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.
These were the Quiz questions for the third week of my edx MOOC – Modern Monetary Theory: Economics for the 21st Century – that recently concluded.
I promised students that I would provide answers and analysis for them after the course finished. So that is what the ‘Weekend Quiz’ for April 2021 will be occupied with.
Which of these situations represents an inflationary episode in the macroeconomic sense?
- (a) On July 1, 2000, the Australian government introduced a Goods and Services Tax of 10 per cent on most goods and services (with some exemptions). In the September-quarter 2000, the Consumer Price Index rose by 6.1 per cent.
- (b) The press reported that Australia’s property prices rose at their fastest rate since 2003 in February 2021.
- (c) The Consumer Price Index rose by 9 per cent in month one, six per cent in month two and 3 per cent in month three.
- (d) The Consumer Price Index rose by 3 per cent in month one, 6 per cent in month two and 9 per cent in month three.
Answer: Options (c) and (d).
In the video and written material, students were told that inflation is the continuous rise in the general price level.
Deflation is the opposite.
A once-off price rise is not an inflationary episode.
If the inflation rate is falling, prices are still rising but at a slower rate.
Extreme cases of accelerating inflation are referred to as hyperinflation.
They were also taught in the first week that the ‘general price level’ is a composite (unobserved) measure compiled by the national statisticians to reflect some basket of prices of actual prices of goods and services.
That measure is called the Consumer Price Index. There are other composite measures like the Producer Price Index produced by the statisticians, each aimed to convey some information about the underlying inflationary environment.
Option (a) was an example of a once-off price level change as business firms adjusted their prices up to accommodate the 10 per cent GST. It is not what we would call an inflationary episode, although it could have led to one.
Option (b) relates to price rises in a particular sector of the economy (property) and is also not a continuous rise in the ‘general’ price level, even though it may have influenced the course of prices generally.
Option (c) is an example of inflation where the price level is continuously rising but the rate of increase is deceleratng (slowing down).
Option (d) is an example of the price level continuously rising with the rate of increase is acceleratng (inflation rate is rising).
In 2008, the consumer price level in Zimbabwe rose by 157 per cent. Between 1998 and 2008, real GDP fell by 50.7 per cent. The hyperinflation arose mainly because:
- (a) The Zimbabwean government was spending too much.
- (b) The Reserve Bank of Zimbabwe was issuing too much money.
- (c) Private banks were issuing too much credit.
- (d) The supply side of the economy contracted so much that previously normal (non-inflationary) levels of spending growth were now vastly excessive.
Answer: Option (d).
While we can make judgements about whether the Zimbabwean government was spending too much, or whether the Reserve Bank was creating too many reserves and whether the private bank lending rates were excessive, the overwhelming reason that the nation experienced hyperinflation was that the supply capacity of the economy contracted sharply rendering the existing spending excessive.
The supply contraction began when Robert Mugabe introduced land reforms to speed up the process of equality and allowed the revolutionary fighters that gained Zimbabwe’s freedom from the white colonial masters to take over productive, white-owned commercial farms which had hitherto fed the population and was the largest employer.
Farming output collapsed, which then led to the central bank rationing foreign exchange that was typically made available to manufacturers to import essential capital equipment. As a result, manufacturing output also declined.
The reality was that the Government could have been running fiscal balances and there still would have been hyperinflation.
Please read my blog post – Zimbabwe for hyperventilators 101 (July 29, 2009) – for a more detailed historical account of what went wrong in Zimbabwe.
An employment buffer stock scheme involves the government offering an infinite demand for labour. This means that:
- (a) the supply of labour is fixed.
- (b) the scheme will expand and contract on demand from workers for jobs.
- (c) the government allocates a fixed amount of currency to run the program.
- (d) unproductive jobs can be created at will.
Answer: Option (b).
The essence of the Job Guarantee (JG) is that the government provides an unconditional, open ended job offer at a socially-inclusive minimum wage to anyone who desires to work.
Instead of a person becoming unemployed when aggregate demand falls below the level required to maintain full employment, the person is able to enter the JG workforce.
Thus, the JG pool expands (declines) when private sector activity declines (expands).
Hence the JG fulfils an absorption function, which minimises the costs associated with the flux of economic activity when aggregate spending fluctuates.
It means that instead of the government setting some fixed ‘budget’ amount for a program, which then limits the scope of the spending, the government maintains an open-ended spending commitment and allows the actual expenditure in any period to be determined by how many workers turn up to get a Job Guarantee position.
This is what we call spending on a ‘price rule’. The government sets the price and lets the quantity float.
Accordingly, the outlays on the program vary according to the strength of the non-government sector econoy.
A major criticism of mainstream economists of the use of fiscal deficits is that they crowd out productive private spending. That criticism errs because:
- (a) A currency-issuing government can buy whatever is for sale in its own currency.
- (b) Banks create deposits when they make loans to credit-worthy customers.
- (c) The central bank is part of government.
- (d) Interest rates are now at very low levels.
Answer: Option (b).
Mainstream economists assert that when national governments run deficits and issue debt, they crowd out more productive private spending.
The assertion is a central part of the mainstream attack on government fiscal intervention.
At the heart of this conception is the Classical Loanable Funds theory, which creates a fictional rendition of the way financial markets work. I won’t go into the full history of this theory, although if you want to get a serious understanding of the debates in macroeconomics then you have to become familiar with this literature.
For our purposes, the crowding out hypothesis is based on the claim that at any point in time, there is a limited supply of private sector saving for which government and private sector borrowing compete.
