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The Weekend Quiz – June 13-14, 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:

The issuance of bonds by a currency-issuing government to match its net spending (fiscal deficit) augments the nominal wealth held by the non-government sector.

The answer is False.

Be careful to differentiate the impact of the fiscal deficit on non-government net wealth and the accompanying bond operation. The latter alters the existing wealth portfolio while the former expands net wealth.

This answer relies on an understanding the banking operations that occur when governments spend and issue debt within a fiat monetary system. That understanding allows us to appreciate what would happen if a sovereign, currency-issuing government (with a flexible exchange rate) ran a budget deficit without issuing debt?

In this situation, 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.

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.

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

Question 2:

When a country runs a small current account deficit and the private domestic sector is saving overall, the government fiscal balance will always be in deficit.

The answer is True.

This question requires an understanding of the sectoral balances that can be derived from the National Accounts. But it also requires some understanding of the behavioural relationships within and between these sectors which generate the outcomes that are captured in the National Accounts and summarised by the sectoral balances.

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 what economic behaviour might lead to the outcome specified in the question?

If the nation is running an external deficit it means that the contribution to aggregate demand from the external sector is negative – that is net drain of spending – dragging output down. The reference to a “small” external deficit was to place doubt in your mind. In fact, it doesn’t matter how large the external deficit is for this question.

Assume, now that the private domestic sector (households and firms) seeks to increase its saving ratio and is successful in doing so. Consistent with this aspiration, households may cut back on consumption spending and save more out of disposable income. The immediate impact is that aggregate demand will fall and inventories will start to increase beyond the desired level of the firms.

The firms will soon react to the increased inventory holding costs and will start to cut back production. How quickly this happens depends on a number of factors including the pace and magnitude of the initial demand contraction.

But if the households persist in trying to save more and consumption continues to lag, then soon enough the economy starts to contract – output, employment and income all fall.

The initial contraction in consumption multiplies through the expenditure system as workers who are laid off also lose income and their spending declines. This leads to further contractions.

The declining income leads to a number of consequences. Net exports improve as imports fall (less income) but the question clearly assumes that the external sector remains in deficit. Total saving actually starts to decline as income falls as does induced consumption.

So the initial discretionary decline in consumption is supplemented by the induced consumption falls driven by the multiplier process.

The decline in income then stifles firms’ investment plans – they become pessimistic of the chances of realising the output derived from augmented capacity and so aggregate demand plunges further. Both these effects push the private domestic balance further towards and eventually into surplus

With the economy in decline, tax revenue falls and welfare payments rise which push the public fiscal balance towards and eventually into deficit via the automatic stabilisers.

If the private sector persists in trying to increase its saving ratio then the contracting income will clearly push the fiscal balance into deficit.

So we would have an external deficit, a private domestic surplus and a fiscal deficit.

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

Question 3:

When discussing cuts to discretionary national fiscal positions, progressive voices typically support imposing tax increases while conservatives recommend spending cuts and privatisation. In terms of the initial impact on national income, which policy option will be more damaging – a tax increase which aims to increase tax revenue at the current level of national income by $x or a spending cut of $x?

(a) Tax increase

(b) Spending cut

(c) Both will be equivalent

(d) There is not enough information to answer this question

The answer is Option (b) Spending cut.

The question is only seeking an understanding of the initial drain on the spending stream rather than the fully exhausted multiplied contraction of national income that will result. It is clear that the tax increase increase will have two effects: (a) some initial demand drain; and (b) it reduces the value of the multiplier, other things equal.

We are only interested in the first effect rather than the total effect. But I will give you some insight also into what the two components of the tax result might imply overall when compared to the impact on demand motivated by an decrease in government spending.

To give you a concrete example which will consolidate the understanding of what happens, imagine that the marginal propensity to consume out of disposable income is 0.8 and there is only one tax rate set at 0.20. So for every extra dollar that the economy produces the government taxes 20 cents leaving 80 cents in disposable income. In turn, households then consume 0.8 of this 80 cents which means an injection of 64 cents goes into aggregate demand which them multiplies as the initial spending creates income which, in turn, generates more spending and so on.

