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.
If the inflation rate is steady and the central bank maintains a constant nominal interest rate, then the public debt ratio will rise if the government deficit doubles (say, from 2 to 4 per cent of GDP) although Modern Monetary Theory would not place any special importance in that increase.
The answer is False.
First, the statement “although Modern Monetary Theory would not place any special importance in that increase” is true but is a throwaway in the context of the issue – whether the public debt ration rises when the primary deficit rises with a real interest rate constant.
The substantive part of the question requires a careful reading and a careful association of concepts to make sure they are commensurate. There are two concepts that are central to the question: (a) a rising fiscal deficit – which is a flow and not scaled by GDP in this case; and (b) a rising public debt ratio which by construction (as a ratio) is scaled by GDP.
So the two concepts are not commensurate although they are related in some way.
A rising fiscal deficit does not necessary lead to a rising public debt ratio. You might like to refresh your understanding of these concepts by reading this blog – Saturday Quiz – March 6, 2010 – answers and discussion.
While the mainstream macroeconomics thinks that a sovereign government is revenue-constrained and is subject to the government fiscal constraint, MMT places no particular importance in the public debt to GDP ratio for a sovereign government, given that insolvency is not an issue.
Which you can read in English as saying that Budget deficit = Government spending + Government interest payments – Tax receipts must equal (be “financed” by) a change in Bonds (B) and/or a change in high powered money (H). The triangle sign (delta) is just shorthand for the change in a variable.
Remember, this is merely an accounting statement. In a stock-flow consistent macroeconomics, this statement will always hold. That is, it has to be true if all the transactions between the government and non-government sector have been corrected added and subtracted.
So from the perspective of Modern Monetary Theory (MMT), the previous equation is just an ex post accounting identity that has to be true by definition and has not real economic importance.
For the mainstream economist, the equation represents an ex ante (before the fact) financial constraint that the government is bound by. The difference between these two conceptions is very significant and the second (mainstream) interpretation cannot be correct if governments issue fiat currency (unless they place voluntary constraints on themselves to act as if it is).
That interpretation is inapplicable (and wrong) when applied to a sovereign government that issues its own currency.
But the accounting relationship can be manipulated to provide an expression linking deficits and changes in the public debt ratio.
The following equation expresses the relationships above as proportions of GDP:
So the change in the debt ratio is the sum of two terms on the right-hand side: (a) the difference between the real interest rate (r) and the GDP growth rate (g) times the initial debt ratio; and (b) the ratio of the primary deficit (G-T) to GDP. A primary fiscal balance is the difference between government spending (excluding interest rate servicing) and taxation revenue.
The real interest rate is the difference between the nominal interest rate and the inflation rate. If inflation is maintained at a rate equal to the interest rate then the real interest rate is constant.
A growing economy can absorb more debt and keep the debt ratio constant or falling. From the formula above, if the primary fiscal balance is zero, public debt increases at a rate r but the public debt ratio increases at r – g.
So if r = 0, and g = 2, the primary deficit ratio could equal 2 per cent (of GDP) and the public debt ratio would be unchanged. Doubling the primary deficit to 4 per cent would require g to rise to 4 for the public debt ratio to remain unchanged. That is entirely possible.
So a nation running a primary deficit can obviously reduce its public debt ratio over time or hold them constant if growth is stimulated. Further, you can see that even with a rising primary deficit, if output growth (g) is sufficiently greater than the real interest rate (r) then the debt ratio can fall from its value last period.
Furthermore, depending on contributions from the external sector, a nation running a deficit will more likely create the conditions for a reduction in the public debt ratio than a nation that introduces an austerity plan aimed at running primary surpluses.
Clearly, the real growth rate has limits and that would limit the ability of a government (that voluntarily issues debt) to hold the debt ratio constant while expanding its fiscal deficit as a proportion of GDP.
The following blog may be of further interest to you:
Progressives have pointed out the slow or non-existent growth in real wages over the last decades. What they demand is that the rate of growth in earnings is faster than the growth in labour productivity. Is this sufficient to achieve their aim of real wages growth?
The answer is No.
The question requires you to understand what determines the real wage and what the relationship between earnings and labour productivity growth is. When economists do not specify the unit you should always assume they are talking in nominal terms. So the reference to the “rate of growth of earnings” is in terms of the monetary unit which is the common understanding that people would have of the term.
In terms of the logic of the question, that would also be the only sensible interpretation.
The real wage is defined as the purchasing power equivalent on the nominal wage that workers get paid each period. To compute the real wage we need to consider two variables: (a) the nominal wage (W) and the aggregate price level (P).
We might consider the aggregate price level to be measured by the consumer price index (CPI) although there are huge debates about that. But in a sense, this macroeconomic price level doesn’t exist but represents some abstract measure of the general movement in all prices in the economy.
Macroeconomics is hard to learn because it involves these abstract variables that are never observed – like the price level, like “the interest rate” etc. They are just stylisations of the general tendency of all the different prices and interest rates.
