The Weekend Quiz – February 26-27, 2022 – 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:

We are told that a country is running a small current account deficit and that the private domestic sector is saving overall. However, until we know the relative magnitudes of these balances, we are unable to conclude the state of the fiscal balance.

The answer is False.

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 (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.

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 overall saving (that is, spend less than it earns) 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 net save then the contracting income will clearly push the fiscal into deficit.

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

There will always be a fiscal deficit at any national income level, if the private domestic sector is succeessfully spending less than it earns and the external sector is in deficit.

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

Question 2:

The initial stock of non-government sector wealth is invariant to the decision by government to issues bonds to match its deficit spending as against not issuing any bonds.

The answer is True.

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 fiscal 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.

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.

Also, note, the question discriminates against the immediate change in wealth and later changes. As interest servicing flows occur – these become income flows to the non-government sector bond holders, which like any government spending, increases net financial assets. But at the time the bonds are purchased – there is only a shift in the composition of the wealth portfolio.

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

Question 3

The stock of government spending continually rises when there are rising fiscal deficits.

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 following blog posts may be of further interest to you:

That is enough for today!

(c) Copyright 2022 William Mitchell. All Rights Reserved.

This Post Has 6 Comments

  1. Hi Bill,
    It may be too political at present but from a MMT perspective do sanctions work when a soveriegn has own currency, floating exchange and industrial capacity and educated society. There is much being made in the media of sanctions and loss of access to swift payment system to discipline Russia at present. Whilst the military action is horrendous the belief that sanctions can be effective in my limited mmt knowledge is not strong where a country has a surplus ie giving real resources for pieces of paper and ownership of property and soccer clubs. Perhaps a basic summary of a real world example for sanctions and swift access could be commented upon. I understand mmt gets a lot of critique and this type of analysis may well ve a step to far. But sound analysis of how the real world economy works wrt swift and sanctions. Does the West hurt themselves more than Russia with sanctions given the west is recipient of real goods. Especially energy given the inflation risk of more supply chain constraints and stagflation risk if energy is constrained from Russia?
    Kind Regards

  2. Dear Ken,

    A sovereign currency and a floating exchange rate will not help much if a self-anointed president for life thinks that he is a tsar living in 19th century. He has a delusion that he can attack with impunity several major cities of a neighbouring country, hoping that his mercenaries can murder whoever he wants. The fact that Americans did similar things not so long time ago is not an excuse. Regarding the industrial capacity of Russia, it is somehow limited. This is the main issue. They have to import a lot of intermediate goods and final products, especially high-tech. The state of obsolete military communication systems proves this point. It is not enough to have missiles and tanks if the US can wiretap all relevant communications and give Ukraine advanced warnings. Financial sanctions will lead to a trade embargo at least with the West. It remains to be seen how much the Chinese will ask for the favour of trading with Russia. Or the Chinese may sell Russia for the second time if the Americans offer lifting some sanctions, why wouldn’t they? So the answer to what happens to Russia in the medium to long run lies in Beijing. Regarding the destabilisation of the financial system, Rouble is losing value and Russia has already effectively imposed capital controls. The whiplash caused by lifting the interest rate to 20% won’t prevent high inflation at least for a certain period of time (due to higher costs of imports) but will cause a deep recession. Some borrowers will go bankrupt on mortgages. There will be 2 exchange rates like in the 1980s. I think they will move to war economy. Russian banks and corporations will undoubtedly default on their foreign debt denominated in USD and EUR. It is possible that losses of Western financial institutions will have to be compensated by governments and central banks, they know how to do it. The negative effects on the West will be limited. Higher prices of energy cause moderately higher inflation but also stimulate investment in the renewables. It is very likely that a prolonged war with Ukraine (which is and will be supplied by the US and European countries) will drain so much real resources that at some point of time Russia will simply not be able to replace damaged equipment and their grip over Eastern Ukraine will fade. In my view, Russia has zero chance winning a war of attrition with Ukraine if the West helps, just like USSR in the 1980s in Afghanistan. Let’s hope that the inevitable removal of President Putin is swift and does not lead to more trouble. The future is grim anyway, power may be taken by liberals who will sell off everything for the second time to another crop of oligarchs and so-called Western investors.

  3. ” Higher prices of energy cause moderately higher inflation but also stimulate investment in the renewables.”

    Why won’t the lack of foreign competition in Russia drive investment in productive capacity there? Why won’t people from the export industry be redeployed to production for the war machine?

    Our hope is that the ‘sound money’ nonsense, as demonstrated by the increased in interest rates, persists and that Russia makes the same sort of mistakes as Turkey.

  4. Their academic circles and their CB are infested by New Keynesians, you can count on them. At a microscale they still haven’t reformed since circa 1861. Critical thinking is not recommended and the majority of independently thinking people have left the country. They believe in their own propaganda. They have highly developed intelligence service which could hack Hillary Clinton’s email account but was not capable of gauging the social mood in Ukraine before the invasion. The prospect of adjusting the economy quickly is limited – they are supply, not demand, constrained. If the Chinese rescue them by breaking the sanctions, this is exactly what the US is hoping for. Then both China and Russia will be cut off from the rest or the world and the West + India can still prevail in the big game. But I don’t think that the Chinese are that stupid. Russian friends will be thrown under the bus to buy a few years of stability to break through the last remaining technological barriers.

  5. Also sanctions alone are probably not enough and Putin has been preparing for them since 2014 however the combination of unexpectedly stiff resistance from the Ukrainians (I don’t believe that Russians are physically capable of occupying the whole country), covert Western military support and the sanctions will certainly do the job even if the Chinese offer some assistance. On the ideological front, Russian invasion is probably an event of the same magnitude as Pearl Harbour at least for Europeans. No longer Western liberals are preoccupied with wokiness, Covid and carbon trading hypocrisy. There is a real enemy of the liberty, committing visible and real crimes against humanity (as defined by the UN), in Europe, not somewhere in Africa or Asia. Liberalism is no longer dead, regardless of its side effects. The real risk is a miscalculation or an act of madness on Russian side, leading to nuking Warsaw, which will spill over within minutes to a global WWIII…

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