Saturday Quiz – January 18, 2014 – 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:

Start from a situation where the external balance is the equivalent of 2 per cent of GDP and the budget surplus is 2 per cent. If the budget balance stays constant and the external balance rises to the equivalent of 4 per cent of GDP then:

(a) National income rises and the private surplus moves from 4 per cent of GDP to 6 per cent of GDP.

(b) National income remains unchanged and the private surplus moves from 4 per cent of GDP to 6 per cent of GDP.

(c) National income falls and the private surplus moves from 4 per cent of GDP to 6 per cent of GDP.

(d) National income rises and the private surplus moves from 0 per cent of GDP to 2 per cent of GDP.

(e) National income remains unchanged and the private surplus moves from 0 per cent of GDP to 2 per cent of GDP

(f) National income falls and the private surplus moves from 0 per cent of GDP to 2 per cent of GDP.

The answer is Option (d) National income rises and the private surplus moves from 0 per cent of GDP to 2 per cent of GDP.

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.

We know that from an accounting sense, if the external sector overall is in deficit, then it is impossible for both the private domestic sector and government sector to run surpluses. One of those two has to also be in deficit to satisfy the accounting rules.

The important point is to understand what behaviour and economic adjustments drive these outcomes.

So here is the accounting (again). 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. The sectoral balances derived are:

  • The private domestic balance (I – S) – positive if in deficit, negative if in surplus.
  • The government deficit (G – T) – negative if in surplus, positive 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.

A simplification is to add (I – S) + (X – M) and call it the non-government sector. Then you get the basic result that the government balance equals exactly $-for-$ (absolutely or as a per cent of GDP) the non-government balance (the sum of the private domestic and external balances).

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

Consider the following graph and accompanying table which depicts two periods outlined in the question.

In Period 1, with an external surplus of 2 per cent of GDP and a government surplus of 2 per cent of GDP the private domestic balance is zero. The demand injection from the external sector is exactly offset by the demand drain (the fiscal drag) coming from the government balance and so the private sector can neither net save or spend more than they earn.

In Period 2, with the external sector adding more to demand now – surplus equal to 4 per cent of GDP and the government balance unchanged (this is stylised – in the real world the government will certainly change), there is a stimulus to spending and national income would rise.

The rising national income also provides the capacity for the private sector to save overall and so they can now save 2 per cent of GDP.

The fiscal drag is overwhelmed by the rising net exports.

This is a highly stylised example and you could tell a myriad of stories that would be different in description but none that could alter the basic point.

If the drain on spending (from the public sector) is more than offset by an external demand injection, then GDP rises and the private sector overall saving increases.

If the drain on spending from the government balance outweighs the external injections into the spending stream then GDP falls (or growth is reduced) and the overall private balance would fall into deficit.

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

Question 2:

Assume a nation is running an external surplus equivalent to 2 per cent of GDP and the private domestic sector is currently saving overall 1 per cent of GDP. In this situation, the government must be running:

(a) A deficit equal to 1 per cent of GDP.

(b) A surplus equal to 1 per cent of GDP.

(c) A deficit equal to 3 per cent of GDP.

(d) A surplus equal to 3 per cent of GDP.

The answer is Option (b) – A surplus equal to 1 per cent of GDP.

Please refer to the explanation in Question 1 for the conceptual material required to understand this question and answer.

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

The following graph shows three situations where the external sector is in surplus of 2 per cent of GDP and the private domestic balance is in surplus of varying proportions of GDP (note I have written the government balance as (T – G).

In Period 1, the private domestic balance is in surplus (1 per cent of GDP) and the government balance is also in surplus (1 per cent of GDP). The net injection to demand from the external sector (equivalent to 2 per cent of GDP) is sufficient to “fund” the private saving drain from expenditure without compromising economic growth. The growth in income would also allow the government balance to be in surplus (via tax revenue).

In Period 2, the rise in private domestic saving drains extra aggregate demand and necessitates a more expansionary position from the government (relative to Period 1), which in this case manifests as a balanced government position.

Period 3, relates to the data presented in the question – an external surplus of 2 per cent of GDP and private domestic saving equal to 3 per cent of GDP. Now the demand injection from the external sector is being more than offset by the demand drain from private domestic saving. The income adjustments that would occur in this economy would then push the government balance into deficit of 1 per cent of GDP.

The movements in income associated with the spending and revenue patterns will ensure these balances arise.

The general rule is that the government deficit (surplus) will always equal the non-government surplus (deficit).

So if there is an external surplus that is greater than private domestic sector saving (a surplus) then there will always be a government surplus. Equally, the higher the private saving is relative to the external surplus, the larger the government deficit.

