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The Weekend Quiz – October 22-23, 2022 – answers and discussion – Bill Mitchell – Modern Monetary Theory

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 second 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.

Question 1:

The reason that MMT economists favour flexible exchange rates over the Bretton Woods system of fixed exchange rates is because

(a) Fiscal and monetary policy tools can target domestic policy outcomes and not be compromised by having to defend a particular exchange rate as was the case under Bretton Woods system.
(b) Taxes are not required to fund government spending.
(c) Government debt is able to be paid back more easily.
(d) Currency speculation is reduced.

The answer is Option (a)

The MOOC students were given visual and written material that provided an historical context to the modern fiat currency era.

This material gave students the understanding of how the Bretton Woods system worked and what it meant for government in terms of constraining policy space.

They learned how the fiat currency system evolved and opened up the fiscal space for governments beyond what had previously been available under the fixed exchange rate system.

The relevance here is that under the Bretton Woods system, central banks had to carefully manage the amount of their currencies in the system to ensure they maintained the agreed parities with other currencies.

An excess supply of say, Australian dollars (pounds before 1966) in foreign exchange markets required the Reserve Bank of Australia (RBA) to purchase dollars with foreign currency reserves and increase domestic interest rates to attract foreign investment (and demand for dollars).

But the money supply contraction and higher interest rates pushed unemployment up and if expansionary fiscal policy was used too aggressively to reduce unemployment – putting currency back in the system – it would compromise the RBA’s efforts to maintain currency stability.

As a consequence, without an increase in gold reserves, increased government expenditure (injecting currency) had to be matched (‘financed’) by taxation and if they wanted to spend more than their tax revenue, they had to issue debt (draining currency).

The collapse of the Bretton Woods system dramatically altered the opportunities available to currency-issuing governments.

First, under a fiat monetary system, ‘state money’ no longer had any intrinsic value (no longer convertible into gold). For an otherwise ‘worthless’ currency to be acceptable in exchange (buying and selling things) some motivation was required. That motivation emerges because the sovereign government requires its use to relinquish private tax obligations.

Second, as the monopoly issuer of the fiat currency, the Bretton Woods restrictions to offset spending with taxation and/or borrowing are no longer binding because the central bank no longer has to defend the floating currency.

There is no financial constraint on government spending. The government can buy any goods and services that are available for sale in its currency including all idle labour.

The only meaningful constraint is the ‘inflationary ceiling’ that is reached when all productive resources are full employed. This is a dramatic change

So the answer is Option (a).

Question 2:

The lesson that the Pompeii story taught us was that:
(a) The old coins used in Pompeii were able to buy goods and services.
(b) The government had to spend first before it could collect taxes.
(c) The once thriving city was destroyed by a volcanic eruption.
(d) Some people worked in the non-government sector.

The answer is Option (b)

MOOC Students were given a short version of Warren Mosler’s Pompei story where he reported on a conversation with a tour guide during an organised public tour of Pompeii in Italy.

The guide had showed him some simple metal coins that had been used in the city during the period when Pompeii was great.

The tour guide said that the Pompei authorities collected these coins as taxes and then paid public servants to deliver excellent public services.

Warren noted that it was backwards – the people were paid then the taxes collected.

After some denial, the question was “where do coins come from?” to which the guide said: “Well, the government made them.”

Which raised the question: “How did anybody get a coin to pay the tax?

The point of the story is that it is the imposition of the tax liability that drives the desire to provide resources to the government in return for its currency.

Then once the currency is spent the capacity to pay taxes is evident.

So the answer is Option (b).

Question 3:

If the expenditure multiplier is estimated to be 1.5, then if the government expands its spending by $100 billion, we expect GDP to rise by

(a) $1500 billion.
(b) $1.5 billion.
(c) $150 billion.
(d) $100 billion less 1.5 times $100 billion.

The answer is Option (c)

A very simple question.

In this blog post – Spending Multipliers (December 28, 2009) – I provided a detailed analysis of what determines the value of the expenditure multiplier.

The expenditure multiplier, which describes the GDP adjustment mechanism that occurs when an existing equilibrium is disturbed by a new spending injection (or withdrawal), is an essential part of the policy making tool kit because it answers the question as to how large an initial stimulus or contractionary package have to be to achieve the desired final outcomes.

GDP and national income will rise if planned spending rises and will fall if planned spending falls.

The question of interest now is by how much will GDP and national income change after a change in planned spending driven, for example, by a change in government spending.

The expenditure multiplier describes a multi-period adjustment process following an initial change in spending.

From an initial equilibrium position, an increase in spending expenditure (say by government) provides an instant boost to total spending.

Firms respond to the increased planned expenditure and raise employment to produce the increased output or GDP. National income increases.

This rise in national income induces further consumption spending which leads to a further rise in aggregate spending, employment and GDP. A proportion of the rise in national income leaks out in the form of higher tax payments, import spending and increased saving.

So, after each ’round’, the induced spending boost gets smaller and smaller.

The process continues until the induced spending becomes so small that there are no further GDP increases. On the other hand, a fall in autonomous expenditure leads to a series of cuts in employment, GDP and tax payments, imports and saving.

