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The Weekend Quiz – April 6-7, 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.

Here are the answers with discussion for yesterday’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:

If the external sector is in deficit overall and GDP growth rate is faster than the real interest rate, then both the private domestic sector and the government sector overall can reduce their overall respective net liabilities.

The answer is False.

Once again it is a test of one’s basic understanding of the sectoral balances that can be derived from the National Accounts. Some people write to me in an incredulous way about the balances.

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 and national income adjustments will ensure that is the case in accordance with the accounting rules.

It doesn’t matter how fast GDP is growing, if a sector is in deficit then it cannot be reducing its their overall net liabilities.

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.

Consider the following graph and associated table of data which shows six states. All states have a constant external deficit equal to 2 per cent of GDP (light-blue columns).

State 1 show a government running a surplus equal to 2 per cent of GDP (green columns). As a consequence, the private domestic balance is in deficit of 4 per cent of GDP (royal-blue columns). This cannot be a sustainable growth strategy because eventually the private domestic sector will collapse under the weight of its indebtedness and start to save. At that point the fiscal drag from the fiscal surpluses will reinforce the spending decline and the economy would go into recession.

State 2 shows that when the fiscal surplus moderates to 1 per cent of GDP the private domestic deficit is reduced.

State 3 is a fiscal balance and then the private domestic deficit is exactly equal to the external deficit. So the private sector spending more than they earn exactly funds the desire of the external sector to accumulate financial assets in the currency of issue in this country.

States 4 to 6 shows what happens when the fiscal position goes into deficit – the private domestic sector (given the external deficit) can then start reducing its deficit and by State 5 it is in balance. Then by State 6 the private domestic sector is able to net save overall (that is, spend less than its income).

Note also that the government balance equals exactly $-for-$ (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.

Most countries currently run external deficits. The crisis was marked by households reducing consumption spending growth to try to manage their debt exposure and private investment retreating. The consequence was a major spending gap which pushed governments into deficits via the automatic stabilisers.

The only way to get income growth going in this context and to allow the private sector surpluses to build was to increase the deficits beyond the impact of the automatic stabilisers. The reality is that this policy change hasn’t delivered large enough fiscal deficits (even with external deficits narrowing). The result has been large negative income adjustments which brought the sectoral balances into equality at significantly lower levels of economic activity.

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Question 2:

The debt of a government which issues its own currency and floats it in international markets is not really a liability because the government can just continuously roll it over without ever having to pay it back. This is different to a household, the user of the currency, which not only has to service its debt but also has to repay them at the due date.

The answer is False.

First, households do have to service their debts and repay them at some due date or risk default. The other crucial point is that households also have to forego some current consumption, use up savings or run down assets to service their debts and ultimately repay them.

Second, a sovereign government also has to service their debts and repay them at some due date or risk default. No different there. But, unlike a household it does not have to forego any current spending capacity (or privatise public assets) to accomplish these financial transactions.

But the public debt is a legal obligation on government and so is totally a liability.

Now can it just roll-it over continuously? Well the question was subtle because the government can always keep issuing new debt when the old issues mature and maintain a stable (or whatever). But as the previous debt-issued matures it is paid out as per the terms of the issue. So that nuance was designed to elicit specific thinking.

The other point is that the liability on a sovereign government is legally like all liabilities – enforceable in courts the risk associated with taking that liability on is zero which is very different to the risks attached to taking on private debt.

There is zero risk that a holder of a public bond instrument will not be paid principle and interest on time.

The other point to appreciate is that the original holder of the public debt might not be the final holder who is paid out. The market for public debt is the most liquid of all debt markets and trading in public debt instruments of all nations is conducted across all markets each hour of every day.

While I am most familiar with the Australian institutional structure, the following developments are not dissimilar to the way bond issuance (in primary markets) is organised elsewhere. You can access information about this from the Australian Office of Financial Management, which is a Treasury-related public body that manages all public debt issuance in Australia.

It conducts the primary market, which is the institutional machinery via which the government sells debt to the non-government sector. In a modern monetary system with flexible exchange rates it is clear the government does not have to finance its spending so the fact that governments hang on to primary market issuance is largely ideological – fear of fiscal excesses rather than an intrinsic need. In this blog – Will we really pay higher interest rates? – I go into this period more fully and show that it was driven by the ideological calls for “fiscal discipline” and the growing influence of the credit rating agencies. Accordingly, all net spending had to be fully placed in the private market $-for-$. A purely voluntary constraint on the government and a waste of time.

A secondary market is where existing financial assets are traded by interested parties. So the financial assets enter the monetary system via the primary market and are then available for trading in the secondary. The same structure applies to private share issues for example. The company raises funds via the primary issuance process then its shares are traded in secondary markets.