Government spending cut

A cut in government spending (say of $1000) is what we call an exogenous withdrawal from the aggregate spending stream and this directly reduces aggregate demand by that amount. So it might be the cancellation of a long-standing order for $1000 worth of gadget X. The firm that produces gadget X thus reduces production of the good or service by the fall in orders ($1000) (if they deem the drop in sales to be permanent) and as a result incomes of the productive factors working for and/or used by the firm fall by $1000. So the initial fall in aggregate demand is $1000.

This initial fall in national output and income would then induce a further fall in consumption by 64 cents in the dollar so in Period 2, aggregate demand would decline by $640. Output and income fall further by the same amount to meet this drop in spending. In Period 3, aggregate demand falls by 0.8 x 0.8 x $640 and so on. The induced spending decrease gets smaller and smaller because some of each round of income drop is taxed away, some goes to a decline in imports and some manifests as a decline in saving.

Tax-increase induced contraction

The contraction coming from a tax-cut does not directly impact on the spending stream in the same way as the cut in government spending.

First, imagine the government worked out a tax rise cut that would reduce its initial fiscal deficit by the same amount as would have been the case if it had cut government spending (so in our example, $1000).

In other words, disposable income at each level of GDP falls initially by $1000. What happens next?

Some of the decline in disposable income manifests as lost saving (20 cents in each dollar that disposable income falls in the example being used). So the lost consumption is equal to the marginal propensity to consume out of disposable income times the drop in disposable income (which if the MPC is less than 1 will be lower than the $1000).

In this case the reduction in aggregate demand is $800 rather than $1000 in the case of the cut in government spending.

What happens next depends on the parameters of the macroeconomic system. The multiplied fall in national income may be higher or lower depending on these parameters. But it will never be the case that an initial fiscal equivalent tax rise will be more damaging to national income than a cut in government spending.

Note in answering this question I am disregarding all the nonsensical notions of Ricardian equivalence that abound among the mainstream doomsayers who have never predicted anything of empirical note! All their predictions come to nought.

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

That is enough for today!

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

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    This Post Has 7 Comments
    1. As usual my quiz results are less than impressive. However having finally decided to part with the necessary to obtain the Kindle edition of bill et al’s book ‘Macroeconomics’ I’m hoping to improve in the coming weeks. I have already penned my first dissertation:

      The Un-Science of Economics
      Greek philosophy was not without its flaws. Aristotle, for example, believed that a falling object fell with a speed related to its weight. Heavy objects fall faster than light ones. “It stands to reason” as some might say. You just believe it to be true without basing your belief on any real evidence at all.
      It was nearly two millennia before a bright lad called Galileo thought that it might be a good idea to test this belief by actually observing something in the real world and proved, by making real experiments, that objects fall at a speed which is independent of their weight. Thus was born the ‘scientific method’ of attempting to understand how the world works. This method follows a definite path:
      1) Formulate an hypothesis that attempts to predict the outcome resulting from a specified set of starting conditions.
      2) Perform an experiment to test the validity of the hypothesis by observing how closely the real outcomes match the prediction.
      3) If the outcomes do not match the prediction attempt to understand why and modify your hypothesis appropriately.
      4) Repeat as required.
      For many years this approach has been seen as the correct and respectable way to develop every scientific discipline… except economics.

    2. The anomaly you point out in your last sentence leads to one of two conclusions: (1) Economics has heretofore failed to develop as an accurate science because it has failed to follow the scientific method; or (2) Economics is not a science at all–at least not fully–but rather necessarily partakes in “the humanities.” While both conclusions seem true to me, and MMT certainly makes a substantial improvement in the application of the scientific method to the economic discipline, I believe the second conclusion to be the more profound and revealing one. I submit that MMT economists like Bill recognize this “partaking in the humanities” by repeated insistence that a meta-economic set of moral and/or political values must be embraced in order to apply what is seen through the MMT lens.

    3. I also think it is because earlier economists might associate economics with soft science (psychology, humanities) more than the physical sciences (physics, biology). But it is also because the sectoral balances equation as the precondition of the macroeconomic system was never anchored/or sat straight in the discussions. Hence, the haphazard developments of discussions of policies regardless of the moral, political and so on values.

      For example, cutting tax or cutting spending – one could create them to produce similar effects, but which one to adopt is very much depended on the set of values a group of people hold, as pointed out by the authors of the first MMT textbook quite often.

