# Saturday Quiz – September 15, 2012 – answers and discussion

Here are the answers with discussion for yesterday’s quiz. The information provided should help you understand the reasoning behind the answers. 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:

National accounting rules dictate that a national government surplus equals a non-government deficit (and vice-versa). If a national government successfully achieves a budget surplus through an austerity program then the private domestic sector must be spending more than it is earning.

The point is that the non-government sector is not equivalent to the private domestic sector in the sectoral balance framework. We have to include the impact of the external sector.

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. The balances reflect the underlying economic behaviour in each sector which is interdependent – given this is a macroeconomic system we are considering.

To refresh your memory the balances are derived as follows. The basic income-expenditure model in macroeconomics can be viewed in (at least) two ways: (a) from the perspective of the sources of spending; and (b) from the perspective of the uses of the income produced. Bringing these two perspectives (of the same thing) together generates the sectoral balances.

From the sources perspective we write:

GDP = C + I + G + (X – M)

which says that total national income (GDP) is the sum of total final consumption spending (C), total private investment (I), total government spending (G) and net exports (X – M).

From the uses perspective, national income (GDP) can be used for:

GDP = C + S + T

which says that GDP (income) ultimately comes back to households who consume (C), save (S) or pay taxes (T) with it once all the distributions are made.

Equating these two perspectives we get:

C + S + T = GDP = C + I + G + (X – M)

So after simplification (but obeying the equation) we get the sectoral balances view of the national accounts.

(I – S) + (G – T) + (X – M) = 0

That is the three balances have to sum to zero.

You can also write this as:

(S – I) + (T – G) = (X – M)

Which gives an easier interpretation (especially in relation to this question).

The sectoral balances derived are:

• The private domestic balance (S – I) – positive if in surplus, negative if in deficit.
• The Budget balance (T – G) – positive if in surplus, negative if in deficit.
• The Current Account balance (X – M) – positive if in surplus, negative if in deficit.

These balances are usually expressed as a per cent of GDP but that doesn’t alter the accounting rules that they sum to zero, it just means the balance to GDP ratios sum to zero.

Using this version of the sectoral balance framework:

(S – I) + (T – G) = (X – M)

So the domestic balance (left-hand side) – which is the sum of the private domestic sector and the government sector equals the external balance.

For the left-hand side of the equation to be positive (that is, in surplus overall) and the individual sectoral components to be in surplus overall, the right-hand side has to be positive (that is, an external surplus) and of sufficient magnitude.

This is also a basic rule derived from the national accounts and has to apply at all times.

The following graph and accompanying table shows a 8-period sequence where for the first four years the nation is running an external deficit (2 per cent of GDP) and for the last four year the external sector is in surplus (2 per cent of GDP).

For the question to be true we should never see the government surplus (T – G > 0) and the private domestic surplus (S – I > 0) simultaneously occurring – which in the terms of the graph will be the green and navy bars being above the zero line together.

You see that in the first four periods that never occurs which tells you that when there is an external deficit (X – M < 0) the private domestic and government sectors cannot simultaneously run surpluses, no matter how hard they might try. The income adjustments will always force one or both of the sectors into deficit.

The sum of the private domestic surplus and government surplus has to equal the external surplus. So that condition defines the situations when the private domestic sector and the government sector can simultaneously spend less than they earn by drawing on the dis-saving of the foreign sector.

It is only in Period 5 that we see the condition satisfied (see red circle).

That is because the private and government balances (both surpluses) exactly equal the external surplus.

So if a national government was able to pursue an austerity program with a burgeoning external sector then the private domestic sector would be able to save overall (that is, spend less than they earn – which is not the same thing as the household sector saving from disposable income).

Going back to the sequence, if the private domestic sector tried to push for higher saving overall (say in Period 6), national income would fall (because overall spending fell) and the government surplus would vanish as the automatic stabilisers responded with lower tax revenue and higher welfare payments.

Periods 7 and 8 show what happens when the private domestic sector runs deficits with an external surplus. The combination of the external surplus and the private domestic deficit adding to demand drives the automatic stabilisers to push the government budget into further surplus as economic activity is high. But this growth scenario is unsustainable because it implies an increasing level of indebtedness overall for the private domestic sector which has finite limits. Eventually, that sector will seek to stabilise its balance sheet (which means households and firms will start to save overall). That would reduce domestic income and the budget would move back into deficit (or a smaller surplus) depending on the size of the external surplus.

So what is the economic understanding that underpin these different situations?

If the nation is running an external deficit it means that the contribution to aggregate demand from the external sector is negative – that is net drain of spending – dragging output down.

The external deficit also means that foreigners are increasing financial claims denominated in the local currency. Given that exports represent a real cost and imports a real benefit, the motivation for a nation running a net exports surplus (the exporting nation in this case) must be to accumulate financial claims (assets) denominated in the currency of the nation running the external deficit.

A fiscal surplus also means the government is spending less than it is “earning” and that puts a drag on aggregate demand and constrains the ability of the economy to grow.

In these circumstances, for income to be stable, the private domestic sector has to spend more than they earn.

You can see this by going back to the aggregate demand relations above. For those who like simple algebra we can manipulate the aggregate demand model to see this more clearly.

Y = GDP = C + I + G + (X – M)

which says that the total national income (Y or GDP) is the sum of total final consumption spending (C), total private investment (I), total government spending (G) and net exports (X – M).

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.

Only when the government budget deficit supports aggregate demand at income levels which permit the overall private domestic sector to save out of that income will the latter achieve its desired outcome. At this point, income and employment growth are maximised and private debt levels will be stable.