The expenditure multiplier thus indicates by how much GDP and national income changes when there is a change in autonomous expenditure. The larger is the multiplier, the larger is the change in GDP and national income for a given change in autonomous expenditure.

So, if the multiplier was 1.8, for example, then if the government increased its spending by $1, total GDP would rise by $1.80. If the multiplier was below
1, then a $1 increase in government spending, for example, would lead to less than $1 rise in GDP, which means a fiscal stimulus would fail.

So in this case, the initial exogenous injection of $100 billion by the government would lead to an overall increase in GDP of $150 billion.

So the answer is Option (c).

Question 4:

The expenditure multiplier will be largest in which case:

(a) Households consume 70 cents of every extra dollar in disposable income received.

(b) Households consume 80 cents of every extra dollar in disposable income received.

(c) Households save 20 cents of every extra dollar in disposable income received.

(d) Households save 10 cents of every extra dollar in disposable income received.

The answer is Option (d)

Refer also to the answer in Question 3.

The determinants of the multiplier’s value all influence how much of the initial spending injection is subsequently induced into the next round of spending and beyond, noting that at each round the induced extra spending gets smaller and smaller.

We can think of this in terms of the leakages from the expenditure stream: taxation, saving and import spending.

So when government spending rises, GDP rises but so does tax revenue, household saving and import expenditure.

Each time GDP rises, these leakages ensure that the amount that will flow into the expenditure stream next period is smaller than the last period from an initial spending injection that disturbs the steady state.

The expenditure multiplier is higher when:

(a) The marginal propensity to consume (MPC), which is the fraction of every dollar of disposable income consumed, is highest. The MPC can be any value of 0 to 1 (conceptually), which means that the marginal propensity to save (MPS) equals 1 – MPC.

The higher the MPC, the higher is the induced household consumption expenditure out of disposable income following an initial spending injection (say from government).

(b) the lower is the tax rate – so the rise in disposable income is higher for every extra dollar of GDP.

(c) the lower is the marginal propensity to import, which is the fraction of every dollar of GDP that goes into buying imports.

In the question:

  • Option (a) MPC = 0.7
  • Option (b) MPC = 0.8
  • Option (c) MPC = 0.8 because MPC = 1 – MPS = 1 – 0.2
  • Option (d) MPC = 0.9 because MPC = 1 – MPS = 1 – 0.1

So the answer is Option (d) and we are assuming the other determinants of the multiplier were constant across each of the options.

Question 5:

If you observed the following conditions, which would be consistent with a stable GDP level?

(a) The government deficit is $10 (spending greater than tax revenue), household saving is $20, Import expenditure is $20, total investment expenditure is $20 and export sales equal $10. The unemployment rate is 10 per cent.

(b) The government deficit is $15 (spending greater than tax revenue), household saving is $20, Import expenditure is $20, total investment expenditure is $15 and export sales equal $15. The unemployment rate is 5 per cent.

(c) The government deficit is $10 (spending greater than tax revenue), household saving is $15, Import expenditure is $20, total investment expenditure is $10 and export sales equal $10. The unemployment rate is 12 per cent.

(d) The government deficit is $10 (spending greater than tax revenue), household saving is $20, Import expenditure is $20, total investment expenditure is $20 and export sales equal $15. The unemployment rate is 10 per cent.

The answer is Option (a)

This is a question about income equilibrium, which means a state where there are not forces present that will cause GDP to change from its current level.

MOOC students learned that the national economy comes to rest (GDP is stable at that level) when the sum of the injections equals the sum of the leakages.

The injections were government spending, business investment and export spending.

The leakages were household saving, tax revenue and import expenditure.

The students also learned that GDP changes promote changes in the leakages because saving is a positive function of disposable income, tax structures usually are geared to generate more revenue as economic activity rises and import spending rises with GDP growth.

So if an equilibrium is disturbed by some new injection (say, a government stimulus package or an export boom) then a process ensues that traces the path back to a new (higher in this case) GDP level and equilibrium.

The question was thus testing this knowledge and putting some numbers to the concepts.

There was a slight twist to the arithmetic required which made the conceptual challenge a little more interesting.

It would have been too easy just laying out the values of the injections and leakages and then it would just be a simple matter of addition.

So I complicated it a little by providing one net injection – the government fiscal position, which is the difference between an injection (G) and a leakage (T).

So the simple rule for a steady-state is:

G + I + X = T + S + M

Now we can arrange that to be another way of writing the steady-state condition:

(G – T) + I + X = S + M

Which puts it into the way the question is framed.

Filling in the values gives:

Option (a): $10 + $20 + $10 equals $20 + $20 (so this is a steady-state situation)

Option (b): $15 + $15 + $15 does not equal $20 + $20 (so this is not a steady-state situation and GDP would still be adjusting)

Option (c): $10 + $10 + $10 does not equal $20 + $20 (so this is not a steady-state situation and GDP would still be adjusting)

Option (d): $10 + $20 + $15 does not equal $20 + $20 (so this is not a steady-state situation and GDP would still be adjusting)

The information about the unemployment rate was irrelevant and included to distract or rather to further test the confidence the student had in their understanding.

So the answer is Option (a).

That is enough for today!

(c) Copyright 2021 William Mitchell. All Rights Reserved.

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