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The Weekend Quiz – April 30-31, 2016 – answers and discussion

Here are the answers with discussion for the Weekend 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:

The National Accounts tell us that total spending is the sum of household consumption, private investment, government spending and net exports. To understand this in terms of a stock-flow consistent macroeconomics, where we have to always trace the impact of flows during a period on the relevant stocks at the end of the period, we would interpret the spending components as flows that add to the stock of aggregate demand (spending) which in turn impacts on the final production (Gross Domestic Product) and national income.

The answer is False.

This is 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 determines the flow of income and output in the same period (that is, GDP).

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, aggregate demand).

Question 2:

Imposing some positive minimum reserve requirements constrains the credit creation activities of the private banks relative to a situation where no requirements were set other than the rule that reserve balances could not be negative.

The answer is False.

While many nations do not have minimum reserve requirements other than reserve account balances at the central bank have to remain non-zero, other nations do persist in these gold standard artefacts. The ability of banks to expand credit is unchanged across either type of country.

These sorts of ‘restrictions’ were put in place to manage the liabilities side of the bank balance sheet in the belief that this would limit volume of credit issued.

It became apparent that in a fiat monetary system, the central bank cannot directly influence the growth of the money supply with or without positive reserve requirements and still ensure the financial system is stable.

The reality is that every central bank stands ready to provide reserves on demand to the commercial banking sector. Accordingly, the central bank effectively cannot control the reserves that are demanded but it can set the price.

However, given that monetary policy (mostly ignoring the current quantitative easing type initiatives) is conducted via the central bank setting a target overnight interest rate the central bank is really required to provide the reserves on demand at that target rate. If it doesn’t then it loses the ability to ensure that target rate is sustained each day.

Imagine the central bank tried to lend reserves to banks above the target rate. Immediately, banks with surplus reserves could lend above the target rate and below the rate the central bank was trying to lend at. This would lead to competitive pressures which would drive the overnight rate upwards and the central bank loses control of its monetary policy stance.

Every central bank conducts its liquidity management activities which allow it to maintain control of the target rate and therefore monetary policy with the knowledge of what the likely reserve demands of the banks will be each day. They take these factors into account when they employ repo lending or open market operations on a daily basis to manage the cash system and ensure they reach their desired target rate.

The details vary across countries (given different institutional arrangements relating to timing etc) but the operations are universal to central banking.

While admitting that the central bank will always provide reserves to the banks on demand, some will still try argue that by the capacity of the central bank to set the price of the reserves they provide ensures it can stifle bank lending by hiking the price it provides the reserves at.

The reality of central bank operations around the world is that this doesn’t happen. Central banks always provide the reserves at the target rate.

So as I have described often, commercial banks lend to credit-worthy customers and create deposits in the process. This is an on-going process throughout each day. A separate area in the bank manages its reserve position and deals with the central bank.

The two sections of the bank do not interact in any formal way so the reserve management section never tells the loan department to stop lending because they don’t have reserves. The banks know they can get the reserves from the central bank in whatever volume they need to satisfy any conditions imposed by the central bank at the overnight rate (allowing for small variations from day to day around this).

If the central bank didn’t do this then it would risk failure of the financial system.

The following blogs may be of further interest to you:

Question 3:

Adopting internal devaluation (reducing wages and prices) for nations that cannot adjust their exchange rate (for example, Greece), while harsh, ultimately improves the nation’s international competitiveness.

The answer is False.

The temptation is to accept the rhetoric after understanding the constraints that the EMU places on member countries and conclude that the only way that competitiveness can be restored is to cut wages and prices. That is what the dominant theme emerging from the public debate is telling us.

However, deflating an economy under these circumstance is only part of the story and does not guarantee that a nations competitiveness will be increased.

We have to differentiate several concepts: (a) the nominal exchange rate; (b) domestic price levels; (c) unit labour costs; and (d) the real or effective exchange rate.

It is the last of these concepts that determines the “competitiveness” of a nation. This Bank of Japan explanation of the real effective exchange rate is informative. Their English-language services are becoming better by the year.

Nominal exchange rate (e)

The nominal exchange rate (e) is the number of units of one currency that can be purchased with one unit of another currency. There are two ways in which we can quote a bi-lateral exchange rate. Consider the relationship between the $A and the $US.

  • The amount of Australian currency that is necessary to purchase one unit of the US currency ($US1) can be expressed. In this case, the $US is the (one unit) reference currency and the other currency is expressed in terms of how much of it is required to buy one unit of the reference currency. So $A1.60 = $US1 means that it takes $1.60 Australian to buy one $US.
  • Alternatively, e can be defined as the amount of US dollars that one unit of Australian currency will buy ($A1). In this case, the $A is the reference currency. So, in the example above, this is written as $US0.625= $A1. Thus if it takes $1.60 Australian to buy one $US, then 62.5 cents US buys one $A. (i) is just the inverse of (ii), and vice-versa.

