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The Weekend Quiz – July 23-24, 2016 – answers and discussion

Here are the answers with discussion for this Weekend’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:

The price at which the central bank provides reserves to the commercial banks is restricted by its target monetary policy rate.

The answer is True.

The facts are as follows. First, central banks will always provided enough reserve balances to the commercial banks at a price it sets using a combination of overdraft/discounting facilities and open market operations.

Second, if the central bank didn’t provide the reserves necessary to match the growth in deposits in the commercial banking system then the payments system would grind to a halt and there would be significant hikes in the interbank rate of interest and a wedge between it and the policy (target) rate – meaning the central bank’s policy stance becomes compromised.

Third, any reserve requirements within this context while legally enforceable (via fines etc) do not constrain the commercial bank credit creation capacity. Central bank reserves (the accounts the commercial banks keep with the central bank) are not used to make loans. They only function to facilitate the payments system (apart from satisfying any reserve requirements).

Fourth, banks make loans to credit-worthy borrowers and these loans create deposits. If the commercial bank in question is unable to get the reserves necessary to meet the requirements from other sources (other banks) then the central bank has to provide them. But the process of gaining the necessary reserves is a separate and subsequent bank operation to the deposit creation (via the loan).

Fifth, if there were too many reserves in the system (relative to the banks’ desired levels to facilitate the payments system and the required reserves then competition in the interbank (overnight) market would drive the interest rate down. This competition would be driven by banks holding surplus reserves (to their requirements) trying to lend them overnight. The opposite would happen if there were too few reserves supplied by the central bank. Then the chase for overnight funds would drive rates up.

In both cases the central bank would lose control of its current policy rate as the divergence between it and the interbank rate widened. This divergence can snake between the rate that the central bank pays on excess reserves (this rate varies between countries and overtime but before the crisis was zero in Japan and the US) and the penalty rate that the central bank seeks for providing the commercial banks access to the overdraft/discount facility.

So the aim of the central bank is to issue just as many reserves that are required for the law and the banks’ own desires.

Now the question seeks to link the penalty rate that the central bank charges for providing reserves to the banks and the central bank’s target rate. The wider the spread between these rates the more difficult does it become for the central bank to ensure the quantity of reserves is appropriate for maintaining its target (policy) rate.

Where this spread is narrow, central banks “hit” their target rate each day more precisely than when the spread is wider.

So if the central bank really wanted to put the screws on commercial bank lending via increasing the penalty rate, it would have to be prepared to lift its target rate in close correspondence. In other words, its monetary policy stance becomes beholden to the discount window settings.

The best answer was True because the central bank cannot operate with wide divergences between the penalty rate and the target rate and it is likely that the former would have to rise significantly to choke private bank credit creation.

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Question 2:

It would be impossible for a central bank to directly purchase treasury debt to facilitate the national government’s fiscal deficit (that is, “monetise the deficit”) while still targeting a positive short-term policy rate.

The answer is False.

The conditionality relates to whether the central bank decided to offer a support rate. In the Australian case, the RBA does offer a support payment on overnight reserves which is 25 basis points below the current target rate. So if this policy was maintained then the answer would be true. If the policy was revised such that the support rate was set equal to the current target rate then the answer would be false.

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 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. 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.

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Question 3:

A sovereign national government, that is, one that issues its own floating currency faces no solvency risk with respect to the debt it issues.

The answer is Maybe.

The answer would be true if the sentence had added (to the debt it issues) … in its own currency. The national government can always service its debts so long as these are denominated in domestic currency.

But because that qualifier was excluded and the question became general, the best answer is false because the said government might borrow in foreign currencies in addition to its own currency.

It also makes no significant difference for solvency whether the debt is held domestically or by foreign holders because it is serviced in the same manner in either case – by crediting bank accounts.

The situation changes when the government issues debt in a foreign-currency. Given it does not issue that currency then it is in the same situation as a private holder of foreign-currency denominated debt.

Private sector debt obligations have to be serviced out of income, asset sales, or by further borrowing. This is why long-term servicing is enhanced by productive investments and by keeping the interest rate below the overall growth rate.

Private sector debts are always subject to default risk – and should they be used to fund unwise investments, or if the interest rate is too high, private bankruptcies are the “market solution”.

Only if the domestic government intervenes to take on the private sector debts does this then become a government problem. Again, however, so long as the debts are in domestic currency (and even if they are not, government can impose this condition before it takes over private debts), government can always service all domestic currency debt.

The solvency risk the private sector faces on all debt is inherited by the national government if it takes on foreign-currency denominated debt. In those circumstances it must have foreign exchange reserves to allow it to make the necessary repayments to the creditors. In times when the economy is strong and foreigners are demanding the exports of the nation, then getting access to foreign reserves is not an issue.

But when the external sector weakens the economy may find it hard accumulating foreign currency reserves and once it exhausts its stock, the risk of national government insolvency becomes real.

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    This Post Has 2 Comments
    1. Well I can’t believe I am saying this but I’m getting worried about getting the answers right. And its only been 4 weeks of this unusual phenomena. If it happens next week I may have to come up with scenarios where my answer was wrong. That should be easy considering the wealth(?) of information provided by mainstream economists. Hopefully, (and in all likelihood) it will not come down to that.
      Thank you for the quiz.

    2. Regarding question 2.
      Let’s say the central bank doesn’t want to rely only on the discount and support rates to hit its target policy.
      Wouldn’t it be possible to have a different kind of bonds, central bank bonds, used to pursue the monetary policy?
      Government bonds would still be issued as usual and might or might not be purchased by the CB but you would have a clear separation between bonds for the two kinds of operations, debt monetisation versus monetary policy.
      At this point you might even go one step further. The treasury could simply stop issuing bonds which would be sold to the CB and have its account credited directly instead.
      The treasury could still issue govt bonds for the sole purpose of offering the private sector (households and firms, but maybe not banks) a safe investment.

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