Clearly secondary market trading has no impact at all on the volume of financial assets in the system – it just shuffles the wealth between wealth-holders. In the context of public debt issuance – the transactions in the primary market are vertical (net financial assets are created or destroyed) and the secondary market transactions are all horizontal (no new financial assets are created). Please read my blog – Deficit spending 101 – Part 3 – for more information.

Primary issues are conducted via auction tender systems and the Treasury determines the timing of these events in addition to the type and volumne of debt to be issued.

The issue is then be put out for tender and the market determines the final price of the bonds issued. Imagine a $A1000 bond is offered at a coupon of 5 per cent, meaning that you would get $A50 dollar per annum until the bond matured at which time you would get $A1000 back.

Imagine that the market wanted a yield of 6 per cent to accommodate risk expectations (see below). So for them the bond is unattractive unless the price is lower than $A1000. So tender system they would put in a purchase bid lower than the $A1000 to ensure they get the 6 per cent return they sought.

The general rule for fixed-income bonds is that when the prices rise, the yield falls and vice versa. Thus, the price of a bond can change in the market place according to interest rate fluctuations.

When interest rates rise, the price of previously issued bonds fall because they are less attractive in comparison to the newly issued bonds, which are offering a higher coupon rates (reflecting current interest rates).

When interest rates fall, the price of older bonds increase, becoming more attractive as newly issued bonds offer a lower coupon rate than the older higher coupon rated bonds.

So for new bond issues the AOFM receives the tenders from the bond market traders. These will be ranked in terms of price (and implied yields desired) and a quantity requested in $ millions. The AOFM (which is really just part of treasury) sometimes sells some bonds to the central bank (RBA) for their open market operations (at the weighted average yield of the final tender).

The AOFM will then issue the bonds in highest price bid order until it raises the revenue it seeks. So the first bidder with the highest price (lowest yield) gets what they want (as long as it doesn’t exhaust the whole tender, which is not likely). Then the second bidder (higher yield) and so on.

In this way, if demand for the tender is low, the final yields will be higher and vice versa. There are a lot of myths peddled in the financial press about this. Rising yields may indicate a rising sense of risk (mostly from future inflation although sovereign credit ratings will influence this). But they may also indicated a recovering economy where people are more confidence investing in commercial paper (for higher returns) and so they demand less of the “risk free” government paper.

So while there is no credit risk attached to holding public debt (that is, the holder knows they will receive the principle and interest that is specified on the issued debt instrument), there is still market risk which is related to movements in interest rates.

For government accounting purposes however the trading of the bonds once issued is of no consequence. They still retain the liability to pay the fixed coupon rate and the face value of the bond at the time of issue (not the market price).

The person/institution that sells the bond before maturity may gain or lose relative to their original purchase price but that is totally outside of the concern of the government.

Its liability is to pay the specified coupon rate at the time of issue and then the whole face value at the time of maturity.

There are complications to the primary sale process – some bonds sell at discounts which imply the coupon value. Further, there are arrangements between treasuries and central banks about the way in which public debt holdings are managed and accounted for. But these nuances do not alter the initial contention – public debt is a liability of the government in just the same way as private debt is a liability for those holders.

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Question 3:

The fact that large scale quantitative easing conducted by central banks in Japan in 2001 and now, more recently, in the UK and the USA has not caused inflation provides a strong refutation of the mainstream Quantity Theory of Money, which claims that growth in the stock of money will be inflationary.

The answer is False.

The question requires you to: (a) understand the Quantity Theory of Money; and (b) understand the impact of quantitative easing in relation to Quantity Theory of Money.

The short reason the answer is false is that quantitative easing has not increased the aggregates that drive the alleged causality in the Quantity Theory of Money – that is, the various estimates of the “money supply”.

The Quantity Theory of Money which in symbols is MV = PQ but means that the money stock times the turnover per period (V) is equal to the price level (P) times real output (Q). The mainstream assume that V is fixed (despite empirically it moving all over the place) and Q is always at full employment as a result of market adjustments.

Yes, in applying this theory they deny the existence of unemployment. The more reasonable mainstream economists (who probably have kids who cannot get a job at present) admit that short-run deviations in the predictions of the Quantity Theory of Money can occur but in the long-run all the frictions causing unemployment will disappear and the theory will apply.

In general, the Monetarists (the most recent group to revive the Quantity Theory of Money) claim that with V and Q fixed, then changes in M cause changes in P – which is the basic Monetarist claim that expanding the money supply is inflationary. They say that excess monetary growth creates a situation where too much money is chasing too few goods and the only adjustment that is possible is nominal (that is, inflation).

One of the contributions of Keynes was to show the Quantity Theory of Money could not be correct. He observed price level changes independent of monetary supply movements (and vice versa) which changed his own perception of the way the monetary system operated.