If government tries to borrow more, by issuing and selling more bonds, then the competition for finance would push up interest rates as the demand for saving rises relative to a scarce supply.
The upshot is that some private firms would then find that the higher borrowing rates render their investment projects unprofitable and so private investment expenditure falls.
They also claim that private investment spending is always more productive and desirable than wasteful government spending, because private firms have to face the market test to survive while there are no shareholders to ‘keep government honest’.
A careful understanding of what drives saving and how banks actually operate shows that the basic crowding out hypothesis is inapplicable in modern monetary systems.
First, government deficits stimulate sales, which leads to higher GDP (income).
As a result, the pool of savings expands because saving is a function of GDP (income).
The other way of understanding this is that government deficits generate non-government surpluses that accumulate to increased wealth holdings in the non-government sector – as students learned in Week 1 of the MOOC.
Since there are more savings and greater financial wealth, government borrowing does not reduce the pool of funds available to private sector borrowers.
Quite the contrary.
Second, if we examine the way modern banks operate, it further becomes obvious that the crowding out conjecture does not apply to the real world.
Students in mainstream banking courses are told that commercial bank lending is reserve constrained.
That is, banks are considered to solicit deposits from lenders, which then allows them to build up reserves that they can then loan out.
But in the real world, bank loans are not reserve-constrained.
Banks do not just sit around waiting to dollop out their current deposits to lenders in some sort of rationing plan.
Banks solicit credit-worthy borrowers to extend loans to.
Importantly this means that loans create deposits, not the other way around.
To extend the discussion, we need then to understand the role of bank reserves.
The commercial banks all have to maintain reserve accounts with the relevant central bank.
The funds in those accounts are used exclusively as a means to settle all the daily transactions between banks.
Loans create deposits which can then be drawn upon by the borrower.
No reserves are needed at that stage.
The loan desks of commercial banks have no interaction with the reserve operations of the monetary system as part of their daily tasks.
They just take applications from credit worthy customers who seek loans and assess them accordingly and then approve or reject the loans.
The reserve accounts are a centralised way to resolve the various cross-bank claims each day. Refer back to the previous discussion on fiscal and monetary policy.
If a bank is short of reserves on any particular day, they can seek loans from other banks with excess reserves.
If they cannot source sufficient reserves to cover all the transactions drawn against them, then they can always borrow from the central bank.
The central bank stands ready to ensure there are always sufficient reserves to ensure financial stability is maintained.
The reality is that banks only loan excess reserves among themselves as part of the payments system (cheque clearing) and that lending is not constrained by deposits (and hence, reserves). Banks do not loan out reserves to customers. They do not need to. They can create loans with a keyboard entry.
In short, fiscal deficits do not reduce the capacity of private borrowers to access funds in the financial markets.
Moreover, given that fiscal deficits provide stimulus to the private economy, they also provide conditions propitious for profit-making and greater investment opportunities.
Rather than crowding out private spending, fiscal deficits actually crowd-in private opportunities.
There is another narrative that an advanced course would relate where fiscal deficits actually create excess reserves in the banking system which places downward pressure on interest rates.
But that story was considered beyond this introductory course.
Commercial banks are required to hold reserve accounts with the central bank for which reason:
- (a) To protect their shareholders from losses.
- (b) To ensure their depositors can earn interest.
- (c) To ensure that all daily transactions in the economy that involve claims between banks can be resolved without any ‘cheques’ bouncing.
- (d) To make it easier for government to know what is going on in financial markets.
Answer: Option (c).
Each commercial bank has to have a reserve account with the central bank with sufficient balances each day, to ensure that all cross-bank transactions clear and no ‘cheques bounce’.
A Bank A customer might send a cheque to a supplier who banks with Bank B. Bank B must be able to get the funds from Bank A.
These transfers are all accomplished by adjusting balances in the respective reserve accounts.
Reserve account funds have typically not earned a competitive return, although since the GFC, many central banks offered such returns on reserve balances.
Prior to that, if there were excessive reserves in the system, the banks with excesses would try to make loans in the interbank market (a market for overnight or very short-term loans between banks) to other banks, which might have shortfalls on any particular day.
In the absence of central bank intervention, this process would drive the interbank market down towards zero because any return is better than none.
To avoid losing control of its monetary policy target, the central bank conducts daily liquidity or reserve management operations.
When there is a system-wide shortfall in reserves, then the central bank will always make the necessary reserves available to the banks.
When excess reserves arise, the central bank would exchange interest-bearing government bonds for bank reserves and thus eliminate any excesses.
This would ensure the interbank interest rate would remain aligned with the central bank’s policy target rate.
Economists call this an Open Market Operation.
It allows you to understand one function of government debt – to stabilise short-term interest rates so they are consistent with the monetary policy target rate.
Since the GFC, many central banks just pay interest on excess reserves, which accomplishes the same outcome. So, there is no need for government to issue debt at all.
The tie in with fiscal policy then arises because when government spends, bank reserve holdings at the central bank increase.
Tax payments do the opposite.
If government spending exceeds taxes, overall bank reserves grow and if fiscal deficits are of any significant size, excess reserves in the banking system will result.
Banks do not want to hold more than they need for cheque clearing and to meet required reserve ratios (if they exist).
Thus, the central bank and treasury must coordinate their daily operations closely to ensure that the impact of fiscal policy on bank reserves is anticipated and central bank liquidity management is effective to maintain the target interest rate.
That is enough for today!
(c) Copyright 2021 William Mitchell. All Rights Reserved.