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The Weekend Quiz – April 4-5, 2020 – 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:

In a fixed coupon government bond auction, the higher is the demand for the bonds, the higher the yields will be at that asset maturity which suggests that larger fiscal deficits will eventually drive short-term interest rates down.

The answer is False.

You may have been thinking, correctly, that in fact there will be lower yields at the asset maturity issued because increased demand will drive prices up and prices and yields are inversely related.

But this tells us nothing about the effect of fiscal deficits on short-term interest rates

The fundamental principles of Modern Monetary Theory (MMT) include the fact that government spending provides the net financial assets (bank reserves) and with no accompanying central bank operations, fiscal deficits put downward pressure on interest rates, which is contrary to the myths that appear in macroeconomic textbooks about ‘crowding out’.

But of-course, the central bank sets the short-term interest rate based on its policy aspirations and conducts the necessary liquidity management operations to ensure the actual short-term market interest rate is consistent with the desired policy rate. However, that doesn’t mean the central bank has a free rein.

It has to either offer a return on reserves equivalent to the policy rate or sell government bonds if it is to maintain a positive target rate. 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.

This situation arises because the central bank essentially lacks control over the quantity of reserves in the system.

So the correct answer is that movements in public bond yields at the primary issue stage, tell us nothing about the intentions of central bank with respect to monetary policy (interest rate setting).

Students often do not understand why yields are inverse to price in a primary issue?

The standard bond has three parameters: (a) the face value – say $A1000; (b) the coupon rate – say 5 per cent; and (c) some maturity – say 10 years.

Taken together, this particular public debt instrument will provide the bond holder with $50 dollar per annum in interest income for 10 years whereupon they will get the $1000 face value returned.

Bonds are issued by government into the primary market, which is simply 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 the institutional machinery is voluntary and reflects the prevailing neo-liberal ideology – which emphasises a fear of fiscal excesses rather than any intrinsic need.

Most primary market issuance is via auction. Accordingly, the government would determine the maturity of the bond (how long the bond would exist for), the coupon rate (the interest return on the bond) and the volume (how many bonds) being specified.

The issue would then be put out for tender and the market then would determine the final price of the bonds issued. Imagine a $1000 bond had a coupon of 5 per cent, meaning that you would get $50 dollar per annum until the bond matured at which time you would get $1000 back.

Imagine that the market wanted a yield of 6 per cent to accommodate risk expectations (inflation or something else). So for them the bond is unattractive and under the tender or auction system they would put in a purchase bid lower than the $1000 to ensure they get the 6 per cent return they sought.

Alternatively if the market wanted security and considered the coupon rate on offer was more than competitive then the bonds will be very attractive. Under the auction system they will bid higher than the face value up to the yields that they think are market-based. The yield reflects the last auction bid in the bond issue

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.

The following blog posts may be of further interest to you:

Question 2:

If the non-government sector desires to net save in the currency of issue and acts accordingly, national income (GDP) adjustments will ensure the government sector is in deficit, irrespective of the intentions of the government.

The answer is True.

This question relies on your understanding of the sectoral balances that are derived from the national accounts and must hold by definition. The statement of sectoral balances doesn’t tell us anything about how the economy might get into the situation depicted. Whatever behavioural forces were at play, the sectoral balances all have to sum to zero. Once you understand that, then deduction leads to the correct answer.

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.

So now we can easily see that if the left-hand side [(S – I) – CAB] turns out to be positive in any period, then the non-government sector, overall is spending less than its income – which could arise in a number of ways:

(a) The private domestic surplus (S > 0) is larger than an external deficit CAB < 0

(b) Both the private domestic sector and the external sector are in surplus.

Referring to Equation (6), if the left-hand side [(S – I) – CAB > 0, then the right-hand side also have to be > 0, which means that G > T, that is a fiscal deficit.

The accounting cannot have it any other way.

The explanation is that if the non-government sector is spending less than its income, then for national income to be stable, the government sector must fill the spending gap via a deficit.

Otherwise, national income would fall, due to insufficient spending being recycled back to support existing production levels, and saving and imports would fall, G would rise (more on unemployment benefits) and T would fall (less people working).

