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Saturday Quiz – August 15, 2015 – 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:

Assume a nation is running an external surplus equivalent to 2 per cent of GDP and the government manages to run a fiscal surplus equivalent to 1 per cent of GDP (taxes greater than spending). The national income changes associated with these balances would ensure that the private domestic sector was running an overall deficit of 1 per cent of GDP.

The answer is False.

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 Budget 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.

So 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 (note I have written the fiscal balance as (T – G).

The data in Period 1 describes the situation outlined in the question. You will note that with the government fiscal balance in surplus (of 1 per cent of GDP) the private domestic balance is 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 fiscal 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 public fiscal balance.

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 fiscal 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 fiscal 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 fiscal surplus. Equally, the higher the private saving is relative to the external surplus, the larger the fiscal deficit.

The following blogs may be of further interest to you:

Question 2:

Starting from the external situation in Question 1, with the surplus being the equivalent of 2 per cent of GDP but this time the fiscal surplus is currently 2 per cent of GDP. If the fiscal balance stays constant and the external surplus rises to the equivalent of 4 per cent of GDP then you can conclude that national income also rises and the private surplus moves from minus 2 per cent of GDP to plus 2 per cent of GDP.

The answer is False.

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

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 fiscal 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 fiscal balance and so the private sector can neither net save overall nor spend more than its earns. So the starting position for the private domestic sector is a balanced state.

In Period 2, with the external sector adding more to demand now – surplus equal to 4 per cent of GDP and the fiscal balance unchanged (this is stylised – in the real world the fiscal balance 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. Please note the difference between saving and saving overall.

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 fiscal 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 3:

If all bank loans had to be backed by reserves held at the bank (a 100 per cent reserve requirement) then the capacity of the banks to lend would be more constrained which would help maintain financial stability.

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 hometo 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 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.

You might like to read these blogs for further information:

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    This Post Has 9 Comments
    1. Would you mind if I go a little off topic and ask a question.
      I know that you are interested in Jeremy Corbyns campaign but are concerned about his neoliberal “need to reduce the deficit.” I understand why but I wondered if you could comment on another aspect of Jeremy’s manifesto called “Green Quantitative Easing.”
      It appears to involve the Bank of England buying debt issued by the government or other bodies using money that it creates. It I believe also involves a natioanl investment bank. I am not sure if this is the same as OMF.
      I am not sure if the Lisbon Treaty would cause any problems here as it restricts the buying of Government debt, and the UK is a signatory to this.

    2. I got 3/3 for the fourth week running but all for the wrong reasons this time. But I am learning it all that’s for sure as I used to get 1/3 all of the time.

      These sectoral balances are a nightmare to understand I would probably need to sit down with a professor on a one to one basis to get it.

      I always thought the 3 sectors had to balance to zero.

      Q1.

      An external surplus equivalent to +2% of GDP

      Fiscal surplus of +1% of GDP

      I Would have thought would have made the non govermental sector a defict of -3% of GDP

      Q2.

      An external surplus equivalent to +2% of GDP

      Fiscal surplus of +2% of GDP

      Would make the non govermental sector -4% of GDP

      If the external surplus rises to +4% of GDP

      Would make the non govermental sector -6% of GDP

      Why I got it so wrong but got the right answer is because of the behavioural relationships within and between these sectors.

      I’m afraid I’ll never understand that if I live to 100.

      Also, you can never see these sectoral balances in real time as they get produced every quarter so there is always a 3 month lag. Add to the mix the effects the automatic stabalisers have on them and I’m not sure if they are worth anything at all. Or maybe it’s because I am sick to the back teeth of not getting them that I See them this way.

      If MMT was just about these balances I would have gave up a long time ago.

      After all this time the only thing they’ve taught me is budget surpluses are bad under certain conditions.

