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The Weekend Quiz – December 26-27, 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

When a government runs a continuous deficit (spending more than they are receiving in revenue), the risk is that the accumulated public spending will build up over time and cause inflation.

The answer is False.

This question tests whether you understand that fiscal deficits are just the outcome of two flows which have a finite lifespan. Flows typically feed into stocks (increase or decrease them) and in the case of deficits, under current institutional arrangements, they increase public debt holdings.

So the expenditure impacts of deficit exhaust each period and underpin production and income generation and saving. Aggregate saving is also a flow but can add to stocks of financial assets when stored.

Under current institutional arrangements (where governments unnecessarily issue debt to match its net spending $-for-$) the deficits will also lead to a rise in the stock of public debt outstanding. But of-course, the increase in debt is not a consequence of any “financing” imperative for the government because a sovereign government is never revenue constrained being the monopoly issuer of the currency.

The point is that there is no inflation risk per se with continuous fiscal deficits. The only time inflation becomes a risk from the demand side if nominal spending outstrips the capacity of the real economy to expand output.

A continuously increasing fiscal deficit might create those conditions, but a correctly calibrated continuous fiscal deficit will not because it will be just filling the non-government spending gap.

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

Question 2:

If governments allowed the automatic stabilisers built into the government balance to work counter-cyclically and avoided discretionary shifts in fiscal policy, the fiscal balance would return to its appropriate level after a cyclical disturbance.

The answer is False.

The factual statement in the proposition is that the automatic stabilisers do operate in a counter-cyclical fashion when economic growth resumes. This is because tax revenue improves given it is typically tied to income generation in some way. Further, most governments provide transfer payment relief to workers (unemployment benefits) and this increases when there is an economic slowdown.

The question is false though because this process while important may not ensure that the government fiscal balance returns to its appropriate level.

The automatic stabilisers just push the fiscal balance towards deficit, into deficit, or into a larger deficit when GDP growth declines and vice versa when GDP growth increases. These movements in aggregate demand play an important counter-cyclical attenuating role.

So when GDP is declining due to falling aggregate demand, the automatic stabilisers work to add demand (falling taxes and rising welfare payments).

When GDP growth is rising, the automatic stabilisers start to pull demand back as the economy adjusts (rising taxes and falling welfare payments).

We also measure the automatic stabiliser impact against some benchmark or “full capacity” or potential level of output, so that we can decompose the fiscal balance into that component which is due to specific discretionary fiscal policy choices made by the government and that which arises because the cycle takes the economy away from the potential level of output.

This decomposition provides (in modern terminology) the structural (discretionary) and cyclical fiscal balances. The fiscal components are adjusted to what they would be at the potential or full capacity level of output.

So if the economy is operating below capacity then tax revenue would be below its potential level and welfare spending would be above. In other words, the fiscal balance would be smaller at potential output relative to its current value if the economy was operating below full capacity. The adjustments would work in reverse should the economy be operating above full capacity.

If the fiscal outcome is in deficit when computed at the “full employment” or potential output level, then we call this a structural deficit and it means that the overall impact of discretionary fiscal policy is expansionary irrespective of what the actual fiscal outcome is presently. If it is in surplus, then we have a structural surplus and it means that the overall impact of discretionary fiscal policy is contractionary irrespective of what the actual fiscal outcome is presently.

So you could have a downturn which drives the fiscal outcome into a deficit but the underlying structural position could be contractionary (that is, a surplus). And vice versa.

The difference between the actual fiscal outcome and the structural component is then considered to be the cyclical fiscal outcome and it arises because the economy is deviating from its potential.

In some of the blog posts listed below I go into the measurement issues involved in this decomposition in more detail. However for this question it these issues are less important to discuss.

The point is that structural fiscal balance has to be sufficient to ensure there is full employment. The only sensible reason for accepting the authority of a national government and ceding currency control to such an entity is that it can work for all of us to advance public purpose.

In this context, one of the most important elements of public purpose that the state has to maximise is employment. Once the private sector has made its spending (and saving decisions) based on its expectations of the future, the government has to render those private decisions consistent with the objective of full employment.

Given the non-government sector will typically desire to net save (accumulate financial assets in the currency of issue) over the course of a business cycle this means that there will be, on average, a spending gap over the course of the same cycle that can only be filled by the national government. There is no escaping that.

So then the national government has a choice – maintain full employment by ensuring there is no spending gap which means that the necessary deficit is defined by this political goal. It will be whatever is required to close the spending gap. However, it is also possible that the political goals may be to maintain some slack in the economy (persistent unemployment and underemployment) which means that the government deficit will be somewhat smaller and perhaps even, for a time, a fiscal surplus will be possible.

But the second option would introduce fiscal drag (deflationary forces) into the economy which will ultimately cause firms to reduce production and income and drive the fiscal outcome towards increasing deficits.

Ultimately, the spending gap is closed by the automatic stabilisers because falling national income ensures that that the leakages (saving, taxation and imports) equal the injections (investment, government spending and exports) so that the sectoral balances hold (being accounting constructs). But at that point, the economy will support lower employment levels and rising unemployment. The fiscal outcome will also be in deficit – but in this situation, the deficits will be what I call “bad” deficits. Deficits driven by a declining economy and rising unemployment.

So fiscal sustainability requires that the government fills the spending gap with “good” deficits at levels of economic activity consistent with full employment – which I define as 2 per cent unemployment and zero underemployment.