The following blogs may be of further interest to you:

Question 3:

Many progressive observers are demanding that bank lending should be more closely regulated to ensure that all bank loans were backed by reserves held at the bank. However, this would unnecessarily reduce the capacity of the banks to lend.

The answer is False.

In a “fractional reserve” banking system of the type the US runs (which is really one of the relics that remains from the gold standard/convertible currency era that ended in 1971), the banks have to retain a certain percentage (10 per cent currently in the US) of deposits as reserves with the central bank. You can read about the fractional reserve system from the Federal Point page maintained by the FRNY.

Where confusion as to the role of reserve requirements begins is when you open a mainstream economics textbooks and “learn” that the fractional reserve requirements provide the capacity through which the private banks can create money. The whole myth about the money multiplier is embedded in this erroneous conceptualisation of banking operations.

The FRNY educational material also perpetuates this myth. They say:

If the reserve requirement is 10%, for example, a bank that receives a $100 deposit may lend out $90 of that deposit. If the borrower then writes a check to someone who deposits the $90, the bank receiving that deposit can lend out $81. As the process continues, the banking system can expand the initial deposit of $100 into a maximum of $1,000 of money ($100+$90+81+$72.90+…=$1,000). In contrast, with a 20% reserve requirement, the banking system would be able to expand the initial $100 deposit into a maximum of $500 ($100+$80+$64+$51.20+…=$500). Thus, higher reserve requirements should result in reduced money creation and, in turn, in reduced economic activity.

This is not an accurate description of the way the banking system actually operates and the FRNY (for example) clearly knows their representation is stylised and inaccurate. Later in the same document they they qualify their depiction to the point of rendering the last paragraph irrelevant. After some minor technical points about which deposits count to the requirements, they say this:

Furthermore, the Federal Reserve operates in a way that permits banks to acquire the reserves they need to meet their requirements from the money market, so long as they are willing to pay the prevailing price (the federal funds rate) for borrowed reserves. Consequently, reserve requirements currently play a relatively limited role in money creation in the United States.

In other words, the required reserves play no role in the credit creation process.

The actual operations of the monetary system are described in this way. Banks seek to attract credit-worthy customers to which they can loan funds to and thereby make profit. What constitutes credit-worthiness varies over the business cycle and so lending standards become more lax at boom times as banks chase market share (this is one of Minsky’s drivers).

These loans are made independent of the banks’ reserve positions. Depending on the way the central bank accounts for commercial bank reserves, the latter will then seek funds to ensure they have the required reserves in the relevant accounting period. They can borrow from each other in the interbank market but if the system overall is short of reserves these “horizontal” transactions will not add the required reserves. In these cases, the bank will sell bonds back to the central bank or borrow outright through the device called the “discount window”.

At the individual bank level, certainly the “price of reserves” will play some role in the credit department’s decision to loan funds. But the reserve position per se will not matter. So as long as the margin between the return on the loan and the rate they would have to borrow from the central bank through the discount window is sufficient, the bank will lend.

So the idea that reserve balances are required initially to “finance” bank balance sheet expansion via rising excess reserves is inapplicable. A bank’s ability to expand its balance sheet is not constrained by the quantity of reserves it holds or any fractional reserve requirements. The bank expands its balance sheet by lending. Loans create deposits which are then backed by reserves after the fact. The process of extending loans (credit) which creates new bank liabilities is unrelated to the reserve position of the bank.

The major insight is that any balance sheet expansion which leaves a bank short of the required reserves may affect the return it can expect on the loan as a consequence of the “penalty” rate the central bank might exact through the discount window. But it will never impede the bank’s capacity to effect the loan in the first place.

The money multiplier myth leads students to think that as the central bank can control the monetary base then it can control the money supply. Further, given that inflation is allegedly the result of the money supply growing too fast then the blame is sheeted home to the “government” (the central bank in this case).

The reality is that the reserve requirements that might be in place at any point in time do not provide the central bank with a capacity to control the money supply.

So would it matter if reserve requirements were 100 per cent? In this blog – 100-percent reserve banking and state banks – I discuss the concept of a 100 per cent reserve system which is favoured by many conservatives who believe that the fractional reserve credit creation process is inevitably inflationary.

There are clearly an array of configurations of a 100 per cent reserve system in terms of what might count as reserves. For example, the system might require the reserves to be kept as gold. In the old “Giro” or “100 percent reserve” banking system which operated by people depositing “specie” (gold or silver) which then gave them access to bank notes issued up to the value of the assets deposited. Bank notes were then issued in a fixed rate against the specie and so the money supply could not increase without new specie being discovered.

Another option might be that all reserves should be in the form of government bonds, which would be virtually identical (in the sense of “fiat creations”) to the present system of central bank reserves.