These income shifts would bring Equation (6) back into equality and a fiscal deficit would have to result if the non-government sector successfully maintained their quest for overall positive savings.

Question 3:

The more public debt a currency-issuing government voluntarily issues the more difficult it is for banks to attract deposits to initiate loans from.

The answer is False.

Banks do not need deposits and reserves before they make loans. Mainstream macroeconomics wrongly asserts 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 this is not how banks operate. 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. As a result, investors can always borrow if they are credit-worthy.

So the statement – “the more difficult it is for banks to attract deposits to initiate loans from” reflects an erroneous view of the banking system.

The following blog posts may be of further interest to you:

That is enough for today!

(c) Copyright 2020 William Mitchell. All Rights Reserved.

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    This Post Has 4 Comments
    1. Dear Bill
      I thought question 2 was one of your semantic tricks but was wrong. I understand the sectoral balances but they are at a point in time.

      The relationships between these various flows is the essential understanding we are trying to understand. The issue for me is how does the private sector save if the gov’t does not run a deficit. If the gov’t refuses to run deficit there is no net saving.
      Perhaps an analogy is fluid flow as you transfer from a gas to a liquid or vice versa as the pressure changes. A urve is the answer not discrete.
      You often argue the gov’t is the initiator ie cause and effect.
      Can you advise where to look to understand this better.

      Question 2, keep trying to understand about this funding costs the Australian banks are always chattering about. Not that easy to find. Have you discussed this previously.

      Wishing you good health.
      Peter

    2. Dear Peter Long,

      Your question deserves thorough consideration. We need to determine the causality. We would need to describe the processes occurring within the non-government sector to have the full picture. Let’s assume a closed economy. The government can to an extent control how much it spends in a period of time (we need to choose short periods of time to correctly describe the dynamics) and can change tax rates. At the same time, at least some households have the ability to change their expenditure, too. Low-income households usually spend all what they earn but the majority of middle and upper class people can refuse to spend money and just hoard it. What households can’t do is changing their disposable income. [1] The volume of this flow depends on the level of overall economic activity. That level also depends on the private sector borrowing. This is the reason Bill used the term “net saving”. Assuming a balanced budget, private sector can still save (some agents can spend less than they earn) if some other agents spend more than they earn, by taking loans from the banking sector. We obviously know that lending comes first, once bank money is created it can be spend, saved or destroyed by repaying the loans. But excessive level of private sector debt is not sustainable, as demonstrated during the GFC.

      What will happen if the government “refuses to run a net deficit”? Well the government cannot control the volume of taxes. They can set tax rates but the volume of money collected over a period of time depends on the level of economic activity. The government can reduce their expenditures but this will reduce the GDP due to the working of the spending multiplier (which is in this case at least about 1.5) and in turn, reduce the volume of taxes collected over a period of time. Most of the adjustments occur by changes in the level of overall economic activity due to changes in aggregate demand – this is what Keynes described in his theory of effective demand. An attempt to reduce budget deficit is therefore futile unless the private sector drops its desire to net save. (But the question was referring to the situation when non-government sector maintains its desire to save). Dropping the desire to net save may happen if the majority of people only earn enough to pay for bare necessities. A working example is Greece after 2012.

      Several people have attempted to build a dynamic stock-flow consistent model of the economy. These effects can be demonstrated in such a model, with realistic behavioural equations. I can write more on this subject if required but if you sift through Bill’s blog you will find it explained much better that I can ever dream of – and my wooden English is better than dysfunctional Polish.

      [1] From Wikipedia’s article on Michał Kalecki: does capitalists’ consumption and investment determine profits or profits instead determine capitalists’ consumption and investment? Kalecki says, “The answer to this question depends on which of these items is directly subject to the decisions of capitalists. Now, it is clear that capitalists may decide to consume and to invest more in a given period than in the preceding one, but they cannot decide to earn more. It is, therefore, their investment and consumption decisions which determine profits, and not vice versa”

    3. Q2: if the private sector desires to save, and acts accordingly by reducing spending, it does not mean that they necessarily succeed. It seems to me that the correct answer is false.

    4. @tonyw

      Q2 is about the Government and Non-Government Sectors.

      The terms private sector and non-government sector are not equivalent.

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