Fiscal sustainability cannot be defined independently of full employment. Once the link between full employment and the conduct of fiscal policy is abandoned, we are effectively admitting that we do not want government to take responsibility of full employment (and the equity advantages that accompany that end).

So it will not always be the case that the dynamics of the automatic stabilisers will leave a structural deficit sufficient to finance the saving desire of the non-government sector at an output level consistent with full utilisation of resources.

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

Question 3:

If austerity led to all national governments simultaneously running public surpluses (which is the aim) then it would be impossible for all their respective private domestic sectors to save overall unless every country balanced their external positions.

The answer is True.

The question tests a knowledge of the sectoral balances and their interactions, the behavioural relationships that generate the flows which are summarised by decomposing the national accounts into these balances, and the constraints that is placed on the behaviour within the three sectors that is evident in the requirement that the balances must add up to zero as a matter of accounting.

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 (CAB). 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.

The private domestic sector is only one part of the non-government sector – the other being the external sector.

Most countries currently run external deficits. This means that if the government sector is in surplus the private domestic sector has to be in deficit.

However, some countries have to run external surpluses if there is at least one country running an external deficit. That country can depending on the relative magnitudes of the external balance and private domestic balance, run a public surplus while maintaining strong economic growth. For example, Norway.

In this case an increasing desire to save by the private domestic sector in the face of fiscal drag coming from the fiscal surplus can be offset by a rising external surplus with growth unimpaired. So the decline in domestic spending is compensated for by a rise in net export income.

So if all governments (in all nations) are running public surpluses and some nations are running external deficits (the majority), public surpluses have to be associated (given the underlying behaviour that generates these aggregates) with private domestic deficits.

Even if the external sector balance was zero, the proposition would still be true. At least one private domestic sector would be unable to save overall.

These deficits can keep spending going for a time but the increasing indebtedness ultimately unwinds and households and firms (whoever is carrying the debt) start to reduce their spending growth to try to manage the debt exposure. The consequence is a widening spending gap which pushes the economy into recession and, ultimately, pushes the fiscal outcome into deficit via the automatic stabilisers.

So you can sustain economic growth with a private domestic surplus and government surplus if the external surplus is large enough. So a growth strategy can still be consistent with a public surplus.

Clearly not every country can adopt this strategy given that the external positions net out to zero themselves across all trading nations. So for every external surplus recorded there has to be equal deficits spread across other nations.

You might like to read these blog posts for further information:

Special Xmas Question 4:

Santa is having trouble keeping his sled and related delivery infrastructure in working order. But he knows

(a) that he is a household and will have to save, earn or borrow to generate the funds necessary for maintenance

(b) he has been told that the household budget is equivalent to the government fiscal balance and he understands the currency-issuing government has no financial constraints so he cannot work out why suppliers won’t just accept his cheques.

The answer is Option (a). Of-course!

That is enough for today!

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

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    This Post Has 4 Comments
    1. Well Santa Claus is obviously not the typical household that needs to obtain funds before he can spend them. The truth is that Santa doesn’t spend any money- so there is no need to obtain it. And if he wanted money he could just ask the elves make it just like they make all the toys up there at the North Pole without any supplies .
      So I will not accept my answer to question 4 being judged unfairly. Of the two options, I picked the less imperfect one.
      But Merry Christmas Professor Mitchell. It is not often you are wrong- but Santa is on my side on this one.

    2. Off topic, but please help me.
      On another site where I post MMT posts, I’ve been asked to provide a list of some of the obviously false assumptions that MS econ. start with to prove their conclusions.
      I can give you just a few from my memory of my years of reading MMT authors. Can you please correct these and/or add some more.
      1] The Market consists of just one person who sells everything to himself.
      2] Banks loan out their depositors’ deposits. So, savings is necessary for investment lending/borrowing.
      3] Natural resources are infinite.
      4] All people just use self interest for all economic decisions.
      5] The national debt will have to be paid off someday using only money from taxes.
      6] That all unemployment is a choice that poor-lazy people make.
      7] All people in the Market have the exact knowledge about the stuff being sold. Or everyone in the Market has 100% of all possible knowledge about the stuff being sold.
      8] One that I remember was made by an MMTer was that after every transaction in the Market both arties are 100% satisfied with what happened. I think he was joking, though.

      So, please provide me with some help.

    3. I’m confused by Q.3 and your answer, Bill. The reason I’m confused is the inclusion of the word “unless” which I take to mean that all that you’ve said before that word becomes possible by the following “every country balanced their external positions.”

      I take those following words to mean that if every country has a balanced trade position, such that for every country CAB = 0, then you say it would be possible for respective private domestic sectors to save even though all of their public sectors were running surpluses? I can see where you say that “Even if the external sector balance was zero, the proposition would still be true. At least one private domestic sector would be unable to save overall.” which I take to mean that the answer to the question should be “False”. If “unless” was replaced by “even if” then I think the answer would be “True”?

      Just a few typos in your answer that don’t concern my above query:
      “(1)” should be inserted before the expression “GDP = C + I + G + (X – M)”; and
      “Expression (2) for GDP” should read “Expression (1) for GDP”
      There is a subsequent flow on of renumbering Expressions where “(x)” should be changed to “(x+1)”

      Thanks for your efforts in educating an interested learner.

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