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The Weekend Quiz – February 16-17, 2019 – 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:

Which scenario represents a more expansionary outcome:

(a) A fiscal deficit equivalent to 2 per cent of GDP (including the impact of automatic stabilisers equivalent to 1 per cent of GDP).

(b) A fiscal deficit equivalent to 2 per cent of GDP completely ‘structural’ in nature.

(c) A fiscal deficit of equivalent to 3 per cent completely ‘cyclical’ in nature.

(d) You cannot tell because of the different cyclical and structural components in the previous options.

The answer is Option (c).

The question probes an understanding of the forces (components) that drive the fiscal balance that is reported by government agencies at various points in time and how to correctly interpret a fiscal balance.

In outright terms, a fiscal deficit that is equivalent to 3 per cent of GDP is more expansionary than a fiscal deficit outcome that is equivalent to 2 per cent of GDP irrespective of the cyclical and structural components.

In that sense, the question lured you into thinking that only the discretionary component (the actual policy settings) were of interest. In that context, Option (b) would have been the correct answer.

To see the why Option (c) is the best answer we have to explore the issue of decomposing the observed fiscal balance into the discretionary (now called structural) and cyclical components. The latter component is driven by the automatic stabilisers that are in-built into the fiscal process.

The federal (or national) government fiscal balance is the difference between total federal revenue and total federal outlays. So if total revenue is greater than outlays, the fiscal position is in surplus and vice versa. It is a simple matter of accounting with no theory involved. However, the fiscal balance is used by all and sundry to indicate the fiscal stance of the government.

So if the fiscal position is in surplus it is often concluded that the fiscal impact of government is contractionary (withdrawing net spending) and if the fiscal position is in deficit we say the fiscal impact expansionary (adding net spending).

Further, a rising deficit (falling surplus) is often considered to be reflecting an expansionary policy stance and vice versa. What we know is that a rising deficit may, in fact, indicate a contractionary fiscal stance – which, in turn, creates such income losses that the automatic stabilisers start driving the fiscal position back towards (or into) deficit.

So the complication is that we cannot conclude that changes in the fiscal impact reflect discretionary policy changes. The reason for this uncertainty clearly relates to the operation of the automatic stabilisers.

To see this, the most simple model of the fiscal balance we might think of can be written as:

Fiscal balance = Revenue – Spending.

Fiscal balance = (Tax Revenue + Other Revenue) – (Welfare Payments + Other Spending)

We know that Tax Revenue and Welfare Payments move inversely with respect to each other, with the latter rising when GDP growth falls and the former rises with GDP growth. These components of the fiscal balance are the so-called automatic stabilisers.

In other words, without any discretionary policy changes, the fiscal balance will vary over the course of the business cycle. When the economy is weak: tax revenue falls and welfare payments rise and so the fiscal balance moves towards deficit (or an increasing deficit).

When the economy is stronger – tax revenue rises and welfare payments fall and the fiscal balance becomes increasingly positive.

Automatic stabilisers attenuate the amplitude in the business cycle by expanding the fiscal position in a recession and contracting it in a boom.

So just because the fiscal position goes into deficit or the deficit increases as a proportion of GDP 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 uncertainty, 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’.

This was a hypothetical construct 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.

So a full employment fiscal position would be balanced if total outlays and total revenue were equal when the economy was operating at total capacity.

If the fiscal position was in surplus at full capacity, then we would conclude that the discretionary structure of the fiscal position was contractionary and vice versa if the fiscal position was in deficit at full capacity.

The calculation of the structural deficit spawned a bit of an industry in the past with lots of complex issues relating to adjustments for inflation, terms of trade effects, changes in interest rates and more.

Much of the debate centred on how to compute the unobserved full employment point in the economy.

There were a plethora of methods used in the period of true full employment in the 1960s. All of them had issues but like all empirical work – it was a dirty science – relying on assumptions and simplifications. But that is the nature of the applied economist’s life.