Now the nominal wage (W) – that is paid by employers to workers is determined in the labour market – by the contract of employment between the worker and the employer. The price level (P) is determined in the goods market – by the interaction of total supply of output and aggregate demand for that output although there are complex models of firm price setting that use cost-plus mark-up formulas with demand just determining volume sold. We shouldn’t get into those debates here.
The inflation rate is just the continuous growth in the price level (P). A once-off adjustment in the price level is not considered by economists to constitute inflation.
So the real wage (w) tells us what volume of real goods and services the nominal wage (W) will be able to command and is obviously influenced by the level of W and the price level. For a given W, the lower is P the greater the purchasing power of the nominal wage and so the higher is the real wage (w).
We write the real wage (w) as W/P. So if W = 10 and P = 1, then the real wage (w) = 10 meaning that the current wage will buy 10 units of real output. If P rose to 2 then w = 5, meaning the real wage was now cut by one-half.
The relationship between the real wage and labour productivity relates to movements in the unit costs, real unit labour costs and the wage and profit shares in national income.
The wage share in nominal GDP is expressed as the total wage bill as a percentage of nominal GDP. Economists differentiate between nominal GDP ($GDP), which is total output produced at market prices and real GDP (GDP), which is the actual physical equivalent of the nominal GDP. We will come back to that distinction soon.
To compute the wage share we need to consider total labour costs in production and the flow of production ($GDP) each period.
Employment (L) is a stock and is measured in persons (averaged over some period like a month or a quarter or a year.
The wage bill is a flow and is the product of total employment (L) and the average wage (w) prevailing at any point in time. Stocks (L) become flows if it is multiplied by a flow variable (W). So the wage bill is the total labour costs in production per period.
So the wage bill = W.L
The wage share is just the total labour costs expressed as a proportion of $GDP – (W.L)/$GDP in nominal terms, usually expressed as a percentage. We can actually break this down further.
Labour productivity (LP) is the units of real GDP per person employed per period. Using the symbols already defined this can be written as:
LP = GDP/L
so it tells us what real output (GDP) each labour unit that is added to production produces on average.
Nominal GDP ($GDP) can be written as P.GDP, where the P values the real physical output.
Now if you put of these concepts together you get an interesting framework. To help you follow the logic here are the terms developed and be careful not to confuse $GDP (nominal) with GDP (real):
- Wage share = (W.L)/$GDP
- Nominal GDP: $GDP = P.GDP
- Labour productivity: LP = GDP/L
- Real wage: w = W/P
By substituting the expression for Nominal GDP into the wage share measure we get:
Wage share = (W.L)/P.GDP
In this area of economics, we often look for alternative way to write this expression – it maintains the equivalence (that is, obeys all the rules of algebra) but presents the expression (in this case the wage share) in a different “view”.
So we can write as an equivalent:
Wage share – (W/P).(L/GDP)
Now if you note that (L/GDP) is the inverse (reciprocal) of the labour productivity term (GDP/L). We can use another rule of algebra (reversing the invert and multiply rule) to rewrite this expression again in a more interpretable fashion.
So an equivalent but more convenient measure of the wage share is:
Wage share = (W/P)/(GDP/L) – that is, the real wage (W/P) divided by labour productivity (GDP/L).
I won’t show this but I could also express this in growth terms such that if the growth in the real wage equals labour productivity growth the wage share is constant. The algebra is simple but we have done enough of that already.
That journey might have seemed difficult to non-economists (or those not well-versed in algebra) but it produces a very easy to understand formula for the wage share.
Two other points to note. The wage share is also equivalent to the real unit labour cost (RULC) measures that Treasuries and central banks use to describe trends in costs within the economy. Please read my blog – Saturday Quiz – May 15, 2010 – answers and discussion – for more discussion on this point.
Now it becomes obvious that if the nominal wage (W) and the price level (P) are growing at the pace the real wage is constant. And if the real wage is growing at the same rate as labour productivity, then both terms in the wage share ratio are equal and so the wage share is constant.
The wage share was constant for a long time during the Post Second World period and this constancy was so marked that Kaldor (the Cambridge economist) termed it one of the great “stylised” facts. So real wages grew in line with productivity growth which was the source of increasing living standards for workers.
The productivity growth provided the “room” in the distribution system for workers to enjoy a greater command over real production and thus higher living standards without threatening inflation.
Since the mid-1980s, the neo-liberal assault on workers’ rights (trade union attacks; deregulation; privatisation; persistently high unemployment) has seen this nexus between real wages and labour productivity growth broken. So while real wages have been stagnant or growing modestly, this growth has been dwarfed by labour productivity growth.
The following blogs may be of further interest to you:
A fiscal surplus may not suggest that the national government is trying to slow the economy down and contain inflation.
The answer is True.
You cannot conclude anything about the government’s policy intentions from the fiscal outcome independent of other information.
The actual fiscal balance outcome that is reported in the press and by Treasury departments is not a pure measure of the fiscal policy stance adopted by the government at any point in time. As a result, a straightforward interpretation of the government’s discretionary fiscal intentions is not possible when using the actual reported fiscal outcome.