So to understand exchange rate quotations you must know which is the reference currency. In the remaining I use the first convention so e is the amount of $A which is required to buy one unit of the foreign currency.

International competitiveness

Are Australian goods and services becoming more or less competitive with respect to goods and services produced overseas? To answer the question we need to know about:

  • movements in the exchange rate, ee; and
  • relative inflation rates (domestic and foreign).

Clearly within the EMU, the nominal exchange rate is fixed between nations so the changes in competitiveness all come down to the second source and here foreign means other nations within the EMU as well as nations beyond the EMU.

There are also non-price dimensions to competitiveness, including quality and reliability of supply, which are assumed to be constant.

We can define the ratio of domestic prices (P) to the rest of the world (Pw) as Pw/P.

For a nation running a flexible exchange rate, and domestic prices of goods, say in the USA and Australia remaining unchanged, a depreciation in Australia’s exchange means that our goods have become relatively cheaper than US goods. So our imports should fall and exports rise. An exchange rate appreciation has the opposite effect.

But this option is not available to an EMU nation so the only way goods in say Greece can become cheaper relative to goods in say, Germany is for the relative price ratio (Pw/P) to change:

  • If Pw is rising faster than P, then Greek goods are becoming relatively cheaper within the EMU; and
  • If Pw is rising slower than P, then Greek goods are becoming relatively more expensive within the EMU.

The inverse of the relative price ratio, namely (P/Pw) measures the ratio of export prices to import prices and is known as the terms of trade.
The real exchange rate

Movements in the nominal exchange rate and the relative price level (Pw/P) need to be combined to tell us about movements in relative competitiveness. The real exchange rate captures the overall impact of these variables and is used to measure our competitiveness in international trade.

The real exchange rate (R) is defined as:

R = (e.Pw/P)

where P is the domestic price level specified in $A, and Pw is the foreign price level specified in foreign currency units, say $US.

The real exchange rate is the ratio of prices of goods abroad measured in $A (ePw) to the $A prices of goods at home(P). So the real exchange rate, R adjusts the nominal exchange rate, e for the relative price levels.

For example, assume P = $A10 and Pw = $US8, and e = 1.60. In this case R = (8×1.6)/10 = 1.28. The $US8 translates into $A12.80 and the US produced goods are more expensive than those in Australia by a ratio of 1.28, ie 28%.

A rise in the real exchange rate can occur if:

  • the nominal e depreciates; and/or
  • Pw rises more than P, other things equal.

A rise in the real exchange rate should increase our exports and reduce our imports.

A fall in the real exchange rate can occur if:

  • the nominal e appreciates; and/or
  • Pw rises less than P, other things equal.

A fall in the real exchange rate should reduce our exports and increase our imports.

In the case of the EMU nation we have to consider what factors will drive Pw/P up and increase the competitive of a particular nation.

If prices are set on unit labour costs, then the way to decrease the price level relative to the rest of the world is to reduce unit labour costs faster than everywhere else.

Unit labour costs are defined as cost per unit of output and are thus ratios of wage (and other costs) to output. If labour costs are dominant (we can ignore other costs for the moment) so total labour costs are the wage rate times total employment = w.L. Real output is Y.

So unit labour costs (ULC) = w.L/Y.

L/Y is the inverse of labour productivity(LP) so ULCs can be expressed as the w/(Y/L) = w/LP.

So if the rate of growth in wages is faster than labour productivity growth then ULCs rise and vice-versa. So one way of cutting ULCs is to cut wage levels which is what the austerity programs in the EMU nations (Ireland, Greece, Portugal etc) are attempting to do.

But LP is not constant. If morale falls, sabotage rises, absenteeism rises and overall investment falls in reaction to the extended period of recession and wage cuts then productivity is likely to fall as well. Thus there is no guarantee that ULCs will fall by any significant amount.

That is enough for today!

(c) Copyright 2016 William Mitchell. All Rights Reserved.

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    This Post Has One Comment
    1. Question without notice and slightly off topic.

      Please correct me where Im going wrong.

      Govt debt is just money that has been spent but no yet collected back. (Warren Mosler)

      Govt debt is held in Bonds … when the bonds mature the govt debits its securities account and credits the bond holder and the debt is reduced by the same amount.

      If the bonds are cashed out and the former bond holder now has his cash back isnt that still govt debt by definition that it is money been spent out but not collected back yet ? So its debt reduction doubled up.

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