      So, in conclusion, even if we recognize this (as in the ‘first dissertation’), but if people are to have a better future now, it might be better to try to promote the desire policies first and change the lens later.

      This is my thesis…

      Have a nice week!
      vorapot

    4. Off topic again.
      I posted this on another site.
      Please discuss this analogy.
      Remember I said or claimed that every economy in the long run MUST have a way to circulate the money from the corps. back to their customers. Think of the money as water in 2 adjacent bath tubs. There are 2 hoses with small pumps between the tubs; 1] is from the people’s tub to the corps’. tub, and 2] is from the corps’. tub to the people’s tub. If the Gov. is not deficit spending and there is no foreign trade then no money at all is being added to either tub except from the other tub.
      . . . In this case, if more water is being pumped from the people’s tub to the corps’. tub than is being returned; then after enough time all the water in the people’s tub will have been pumped into the corps’. tub and it might be overflowing. The reverse is also true. Therefore, all stable economies [b]MUST have exactly equal[/b] flows in the 2 hoses.

      But, we know that the US Gov. does deficit spend. This is represented by 2 spigots that add water to both tubs. Soc. Sec. adds to the people’s tub and QE adds to the corps’. tub. Obviously the amounts can be varied in an infinite number of ways. Right now much more QE is going on than all payments to the people. But, it doesn’t matter all that much, so assume the 2 spigots add equal amounts.
      . . . Now, if more water flows thru the hose from the people’s tub into the corps’. tub, then then after long enough time the people’s tub will be empty; unless enough is being added from the spigot. Assume it isn’t.
      . . . Remember the Gov. has infinite water to add to the tubs. So, by the time the above people’s tub is empty the corps’, tub will be overflowing. It has had all the water from both spigots and all the water that started in the people’s tub poured or pumped into it (the corps’. tub).
      . . . I claim that this is just reality. It must be true.
      . . . I claim that the analogy is a good one.
      . . . I therefore claim that my original statement is true [that all stable economies must circulate the money round and round.] To be more specific, there must be some way for an amount of money be somehow sent from the corps. (and rich) down to the people that is [b]equal[/b] (on the average over time) to the amount that the people spend to buy stuff from the corps. The deficit spending by the Gov. complicates this, but most of it is saved by the rich. And so this saving doesn’t cause inflation, except in asset prices.
      . . . MMT would add a 3rd tub that represents all the saving being done by both the people and the corps. MMT says that replacing those dollars that the people want to save is necessary to keep incomes up. That every dollar parked as savings is a dollar that didn’t add to someone’s income [banks don’t recirculate savings with loans, banks create dollars when they make loans, and this is offset by new debt].

      End of this.
      Because there are 2 or 3 tubs with 2 spigots and hoses & pumps there are now flows going on in this analogy.

    5. @Steve_American

      Just happened to see your comments. In my opinion, if you allow me, what you wrote doesn’t make any sense nor lead to any where.

      The analogy doesn’t paint any meaningful pictures or add any new insights.

      The problem I think lies in the lens you used.

      I would improve the passage by reading all the related sectoral balance equations carefully (I think this is the reason why Bill repeats it every so often in the weekly quizzes), and if you want to challenge any part, or propose any new thing, start from there and re-present again. I think we would be able to see and judge it better.

      That would be my discussions…

      Best regards,
      Vorapot

    6. vorapot,
      The old (for you) insight I was illustrating is that an economy is not stable if the money keeps flowing up to the wealthy.
      The people I was responding to did not seem to understand that.
      So, for them it is a NEW insight.

    7. @Newton Finn
      I quite agree that good moral/political values are required if the clear view provided by the MMT lens is to be of general benefit. I have bought the book in order to try and better understand how this might work in practice.
      My primary point was how the mainstream seems unable or unwilling to learn from it’s experience and it’s mistakes and thus improve it’s methods. Austerity measures haven’t worked in the UK, Japan doesn’t have hyperinflation, Trickle-Down policies haven’t reduced the gap between rich and poor (Trickle-UP seems a better description of what happens in practice) .

      @Steve_American
      You need to take account of the varying size of the tubs and therefore the varying quantity of water required to avoid an overflow (inflation) or too much tub above the waterline (unemployment).

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