As I explain in the blog posts cited below, the measurement issues have a long history and current techniques and frameworks based on the concept of the Non-Accelerating Inflation Rate of Unemployment (the NAIRU) bias the resulting analysis such that actual discretionary positions which are contractionary are seen as being less so and expansionary positions are seen as being more expansionary.

The result is that modern depictions of the structural deficit systematically understate the degree of discretionary contraction coming from fiscal policy.

So the data provided by the question unambiguously points to Option (c) being the more expansionary impact – made up of a discretionary (structural) deficit of 0 per cent of GDP and a cyclical impact of 3 per cent.

You might like to read these blogs for further information:

Question 2:

If net exports are running at 2 per cent of GDP, and the private domestic sector overall is saving an equivalent of 3 per cent of GDP, the government must be running a surplus equal to 1 per cent of GDP.

The answer is False.

The correct answer is that the government must be running a deficit equal to 1 per cent of GDP.

This question tests your knowledge of the sectoral balances that are derived from the National Accounts.

To refresh your memory the sectoral balances are derived as follows. 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).

Expression (1) tells us that total income in the economy per period will be exactly equal to total spending from all sources of expenditure.

We also have to acknowledge that financial balances of the sectors are impacted by net government taxes (T) which includes all taxes and transfer and interest payments (the latter are not counted independently in the expenditure Expression (1)).

Further, as noted above the trade account is only one aspect of the financial flows between the domestic economy and the external sector. we have to include net external income flows (FNI).

Adding in the net external income flows (FNI) to Expression (2) for GDP we get the familiar gross national product or gross national income measure (GNP):

(2) GNP = C + I + G + (X – M) + FNI

To render this approach into the sectoral balances form, we subtract total taxes and transfers (T) from both sides of Expression (3) to get:

(3) GNP – T = C + I + G + (X – M) + FNI – T

Now we can collect the terms by arranging them according to the three sectoral balances:

(4) (GNP – C – T) – I = (G – T) + (X – M + FNI)

The the terms in Expression (4) are relatively easy to understand now.

The term (GNP – C – T) represents total income less the amount consumed less the amount paid to government in taxes (taking into account transfers coming the other way). In other words, it represents private domestic saving.

The left-hand side of Equation (4), (GNP – C – T) – I, thus is the overall saving of the private domestic sector, which is distinct from total household saving denoted by the term (GNP – C – T).

In other words, the left-hand side of Equation (4) is the private domestic financial balance and if it is positive then the sector is spending less than its total income and if it is negative the sector is spending more than it total income.

The term (G – T) is the government financial balance and is in deficit if government spending (G) is greater than government tax revenue minus transfers (T), and in surplus if the balance is negative.

Finally, the other right-hand side term (X – M + FNI) is the external financial balance, commonly known as the current account balance (CAD). It is in surplus if positive and deficit if negative.

In English we could say that:

The private financial balance equals the sum of the government financial balance plus the current account balance.

We can re-write Expression (6) in this way to get the sectoral balances equation:

(5) (S – I) = (G – T) + CAB

which is interpreted as meaning that government sector deficits (G – T > 0) and current account surpluses (CAB > 0) generate national income and net financial assets for the private domestic sector.

Conversely, government surpluses (G – T < 0) and current account deficits (CAB < 0) reduce national income and undermine the capacity of the private domestic sector to add financial assets.

Expression (5) can also be written as:

(6) [(S – I) – CAB] = (G – T)

where the term on the left-hand side [(S – I) – CAB] is the non-government sector financial balance and is of equal and opposite sign to the government financial balance.

This is the familiar MMT statement that a government sector deficit (surplus) is equal dollar-for-dollar to the non-government sector surplus (deficit).

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)) plus net income transfers.

All these relationships (equations) hold as a matter of accounting and not matters of opinion.

Thus, when an external deficit (X – M < 0) and public surplus (G – T < 0) coincide, there must be a private deficit.

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.

Second, you then have to appreciate the relative sizes of these balances to answer the question correctly.

The rule is that the sectoral balances have to sum to zero.