The following blogs may be of further interest to you:

Question 2:

If the stock of aggregate demand exceeds the capacity of the productive sector to respond by producing extra real goods and services then inflation is inevitable.

Spending definitely equals income and too much spending relative to the real capacity of the economy to absorb it will create inflation. But those facts do not relate to the point of the question, which is, in fact, a very easy test of the difference between flows and stocks.

All expenditure aggregates – such as government spending and investment spending are flows. They add up to total expenditure or aggregate demand which is also a flow rather than a stock. Aggregate demand (a flow) in any period and it jointly determines the flow of income and output in the same period (that is, GDP) (in partnership with aggregate supply).

So while flows can add to stock – for example, the flow of saving adds to wealth or the flow of investment adds to the stock of capital – flows can also be added together to form a “larger” flow.

For example, if you wanted to work out annual GDP from the quarterly national accounts you would sum the individual quarterly observations for the 12-month period of interest. Conversely, employment is a stock so if you wanted to create an annual employment time series you would average the individual quarterly observations for the 12-month period of interest.

The question thus tests the precision of language as they relate to economic concepts. Too often the language is loose and the concepts become confused as a result.

The following blog may be of further interest to you:

Question 3:

If a nation is running a current account deficit and the private domestic sector is saving overall, then national income adjustments will ensure the government budget is in surplus.

This question requires an understanding of the sectoral balances that can be derived from the National Accounts. But it also requires some understanding of the behavioural relationships within and between these sectors which generate the outcomes that are captured in the National Accounts and summarised by the sectoral balances – see Question 1 for derivation.

What economic behaviour might lead to the outcome specified in the question?

If the nation is running an external deficit it means that the contribution to aggregate demand from the external sector is negative – that is net drain of spending – dragging output down.

Assume, now that the private domestic sector (households and firms) seeks to increase its overall saving ratio (as a percentage of GDP). Consistent with this aspiration, households may cut back on consumption spending and save more out of disposable income while firms might cut back on investment spending. The immediate impact is that aggregate demand will fall and inventories will start to increase beyond the desired level of the firms.

The firms will soon react to the increased inventory holding costs and will start to cut back production. How quickly this happens depends on a number of factors including the pace and magnitude of the initial demand contraction. But if the households persist in trying to save more and consumption continues to lag, then soon enough the economy starts to contract – output, employment and income all fall.

The initial contraction in consumption multiplies through the expenditure system as workers who are laid off also lose income and their spending declines. This leads to further contractions.

The declining income leads to a number of consequences. Net exports improve as imports fall (less income) but the question clearly assumes that the external sector remains in deficit. Total saving actually starts to decline as income falls as does induced consumption.

So the initial discretionary decline in consumption is supplemented by the induced consumption falls driven by the multiplier process.

The decline in income then stifles firms’ investment plans – they become pessimistic of the chances of realising the output derived from augmented capacity and so aggregate demand plunges further. Both these effects push the private domestic balance further towards and eventually into surplus

With the economy in decline, tax revenue falls and welfare payments rise which push the public budget balance towards and eventually into deficit via the automatic stabilisers.

If the private sector persists in trying to increase its overall saving ratio then the contracting income will clearly push the budget into deficit.

So when there is an external deficit and the private domestic sector is spending less than it earns (ex post) then there will always be a budget deficit. Government attempts to avoid that will drive aggregate demand lower and their deficit higher.

The following blogs may be of further interest to you:

Question 4:

A central bank cannot simultaneously debt monetise a budget deficit (sell debt to the treasury) and maintain a positive short-term policy rate.

The ignoring specific legal considerations qualification refers to the fact that some legislatures have banned central banks from directly purchasing treasury debt as an ideological act to limit the possibilities available to government.

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.

• The central bank sets the short-term interest rate based on its policy aspirations.
• Government spending is independent of borrowing which the latter best thought of as coming after spending.
• Government spending provides the net financial assets (bank reserves) which ultimately represent the funds used by the non-government agents to purchase the debt.
• Budget deficits put downward pressure on interest rates contrary to the myths that appear in macroeconomic textbooks about ‘crowding out’.
• The “penalty for not borrowing” is that the interest rate will fall to the bottom of the “corridor” prevailing in the country which may be zero if the central bank does not offer a return on reserves.
• Government debt-issuance is a “monetary policy” operation rather than being intrinsic to fiscal policy, although in a modern monetary paradigm the distinctions between monetary and fiscal policy as traditionally defined are moot.

Accordingly, while a fiat-issuing government has no need to “fund” its spending, public debt still has to be sold to the private sector (to match the public deficit) as an interest-maintenance strategy.

This means that the idea that governments could 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 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:

Assume that the government increases spending by \$100 billion at the start of each year and maintains this policy for the next three years from now. Economists estimate the spending multiplier to be 2 and the impact is exhausted within each year (all induced consumption is completed within 12 months). The tax multiplier is estimated to be equal to 1 and the current average tax rate is equal to 25 per cent (so tax revenue rises by 25 cents for every extra dollar of GDP produced ). What is the cumulative impact of this fiscal expansion on GDP after three years?

(a) \$600 billion
(b) \$200 billion
(c) \$150 billion
(d) \$450 billion

In Year 1, government spending rises by \$100 billion, which leads to a total increase in GDP of \$200 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 \$600 billion.

It is true that total tax revenue rises by \$150 billion 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 \$150 billion from the \$600 billion to get answer (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.

Some might have just computed \$150 billion and said (c). Clearly, not correct.

Some might have thought it was a total injection of \$100 billion and multiplied that by 2 to get answer (b). Also, not correct.