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Saturday Quiz – April 12, 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:

Ignoring political reality, the central bank in a currency-issuing nation could still increase interest rates even if the government instructed it to directly purchase treasury debt to facilitate the national government’s fiscal deficit.

The answer is True.

Note the question is not asking whether it is politically possible for such a government to do this. We are assuming that if it desired to go down this path then the legislative and regulative changes that might be necessary could be achieved.

The question hinges on an unstated condition which relates to whether the central bank is offering a support rate on overnight reserves held with it by the private banks.

So what is the explanation?

The central bank conducts what are called liquidity management operations for two reasons. First, it has to ensure that all private cheques (that are funded) clear and other interbank transactions occur smoothly as part of its role of maintaining financial stability. Second, it must maintain aggregate bank reserves at a level that is consistent with its target policy setting given the relationship between the two.

So operating factors link the level of reserves to the monetary policy setting under certain circumstances. These circumstances require that the return on “excess” reserves held by the banks is below the monetary policy target rate. In addition to setting a lending rate (discount rate), the central bank also sets a support rate which is paid on commercial bank reserves held by the central bank.

Commercial banks maintain accounts with the central bank which permit reserves to be managed and also the clearing system to operate smoothly. In addition to setting a lending rate (discount rate), the central bank also can set a support rate which is paid on commercial bank reserves held by the central bank (which might be zero).

Many countries (such as Australia, Canada and zones such as the European Monetary Union) maintain a default return on surplus reserve accounts (for example, the Reserve Bank of Australia pays a default return equal to 25 basis points less than the overnight rate on surplus Exchange Settlement accounts). Other countries like Japan and the US have typically not offered a return on reserves until the onset of the current crisis.

If the support rate is zero then persistent excess liquidity in the cash system (excess reserves) will instigate dynamic forces which would drive the short-term interest rate to zero unless the government sells bonds (or raises taxes). This support rate becomes the interest-rate floor for the economy.

The short-run or operational target interest rate, which represents the current monetary policy stance, is set by the central bank between the discount and support rate. This effectively creates a corridor or a spread within which the short-term interest rates can fluctuate with liquidity variability. It is this spread that the central bank manages in its daily operations.

In most nations, commercial banks by law have to maintain positive reserve balances at the central bank, accumulated over some specified period. At the end of each day commercial banks have to appraise the status of their reserve accounts. Those that are in deficit can borrow the required funds from the central bank at the discount rate.

Alternatively banks with excess reserves are faced with earning the support rate which is below the current market rate of interest on overnight funds if they do nothing. Clearly it is profitable for banks with excess funds to lend to banks with deficits at market rates. Competition between banks with excess reserves for custom puts downward pressure on the short-term interest rate (overnight funds rate) and depending on the state of overall liquidity may drive the interbank rate down below the operational target interest rate. When the system is in surplus overall this competition would drive the rate down to the support rate.

The main instrument of this liquidity management is through open market operations, that is, buying and selling government debt. When the competitive pressures in the overnight funds market drives the interbank rate below the desired target rate, the central bank drains liquidity by selling government debt. This open market intervention therefore will result in a higher value for the overnight rate. Importantly, we characterise the debt-issuance as a monetary policy operation designed to provide interest-rate maintenance. This is in stark contrast to orthodox theory which asserts that debt-issuance is an aspect of fiscal policy and is required to finance deficit spending.

So the fundamental principles that arise in a fiat monetary system which are relevant here 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, debt is issued as an interest-maintenance strategy by the central bank. It has no correspondence with any need to fund government spending. Debt might also be issued if the government wants the private sector to have less purchasing power.

Further, the idea that governments would simply get the central bank to “monetise” treasury debt (which is seen orthodox economists as the alternative “financing” method for government spending) is highly misleading. Debt monetisation is usually referred to as a process whereby the central bank buys government bonds directly from the treasury.

In other words, the federal government borrows money from the central bank rather than the public. Debt monetisation is the process usually implied when a government is said to be printing money. Debt monetisation, all else equal, is said to increase the money supply and can lead to severe inflation.

However, as long as the central bank has a mandate to maintain a target short-term interest rate, the size of its purchases and sales of government debt are not discretionary unless it is prepared to offer a support rate to the banks for excess reserves held. In the absence of that offer, 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 under these circumstances (no support rate). The central bank is unable to monetise the federal debt by purchasing government securities at will because to do so would cause the short-term target rate to fall to zero or to the support rate. If the central bank purchased securities directly from the treasury and the treasury then spent the money, its expenditures would be excess reserves in the banking system. The central bank would be forced to sell an equal amount of securities to support the target interest rate.

The central bank would act only as an intermediary. The central bank would be buying securities from the treasury and selling them to the public. No monetisation would occur.

However, the central bank may agree to pay the short-term interest rate to banks who hold excess overnight reserves. This would eliminate the need by the commercial banks to access the interbank market to get rid of any excess reserves and would allow the central bank to maintain its target interest rate without issuing debt.