Economists conceptualise the actual fiscal outcome as being the sum of two components: (a) a discretionary component – that is, the actual fiscal stance intended by the government; and (b) a cyclical component reflecting the sensitivity of certain fiscal items (tax revenue based on activity and welfare payments to name the most sensitive) to changes in the level of activity.
The former component is now called the “structural deficit” (or surplus) and the latter component is sometimes referred to as the automatic stabilisers.
The structural deficit/surplus thus conceptually reflects the chosen (discretionary) fiscal stance of the government independent of cyclical factors.
The cyclical factors refer to the automatic stabilisers which operate in a counter-cyclical fashion. When economic growth is strong, tax revenue improves given it is typically tied to income generation in some way. Further, most governments provide transfer payment relief to workers (unemployment benefits) and this decreases during growth.
In times of economic decline, the automatic stabilisers work in the opposite direction and push the fiscal balance towards deficit, into deficit, or into a larger deficit. These automatic movements in aggregate demand play an important counter-cyclical attenuating role. So when GDP is declining due to falling aggregate demand, the automatic stabilisers work to add demand (falling taxes and rising welfare payments). When GDP growth is rising, the automatic stabilisers start to pull demand back as the economy adjusts (rising taxes and falling welfare payments).
The alternative is true when the economy is growing fast – tax revenue increases and welfare payments decline. So a fiscal outcome may move into surplus even though the discretionary policy stance is expansionary. This would mean however that the overall fiscal impact is contractionary because the automatic stabiliser impact is overriding the discretionary intent.
The problem is always how to determine whether the chosen discretionary fiscal stance is adding to demand (expansionary) or reducing demand (contractionary). It is a problem because a government could be run a contractionary policy by choice but the automatic stabilisers are so strong that the fiscal outcome goes into deficit which might lead people to think the “government” is expanding the economy.
So just because the fiscal outcome goes into deficit doesn’t allow us to conclude that the Government has suddenly become of an expansionary mind. In other words, the presence of automatic stabilisers make it hard to discern whether the fiscal policy stance (chosen by the government) is contractionary or expansionary at any particular point in time.
To overcome this ambiguity, economists decided to measure the automatic stabiliser impact against some benchmark or “full capacity” or potential level of output, so that we can decompose the fiscal balance into that component which is due to specific discretionary fiscal policy choices made by the government and that which arises because the cycle takes the economy away from the potential level of output.
As a result, economists devised what used to be called the Full Employment or High Employment Budget. In more recent times, this concept is now called the Structural Balance. As I have noted in previous blogs, the change in nomenclature here is very telling because it occurred over the period that neo-liberal governments began to abandon their commitments to maintaining full employment and instead decided to use unemployment as a policy tool to discipline inflation.
The Full Employment Budget Balance was a hypothetical construction of the fiscal balance that would be realised if the economy was operating at potential or full employment. In other words, calibrating the fiscal position (and the underlying fiscal parameters) against some fixed point (full capacity) eliminated the cyclical component – the swings in activity around full employment.
This framework allowed economists to decompose the actual fiscal balance into (in modern terminology) the structural (discretionary) and cyclical fiscal balances with these unseen fiscal components being adjusted to what they would be at the potential or full capacity level of output.
The difference between the actual fiscal outcome and the structural component is then considered to be the cyclical fiscal outcome and it arises because the economy is deviating from its potential.
So if the economy is operating below capacity then tax revenue would be below its potential level and welfare spending would be above. In other words, the fiscal balance would be smaller at potential output relative to its current value if the economy was operating below full capacity. The adjustments would work in reverse should the economy be operating above full capacity.
If the fiscal outcome is in deficit when computed at the “full employment” or potential output level, then we call this a structural deficit and it means that the overall impact of discretionary fiscal policy is expansionary irrespective of what the actual fiscal outcome is presently. If it is in surplus, then we have a structural surplus and it means that the overall impact of discretionary fiscal policy is contractionary irrespective of what the actual fiscal outcome is presently.
So you could have a downturn which drives the fiscal outcome into a deficit but the underlying structural position could be contractionary (that is, a surplus). And vice versa.
The following blogs may be of further interest to you:
- A modern monetary theory lullaby
- Saturday Quiz – April 24, 2010 – answers and discussion
- The dreaded NAIRU is still about!
- Structural deficits – the great con job!
- Structural deficits and automatic stabilisers
- Another economics department to close
Reclaiming the State Lecture Tour – September-October, 2017
For up to date details of my upcoming book promotion and lecture tour in Late September and early October through Europe go to – The Reclaim the State Project Home Page.
You can also find details on that site of how to purchase a copy of the book (paperback version) at discounted prices, well below the current market price from the booksellers.
The discounted price I can make the book available (while my stock lasts) is plus postage.
My stocks are limited.
That is enough for today!
(c) Copyright 2017 William Mitchell. All Rights Reserved.