    3. Derek:
      An “external surplus” really means the external sector’s deficit (in other words, the surplus from the perspective of the domestic sectors). So if the external surplus is +2 then the external sector has a surplus of -2, or a deficit of +2.
      As we know the sectoral balances add up to 0:
      Government surplus (1) + Private domestic surplus (P) + External sector’s surplus (-2) = 0
      (1) + P + (-2) = 0
      P + 1 – 2 = 0
      P – 1 = 0
      P = +1

      Question 2 should be clearer as well when you understand that “external surplus” means a negative fiscal balance from the external sector’s perspective.

    4. The answer to Q3 is TRUE, contrary to the “explanation” given above. The explanation given above is based on a misunderstand of proposals for 100% reserve banking.

      First note there is a slip in the wording of the question. The question suggests that a 100 per cent reserve requirement requires that “all bank loans had to be backed by reserves”.
      However, reserve requirements usually relate to bank deposits, not loans. So with 100% reserve requirement, banks would no longer be allowed lend deposits – all deposits would have to be “invested” as reserves at the Central Bank (and maybe also in other approved safe securities, e.g. short term tresury bills).
      Bank deposits relevant to the reserve requirement would include all deposits which banks are obliged to repay on demand (and possibly also some other liabilities which are repayable a very short notice).

      This slip in the wording of the question is not the reason why the purported answer is wrong.
      The error arises from failure to realise that 100% reserve requirement would in effect distinguish two types of bank (or two separate types of banking activity), namely deposit-taking banks and risk-taking investment banks.
      The former would no longer make any loans. So all the analysis regarding the current system in the “explanation” above regarding how loans are financed and how money is created by banks , would no longer apply with 100% reserve banking.

      With 100% reserve banking loans would no longer be made by deposit-taking banks. However loans would still be available from various other financial companies, e.g. investment banks, mutual funds, loan companies, etc. These would quickly adapt and expand to provide the loans currently provided by banks. They would get their finance (equity and debt) from domestic private sector savings (from individuals and companies), and also from foreign funds. The latter in particular would ensure that the supply of loans for worthwhile projects would not dry up and hamper economic growth.

      The risk-taking investment banking sector would no longer be financed or subsidised by the government. Unlike the current system, there would be no need for the Government to ensure the stability of the payments system by providing deposit insurance, lender of last resort facilities, and in more extreme cases bailout facilities for too-big-to-fail financial institutions.

      Possibly there is a hidden assumption in the “explanation” above that failing or illiquid investment banks would still be able get finance from the government.
      If this happened the system might revert to a version of the existing system where “loans create deposits”.
      However, this is certainly not part of any of the schemes that have been proposed for 100% reserve banking.

    5. Dear Kingsley Lewis (at 2015/08/16 at 12:31)

      I am sorry to say that you cannot redefine the question to suit yourself and then make up a story that fits.

      The answer to the question as posed and understood is False.

      best wishes and thanks for your continual sniping
      bill

    6. To Derek Henry

      The clue to your difficulty is, I think, centred around this part:
      (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 Budget 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.

      We talk about surpluses and deficits, but to use the formula, you need to ensure you have the correct idea of the meaning in terms whether it is a positive or negative in the formula. Try writing out thee formula and then copying the above meanings down against each individual term.
      Hope this helps

    7. Sandra Crawford.

      I’m sorry, but I doubt if Bill will respond to your query as he is a very busy man. In fact I don’t know how he does it.

      My view is that the idea of “Green Quantitative Easing” is just a political gimmick. As someone who understands (mostly) MMT, I don’t consider it to be of much relevance. If the government wants to promote council house building all it needs to do is to provide local authorities with the funds to do so simply by using its money-creation powers (via the BoE). What you call it is just semantics and political posturing.

      Bill appears to support Corbyn, but I’m afraid I don’t. His proposals are all very laudible, but none of it is properly thought through. I particularly disagree with his intention to withdraw from NATO. As for Trident, I’m not particulaly bothered whether we have it or not. Cancelling, again as we know from MMT, will not suddenly release a pot of money for other purposes – the money is there anyway or not depending on government policy.

      Maybe I’ll change my opinion when I have heard him speak on Thursday week.

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