The following blogs may be of further interest to you:

Question 2:

If a nation is earning less than it is spending with respect to its transactions with the rest of the world and household saving suddenly increases as a proportion of disposable income, then the government could still run its current surplus without a decline in output and income occurring.

The answer is True.

This question tests one’s basic understanding of the sectoral balances that can be derived from the National Accounts. The secret to getting the correct answer is to realise that the household saving ratio is not the overall sectoral balance for the private domestic sector.

In other words, if you just compared the household saving ratio with the external deficit and the fiscal balance you would be leaving an essential component of the private domestic balance out – private capital formation (investment).

Further, if a nation is earning less than it is spending with respect to its transactions with the rest of the world, it will be running an external (or current account) deficit on its Balance of Payments.

To understand that, in macroeconomics we have a way of looking at the national accounts (the expenditure and income data) which allows us to highlight the various sectors – the government sector and the non-government sector (and the important sub-sectors within the non-government sector).

So we start by focusing on the final expenditure components of consumption (C), investment (I), government spending (G), and net exports (exports minus imports) (NX).

The basic aggregate demand equation in terms of the sources of spending is:

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).

In terms of the uses that national income (GDP) can be put too, we say:

GDP = C + S + T

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

So if we equate these two ideas sources of GDP and uses of GDP, we get:

C + S + T = C + I + G + (X – M)

Which we then can simplify by cancelling out the C from both sides and re-arranging (shifting things around but still satisfying the rules of algebra) into what we call the sectoral balances view of the national accounts.

There are three sectoral balances derived – the Budget Deficit (G – T), the Current Account balance (X – M) and the private domestic balance (S – I).

These balances are usually expressed as a per cent of GDP but we just keep them in $ values here:

(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.

You can then manipulate these balances to tell stories about what is going on in a country.

For example, when an external deficit (X – M < 0) and a public surplus (G – T < 0) coincide, there must be a private deficit. So if X = 10 and M = 20, X - M = -10 (a current account deficit assuming the invisibles are zero). Also if G = 20 and T = 30, G - T = -10 (a fiscal surplus). So the right-hand side of the sectoral balances equation will equal (20 - 30) + (10 - 20) = -20. As a matter of accounting then (S - I) = -20 which means that the domestic private sector is spending more than they are earning because I > S by 20 (whatever $ units we like). So the fiscal drag from the public sector is coinciding with an influx of net savings from the external sector. 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. It is an unsustainable growth path.

So if a nation usually has a current account deficit (X – M < 0) then if the private domestic sector is to net save (S - I) > 0, then the public fiscal deficit has to be large enough to offset the current account deficit. Say, (X – M) = -20 (as above). Then a fiscal balance (G – T = 0) will force the domestic private sector to spend more than they are earning (S – I) = -20. But a government deficit of 25 (for example, G = 55 and T = 30) will give a right-hand solution of (55 – 30) + (10 – 20) = 15. The domestic private sector can net save.

But if the external deficit is say -20 and the private domestic balance (S – I) is -20 then the government balance at that level of income would be zerp. So if households increased their saving and investment increased by more than that, the income level could remain unchanged yet the government balance would go into surplus.

So in focusing on the household saving ratio, the question was only referring to one component of the private domestic balance. Clearly in the case of the question, if private investment is strong enough to offset the household desire to increase saving (and withdraw from consumption) then no spending gap arises as households save more.

In the present situation in most countries, households have reduced the growth in consumption (as they have tried to repair overindebted balance sheets) at the same time that private investment has fallen dramatically.

As a consequence a major spending gap emerged that could only be filled in the short- to medium-term by government deficits if output growth was to remain intact. The reality is that the fiscal deficits were not large enough and so income adjustments (negative) occurred and this brought the sectoral balances in line at lower levels of economic activity.

The following blogs may be of further interest to you:

Question 3

A continuous fiscal deficit leads to public spending building up and an increase in the inflation risk faced by the economy.

The answer is False.

This question tests whether you understand that fiscal deficits are just the outcome of two flows which have a finite lifespan. Flows typically feed into stocks (increase or decrease them) and in the case of deficits, under current institutional arrangements, they increase public debt holdings.

So the expenditure impacts of deficit exhaust each period and underpin production and income generation and saving. Aggregate saving is also a flow but can add to stocks of financial assets when stored.

Under current institutional arrangements (where governments unnecessarily issue debt to match its net spending $-for-$) the deficits will also lead to a rise in the stock of public debt outstanding. But of-course, the increase in debt is not a consequence of any “financing” imperative for the government because a sovereign government is never revenue constrained being the monopoly issuer of the currency.

The point is that there is no inflation risk per se with continuous fiscal deficits. The only time inflation becomes a risk from the demand side if nominal spending outstrips the capacity of the real economy to expand output.

A continuously increasing fiscal deficit might create those conditions, but a correctly calibrated continuous fiscal deficit will not because it will be just filling the non-government spending gap.

The following blogs may be of further interest to you:

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