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The Weekend Quiz – September 14-15, 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:

Government spending which is accompanied by a bond sale to the non-government sector adds less to aggregate spending than would be the case if there was no bond sale.

The answer is False.

The mainstream macroeconomic textbooks all have a chapter on fiscal policy (and it is often written in the context of the so-called IS-LM model but not always).

The chapters always introduces the so-called ‘Government Budget Constraint’ that alleges that governments have to “finance” all spending either through taxation; debt-issuance; or money creation. The writer fails to understand that government spending is performed in the same way irrespective of the accompanying monetary operations.

Anyway, they claim that money creation (borrowing from central bank) is inflationary while the latter (private bond sales) is less so. These conclusions are based on their erroneous claim that “money creation” adds more to aggregate demand than bond sales, because the latter forces up interest rates which crowd out some private spending.

All these claims are without foundation in a fiat monetary system and an understanding of the banking operations that occur when governments spend and issue debt helps to show why.

So what would happen if a sovereign, currency-issuing government (with a flexible exchange rate) ran a budget deficit without issuing debt?

Like all government spending, the Treasury would credit the reserve accounts held by the commercial bank at the central bank. The commercial bank in question would be where the target of the spending had an account. So the commercial bank’s assets rise and its liabilities also increase because a deposit would be made.

The transactions are clear: The commercial bank’s assets rise and its liabilities also increase because a new deposit has been made.

Further, the target of the fiscal initiative enjoys increased assets (bank deposit) and net worth (a liability/equity entry on their balance sheet).

Taxation does the opposite and so a deficit (spending greater than taxation) means that reserves increase and private net worth increases.

This means that there are likely to be excess reserves in the “cash system” which then raises issues for the central bank about its liquidity management. The aim of the central bank is to “hit” a target interest rate and so it has to ensure that competitive forces in the interbank market do not compromise that target.

When there are excess reserves there is downward pressure on the overnight interest rate (as banks scurry to seek interest-earning opportunities), the central bank then has to sell government bonds to the banks to soak the excess up and maintain liquidity at a level consistent with the target.

Some central banks offer a return on overnight reserves which reduces the need to sell debt as a liquidity management operation.

There is no sense that these debt sales have anything to do with “financing” government net spending. The sales are a monetary operation aimed at interest-rate maintenance.

So M1 (deposits in the non-government sector) rise as a result of the deficit without a corresponding increase in liabilities. It is this result that leads to the conclusion that that deficits increase net financial assets in the non-government sector.

What would happen if there were bond sales? All that happens is that the banks reserves are reduced by the bond sales but this does not reduce the deposits created by the net spending. So net worth is not altered. What is changed is the composition of the asset portfolio held in the non-government sector.

The only difference between the Treasury “borrowing from the central bank” and issuing debt to the private sector is that the central bank has to use different operations to pursue its policy interest rate target. If it debt is not issued to match the deficit then it has to either pay interest on excess reserves (which most central banks are doing now anyway) or let the target rate fall to zero (the Japan solution).

There is no difference to the impact of the deficits on net worth in the non-government sector.

Mainstream economists would say that by draining the reserves, the central bank has reduced the ability of banks to lend which then, via the money multiplier, expands the money supply.

However, the reality is that:

  • Building bank reserves does not increase the ability of the banks to lend.
  • The money multiplier process so loved by the mainstream does not describe the way in which banks make loans.
  • Inflation is caused by aggregate demand growing faster than real output capacity. The reserve position of the banks is not functionally related with that process.

So the banks are able to create as much credit as they can find credit-worthy customers to hold irrespective of the operations that accompany government net spending.

This doesn’t lead to the conclusion that deficits do not carry an inflation risk. All components of aggregate demand carry an inflation risk if they become excessive, which can only be defined in terms of the relation between spending and productive capacity.

It is totally fallacious to think that private placement of debt reduces the inflation risk. It does not.

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

Question 2:

In the same way the spending multiplier indicates the extent to which GDP rises when there is a given rise in government spending, the tax multiplier captures the impact of rising tax rates on GDP as people reduce their labour supply because of the disincentives associated with taxation.

The answer is False.

Mainstream economics analysis does posit that rising marginal tax rates distort the labour supply choice – by increasing the hourly cost of work and providing greater incentives for workers to choose more leisure. This allegation forms the basis of their case for substantial tax cuts and proportional tax systems; and, as a consequence, reduced budget deficits.

As an aside there is no empirical evidence to support this claim. Most of the credible studies find very little evidence of a negative tax elasticity within normal ranges that these variables shift. The most significant tax effect is found at the intersection of the welfare system and the wage system where workers who work an extra hour while on benefits often face 100 per cent marginal taxes (loss of benefit equal to earnings). But that is another story again.

However, in terms of this question, the trick was in understanding what the tax multiplier is trying to conceptualise.

First, it is a macroeconomic rather than a microeconomic concept. Households are assumed to pay some tax out of gross income and the tax rate (keeping it simple) specifies that proportion. In reality, there are a myriad of tax rates but the total effect can be summarised by a single (weighted-average!) tax rate.

Households consume out of disposable income. Assume the overall propensity to consume is 0.80 – which means that overall consumers will spend 80 cents for every extra dollar of disposable income received.

So, if the tax rate rises, then disposable income falls. If nothing else changes, then this fall in disposable income will lead to a reduction in consumption (equal to the propensity to consume times the fall in disposable income). The resulting fall in GDP is defined as the tax multiplier.

Similarly, when tax rates falls and increase disposable income, the reverse occurs.

You should not confuse the hypothesised tax multiplier effect with the increase in tax revenue that occurs as a result of the automatic stabilisers. This effect occurs with no discretionary change in the tax regime. It is a common mistake to assume that because tax revenue is rising that tax policy is becoming contractionary.

Further, at the individual level, as GDP growth recovers most people will not be paying higher taxes at all while others will be paying a substantial increase – why? Because they move from unemployment (zero taxes paid) to earning an income (some taxes paid).

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

Question 3

In a stock-flow consistent macroeconomics, we have to always trace the impact of flows during a period on the relevant stocks at the end of the period. Accordingly, government and private investment spending are two examples of flows that adds to the stock of aggregate demand which in turn impacts on GDP.

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) 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.

That is enough for today!

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

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    This Post Has 2 Comments
    1. Bill. So many times, you answer a different question than the one I read. Question 1. True. Sure it can marginally cause more spending. Why? Because there is less debt out there to buy! So. Instead of buying government bonds, the people spend their money on consumption. The depression of interest rates entices some marginal extra amount of spending. I don’t disagree with any of the structural points you make about central banking.

    2. With regards to question 1

      You are assuming that banks are the only bodies that buy government debt

      That isn’t true: pension funds, private individuals etc are buying them too no ?

      They receive their coupon/yield as deposits , not as reserves ?

      So , first, the rate of change in outstanding bonds DOES effect the money supply

      Second, paying a rate greater than zero increases the money supply (though perhaps offset by selling more bonds in order to “pay” that interest)

      Where has my thinking gone wrong?

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