Further, with high rates of capacity and labour underutilisation at various times (including now) one can hardly seriously maintain the view that Q is fixed. There is always scope for real adjustments (that is, increasing output) to match nominal growth in aggregate demand. So if increased credit became available and borrowers used the deposits that were created by the loans to purchase goods and services, it is likely that firms with excess capacity will re

The mainstream have related the current non-standard monetary policy efforts – the so-called quantitative easing – to the Quantity Theory of Money and predicted hyperinflation will arise.

So it is the modern belief in the Quantity Theory of Money is behind the hysteria about the level of bank reserves at present – it has to be inflationary they say because there is all this money lying around and it will flood the economy.

Textbook like that of Mankiw mislead their students into thinking that there is a direct relationship between the monetary base and the money supply. They claim that the central bank “controls the money supply by buying and selling government bonds in open-market operations” and that the private banks then create multiples of the base via credit-creation.

Students are familiar with the pages of textbook space wasted on explaining the erroneous concept of the money multiplier where a banks are alleged to “loan out some of its reserves and create money”. As I have indicated several times the depiction of the fractional reserve-money multiplier process in textbooks like Mankiw exemplifies the mainstream misunderstanding of banking operations. Please read my blog – Money multiplier and other myths – for more discussion on this point.

The idea that the monetary base (the sum of bank reserves and currency) leads to a change in the money supply via some multiple is not a valid representation of the way the monetary system operates even though it appears in all mainstream macroeconomics textbooks and is relentlessly rammed down the throats of unsuspecting economic students.

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 home to the “government” (the central bank in this case).

The reality is that the central bank does not have the capacity to control the money supply. We have regularly traversed this point. In the world we live in, bank loans create deposits and are made without reference to the reserve positions of the banks. The bank then ensures its reserve positions are legally compliant as a separate process knowing that it can always get the reserves from the central bank.

The only way that the central bank can influence credit creation in this setting is via the price of the reserves it provides on demand to the commercial banks.

So when we talk about quantitative easing, we must first understand that it requires the short-term interest rate to be at zero or close to it. Otherwise, the central bank would not be able to maintain control of a positive interest rate target because the excess reserves would invoke a competitive process in the interbank market which would effectively drive the interest rate down.

Quantitative easing then involves the central bank buying assets from the private sector – government bonds and high quality corporate debt. So what the central bank is doing is swapping financial assets with the banks – they sell their financial assets and receive back in return extra reserves. So the central bank is buying one type of financial asset (private holdings of bonds, company paper) and exchanging it for another (reserve balances at the central bank). The net financial assets in the private sector are in fact unchanged although the portfolio composition of those assets is altered (maturity substitution) which changes yields and returns.

In terms of changing portfolio compositions, quantitative easing increases central bank demand for “long maturity” assets held in the private sector which reduces interest rates at the longer end of the yield curve. These are traditionally thought of as the investment rates. This might increase aggregate demand given the cost of investment funds is likely to drop. But on the other hand, the lower rates reduce the interest-income of savers who will reduce consumption (demand) accordingly.

How these opposing effects balance out is unclear but the evidence suggests there is not very much impact at all.

For the monetary aggregates (outside of base money) to increase, the banks would then have to increase their lending and create deposits. This is at the heart of the mainstream belief is that quantitative easing will stimulate the economy sufficiently to put a brake on the downward spiral of lost production and the increasing unemployment. The recent experience (and that of Japan in 2001) showed that quantitative easing does not succeed in doing this.

Should we be surprised. Definitely not. The mainstream view is based on the erroneous belief that the banks need reserves before they can lend and that quantitative easing provides those reserves. That is a major misrepresentation of the way the banking system actually operates. But the mainstream position asserts (wrongly) that banks only lend if they have prior reserves.

The illusion is that a bank is an institution that accepts deposits to build up reserves and then on-lends them at a margin to make money. The conceptualisation suggests that if it doesn’t have adequate reserves then it cannot lend. So the presupposition is that by adding to bank reserves, quantitative easing will help lending.

But banks do not operate like this. Bank lending is not “reserve constrained”. Banks lend to any credit worthy customer they can find and then worry about their reserve positions afterwards. If they are short of reserves (their reserve accounts have to be in positive balance each day and in some countries central banks require certain ratios to be maintained) then they borrow from each other in the interbank market or, ultimately, they will borrow from the central bank through the so-called discount window. They are reluctant to use the latter facility because it carries a penalty (higher interest cost).

The point is that building bank reserves will not increase the bank’s capacity to lend. Loans create deposits which generate reserves.

The reason that the commercial banks are currently not lending much is because they are not convinced there are credit worthy customers on their doorstep. In the current climate the assessment of what is credit worthy has become very strict compared to the lax days as the top of the boom approached.