While all these issues are interesting to explore in their own right, the question does not relate to these system requirements of this type. It was obvious that the question maintained a role for central bank (which would be unnecessary in a 100-per cent reserve system based on gold, for example.

It is also assumed that the reserves are of the form of current current central bank reserves with the only change being they should equal 100 per cent of deposits.

We also avoid complications like what deposits have to be backed by reserves and assume all deposits have to so backed.

In the current system, the the central bank ensures there are enough reserves to meet the needs generated by commercial bank deposit growth (that is, lending). As noted above, the required reserve ratio has no direct influence on credit growth. So it wouldn’t matter if the required reserves were 10 per cent, 0 per cent or 100 per cent.

In a fiat currency system, commercial banks require no reserves to expand credit. Even if the required reserves were 100 per cent, then with no other change in institutional structure or regulations, the central bank would still have to supply the reserves in line with deposit growth.

Now I noted that the central bank might be able to influence the behaviour of banks by imposing a penalty on the provision of reserves. It certainly can do that. As a monopolist, the central bank can set the price and supply whatever volume is required to the commercial banks.

But the price it sets will have implications for its ability to maintain the current policy interest rate which we consider in Question 3.

The central bank maintains its policy rate via open market operations. What really happens when an open market purchase (for example) is made is that the central bank adds reserves to the banking system. This will drive the interest rate down if the new reserve position is above the minimum desired by the banks. If the central bank wants to maintain control of the interest rate then it has to eliminate any efforts by the commercial banks in the overnight interbank market to eliminate excess reserves.

One way it can do this is by selling bonds back to the banks. The same would work in reverse if it was to try to contract the money supply (a la money multiplier logic) by selling government bonds.

The point is that the central bank cannot control the money supply in this way (or any other way) except to price the reserves at a level that might temper bank lending.

So if it set a price of reserves above the current policy rate (as a penalty) then the policy rate would lose traction for reasons explained in the answer to Question 3.

The fact is that it is endogenous changes in the money supply (driven by bank credit creation) that lead to changes in the monetary base (as the central bank adds or subtracts reserves to ensure the “price” of reserves is maintained at its policy-desired level). Exactly the opposite to that depicted in the mainstream money multiplier model.

The other fact is that the money supply is endogenously generated by the horizontal credit (leveraging) activities conducted by banks, firms, investors etc – the central bank is not involved at this level of activity.

You might like to read these blogs for further information:

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    13 Responses to Saturday Quiz – January 18, 2014 – answers and discussion

    1. KongKing says:

      A 100% reserve requirement would reduce the capacity of deposit banks to lend. Their lending capacity woud be reduced to ZERO. So the correct answer must be TRUE, ignoring the word “unnecessarily” in the question.

      However, the question asked is whether a 100% reserve requirement “would UNNECESSARILY reduce the capacity of the banks to lend”.
      It is unclear to me what this wording means or how it changes the answer to “false”.

    2. Neil Wilson says:

      “A 100% reserve requirement would reduce the capacity of deposit banks to lend. ”

      No it wouldn’t. That is a static analysis of the situation that presume that there is some entity there that stops the banks from lending ahead of getting the deposits – and that lending happens at one particular instant in time. Neither are the case in the real world.

      Any individual bank can line up the offers to lend and then offer a slightly higher deposit rate to attract the necessary deposits to square the book on the day of advance. That then makes the shortage of deposits some other bank’s problem – which the central bank would then have to accommodate to prevent the payment system/the weakest bank going boom every two minutes.

      You cannot stop a bank lending first in any design. Loans before deposits is inherent in the nature of the accounting systems.

    3. hamstray says:

      doesn’t a 100% reserve requirement simply mean eliminating the discount window altogether, and instead force banks to default?

    4. KongKing says:

      @ Neil Wilson.
      I think your comment assumes a situation like today with a fractional reserve requirement of less tha 100%, which is irrelevant to the question here.

      100% reserve requirement would be radically different.
      By law there could be obsolutely ZERO lending or money creation by deposit banks.
      How could a bank lend to the public if all deposits received have to be kept as reserves?

    5. Alan Dunn says:

      KongKing is assuming that deposits create loans.

      Neil Wilson has demonstrated that this is not the case.

      Loans create deposits.

    6. Neil Wilson says:

      “How could a bank lend to the public if all deposits received have to be kept as reserves?”

      The advance is just the end of the lending process, not the beginning.

      Lending doesn’t happen in an instant. It is a long process, that allows the Treasury department of a strong bank to line up the strategy to backfill on deposits, etc ahead of time.

