commercial bank can borrow short from the fed’s discount window (or from noninterest bearing deposits) to buy longer dated debt and pocket the difference.

      The U. S. Treasury does not issue debt for the explicit reason of maintaining an interest rate target. If they did then they would never need to issue marketable debt and there would be no reason for federal reserve open market operations. The U. S. Treasury sells debt to finance the budget deficit. The federal reserve does not require marketable government debt to hit an interest rate target. They could just as easily announce what the discount window rate is going to be without any buying or selling of liabilities (government or otherwise).

      Also, on inflation:

      “Funding deficits with debt issuing is less inflationary in the future: The mainstream believes this on the basis of a plethora of elaborate and purely theoretical models that bluntly contradict the actual historical record, and range from the ridiculous to the truly bizzare.”

      From the equation of exchange:

      Debt * Velocity = Real GDP * (1 + Inflation Rate)
      Productivity = Real GDP / Debt

      If we let productivity and velocity be our exogenous variables
      Inflation Rate = Velocity / Productivity – 1

      And so inflation is caused by productivity not growing as fast as money velocity. Why might that happen? Because a government or an individual enterprise (or both) may decide that non-productive ventures (like wars and commodity speculation both financed with debt) are “good ideas”.

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