Those that claim that quantitative easing will expose the economy to uncontrollable inflation are just harking back to the old and flawed Quantity Theory of Money. This theory has no application in a modern monetary economy and proponents of it have to explain why economies with huge excess capacity to produce (idle capital and high proportions of unused labour) cannot expand production when the orders for goods and services increase. Should quantitative easing actually stimulate spending then the depressed economies will likely respond by increasing output not prices.

So the fact that large scale quantitative easing conducted by central banks in Japan in 2001 and now in the UK and the USA has not caused inflation does not provide a strong refutation of the mainstream Quantity Theory of Money because it has not impacted on the monetary aggregates.

The fact that is hasn’t is not surprising if you understand how the monetary system operates but it has certainly bedazzled the (easily dazzled) mainstream economists.

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That is enough for today!

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

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    This Post Has 7 Comments
    1. So question 3 really asks what was the ‘mainstream’ understanding of MV=PY before quantitative easing took place. As in the question does not ask whether MV=PY is correct but rather how that identity was interpreted by a majority of economists. It seems to me that Bill himself has made an excellent argument that the ‘mainstream’ considered ‘V’ to be more or less constant and ‘Y’ to be assumed at full employment absent government interference. And Bill has demolished those suppositions many times and again here in the answer. And so Bill himself has shown that the ‘mainstream’ ideas about the identity were wrong. And I shouldn’t even have to argue why the answer really should be ‘True’ because Bill already did all that work.

      Now since quantitative easing has happened there are some economists that are not willing to give up on their prior understandings of that equation. Which obviously would have put inflation through the roof what with the massive increases in the ‘base’ money supply. So we have someone like Scott Sumner saying that bank reserves that are paid interest don’t count as base money anymore. So QE didn’t actually increase the money supply (M) in MV=PY because the Fed paid interest on excess reserves and therefore that’s not money and therefore the mainstream understanding of the Quantity Theory of Money still holds. So maybe Bill would argue Sumner is right? I doubt it.

      On the topic of Scott Sumner- he wants to know why MMT economists have a lack of ‘self awareness’ about why their views are controversial. And why they don’t explain the entirety of the foundations of MMT in every blog post or paper they write. He didn’t like my answer so I told him to ask Bill or just read the darn stuff for himself. Among other things. So maybe you might get a question from him Bill about the Fisher effect. But I doubt it.

    2. Jerry,
      I read his March 4th. Washington post article. When someone claims, amongst other things, that MMT is the “supply-side economics of our time” and “modern monetary theorists typically reason in terms of a closed economy”, It brings to mind a person trying to put together a puzzle, without first looking at the picture on the box. Quite “mind mumbing” really.

    3. I must have missed that article Philip. From your description of it, I doubt I missed much though! Trying to put a puzzle together without any idea of what it looks like- Nice!

    4. Jerry, I read some of you good comments on some of Sumner’s blogs. Well done! I think you made good rebuttle.

      I don’t really understand how the Market Monetarists thing NGDPLT targeting would be substantially different to what we have now. They seem to have huge faith in low or negative interest rates and QE and maintain that fiscal policy is useless and that Japan shows that is the case (???!). That seems to me to just be a continuation of more of the same monetary policy solution people cling to now? They seem to think fiscal austerity combined with expansionary monetary policy will work as long as inflation expectations are pushed up by a lot of monetary easing and no interest is paid on reserves.

      Sumner seems to think that central banks can’t really control interest rates and that the Fisher Effect will push up interest rates if governments spend without bond issuance.

      It would be interesting to hear Bill’s take on the NGDPLT “solution” that economists like Sumner put forward.

    5. Thanks cs! The libertarian crowd over there is often not ‘predisposed’ to appreciate MMT. To say the least. But Ahmed Fares definitely knew MMT and made a lot of good points there.

      I remember Randall Wray had written a post about the NGDP level targeting idea several years ago. If I remember correctly, his conclusion was that it is a decent idea but, like monetary policy in general, probably going to be mostly ineffective as a counter-cyclical force. Which is what I think of it :) The idea behind NGDPLT is that monetary policy IS very effective and that it can act in a more counter-cyclical way than current inflation targeting central bank policy. But god forbid you ask how it is supposed to work- it’s all expectations and demand for money and hot potatoes. Faith-based reasoning stuff where if you have to ask for the ‘concrete mechanisms’ behind it … well you just don’t understand just take our word for it that it will happen.

    6. Thanks for link Jerry! Can’t get enough of lectures and podcasts- we need more!!!!

      Yes I am a bit bemused by the hot potato idea. It seems to me QE created a lot of hot potatoes and not much came of it. They were distinctly cold potatoes easily held in the hand.

      They sometimes seem to refer back to the example of “if everyone somehow got $100 credited to their bank account in cash they’d spend it – more money – more NGDP via MV=PQ” – but that to me is ‘vertical’ fiscal policy – very different to ‘horizontal’ QE increasing base money as an asset swap which is net financial asset neutral for the private sector.

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