So if we write the condition above as:

(S – 1) – (G – T) – (X – M) = 0

And substitute the values of the question we get:

3 – (G – T) – 2 = 0

We can solve this for (G – T) as

(G – T) = 3 – 2 = 1

Given the construction (G – T) a positive number (1) is a deficit.

This tells us that even if the external sector is growing strongly and is in surplus there may still be a need for public deficits. This will occur if the private domestic sector seek to save at a proportion of GDP higher than the external surplus.

The economics of this situation might be something like this.

The external surplus would be adding to overall aggregate demand (the injection from exports exceeds the drain from imports).

However, if the drain from private sector spending (S > I) is greater than the external injection then the only way output and income can remain constant is if the government is in deficit.

National income adjustments would occur if the private domestic sector tried to push for higher saving overall – income would fall (because overall spending fell) and the government would be pushed into deficit whether it liked it or not via falling revenue and rising welfare payments.

You may wish to read the following blogs for more information:

Question 3:

A nation can export less than the sum of imports, net factor income (such as interest and dividends) and net transfer payments (such as foreign aid) and run a government surplus:

  • Of of equal proportion to GDP, while the private domestic sector is spending less than they are earning.
  • Of equal proportion to GDP, while the private domestic sector is spending more than they are earning.
  • That is larger, while the private domestic sector is spending less than they are earning.
  • None of the above are possible as they all defy the sectoral balances accounting identity.

The correct answer is the second option – “A nation can run a current account deficit accompanied by a government sector surplus of equal proportion to GDP, while the private domestic sector is spending more than they are earning”.

Note that the the current account is equal to the trade balance plus invisibles. The trade balance is exports minus imports and the invisibles are equal to the sum of net factor income (such as interest and dividends) and net transfer payments (such as foreign aid). So the question is asking about a current account deficit.

Draw on the explanation in Question 2 for background.

The following Table represents the three options in percent of GDP terms.

To aid interpretation remember that:

1. (S-I ) < 0 means that the private domestic sector is spending more than they are earning.

2. (G-T) < 0 means that the government is running a surplus because T > G.

3. (X-M) < 0 means the external position is in deficit because imports are greater than exports (taking net factor income into account).

The first two possibilities we might call Case A and Case B:

A: A nation can run a current account deficit with an offsetting government sector surplus, while the private domestic sector is spending less than they are earning.

B: A nation can run a current account deficit with an offsetting government sector surplus, while the private domestic sector is spending more than they are earning.

So Case A says the private domestic sector is saving overall, whereas Case B say the private domestic sector is dis-saving (and going into increasing indebtedness).

These options are captured in the first column of the Table.

The arithmetic example depicts an external sector deficit of 2 per cent of GDP and an offsetting fiscal surplus of 2 per cent of GDP.

You can see that the private sector balance is negative (that is, the sector is spending more than they are earning – Investment is greater than Saving – and has to be equal to 4 per cent of GDP.

Given that, the only proposition that can be true is:

B: A nation can run a current account deficit with an offsetting government sector surplus, while the private domestic sector is spending more than they are earning.

Column 2 in the Table captures Case C:

C: A nation can run a current account deficit with a government sector surplus that is larger, while the private domestic sector is spending less than they are earning.

So the current account deficit is equal to 2 per cent of GDP while the fiscal surplus is now larger at 3 per cent of GDP. You can see that the private domestic deficit rises to 5 per cent of GDP to satisfy the accounting rule that the balances sum to zero.

The final option available is:

D: None of the above are possible as they all defy the sectoral balances accounting identity.

It cannot be true because as the Table data shows the rule that the sectoral balances add to zero because they are an accounting identity is satisfied in both cases.

So if the government is spending less than it is ‘earning’ and the external sector is adding less income (X) than it is absorbing spending (M), then the other spending components must be greater than total income.

The following blogs may be of further interest to you:

That is enough for today!

(c) Copyright 2019 William Mitchell. All Rights Reserved.

That is enough for today!

(c) Copyright 2019 William Mitchell. All Rights Reserved.

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