      A bank then makes an advance and then nicks the backfill deposits and capital from a weaker bank. The system is now short of reserves, but it isn’t the strong bank-that-made-the-loan’s problem. What happens now is a chase up of interest rates until either a bank goes bust, sufficient loans are called in, or the central system relents and provides the additional reserves to protect the payment system and steady the churn of interest rates in the economy.

      In other words exactly how it works now – just with bigger numbers and Volker style volatility caused by once again trying to control quantity rather than price.

      Trying to turn banks into old style per-computerised building societies is like trying to un-invent nuclear weapons. You can’t do it. There is no way you can enforce what you want – serialising of deposits before lending – because we have the computers and the asynchronous systems that allow a more profitable alternative that would be entirely within any enforceable ruleset you can come up with.

      Sorry to pop your bubble.

    7. KongKing says:

      @ Neil Wlson
      Very many thanks for popping my bubble.

      What you say strictly violates assumption of 100% reserve backing for deposits. You say:
      “A bank then makes an advance and then nicks the backfill deposits and capital from a weaker bank “.
      i.e you assume banks would continue to be allowed to make loans and create deposits WITHOUT reserve backing.
      This state might only persist for a few seconds if the bank has access to funds which it can borrow. But in that brief interlude, the deposits were NOT 100% covered.

      But I guess that you are right, that’s how a 100% reserve regime would work in practice – the reserve requirement would be enforced at the end of a day, week or month, not at every instant in time.

      It seems to me that this doesn’t merely pop my bubble, it also explodes the arguments of ‘Positive Money’ and other 100% reserve advocates.

    8. Ben Johannson says:

      @KongKing,

      Banks don’t need reserves to make a loan. If they find a creditworthy customer they simply create a deposit for them. After the loan is made the bank will assess its reserve balances; if it finds its reserves insufficient under any requirement, whether 10% or 100%, it will then get the reserves either from a bank which has more than it needs or from the central bank itself. The CB is obligated to supply the reserves or it will lose control of the short-term interest rate, so increasing reserve requirements doesn’t change the process one bit.

    9. Neil Wilson says:

      “This state might only persist for a few seconds if the bank has access to funds which it can borrow. ”

      More important is the ability to push the issue onto another financial institution. Very difficult to differentiate expansion from ‘competition’.

      This has of course happened before. Traditional British building societies (those without central bank accounts) were essentially ’100%’ institutions, and those that discovered sophisticated financial techniques first (e.g. Halifax – where I live) became big as they drained the life-force (deposits and capital bonds) from those that were not so quick off the mark.

      The result was mergers, failures and ever growing concentration of the market – before they all converted to banks, got a central bank account and blew themselves up.

    10. Dirk says:

      I think question 1 is open to discussion:

      “In Period 2, with the external sector adding more to demand now – surplus equal to 4 per cent of GDP and the government balance unchanged (this is stylised – in the real world the government will certainly change), there is a stimulus to spending and national income would rise.”

      Who says the external sector is adding more demand? The external surplus might have widened because imports fell. The text just reads:

      “If the budget balance stays constant and the external balance rises to the equivalent of 4 per cent of GDP then:”

      The whole adjustment process might have led to lower GDP if falling imports are behind the rise in the external balance. Or do I miss something?

    11. Alan Dunn says:

      “The whole adjustment process might have led to lower GDP if falling imports are behind the rise in the external balance. Or do I miss something?”

      Changes in the net income component of the current account dwarf changes in net imports.

      Unfortunately, writing the external account as (X-M) is a little misleading when:

      Current Account = (Net exports) + Net income + net current transfers.

    12. Neil,

      You claim “There is no way you can enforce what you want..” without explaining why the Positive Money / Milton Friedman / Lawrence Kotlikoff system fails to “get what it wants”. Plus you contradict yourself by saying (correctly) that under the PM/MF/LK system, bank lending is controlled by quantity whereas under the existing system, lending is controlled by price. I.e. you admit that lending IS CONTROLLED under the PM/MF/LK system.

      Plus there is actually a whapping great difference between the latter system and the existing system. And that’s that under the Friedman and Kotlikoff system it’s virtually impossible for a commercial bank to suddenly go bust. Ergo there is no need for TBTF or other bank subsidies.

      Positive Money’s system is very similar to Friedman and Kotlikoff’s, but PM’s system does allow banks to go bust, while (in common with F&K’s system) taxpayers don’t pay any sort of bill when a bank goes bust. Frankly I can’t see the point of that aspect of PM’s system. That is, I think PM’s system should be tweeked so that banks can’t go bust.

    13. Neil Wilson says:

      “Plus you contradict yourself”

      No I don’t Ralph. You just have your filter on as usual and completely miss the point.

      Endogenous money is the way things work, and you can’t turn it off.

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