Weekend Quiz – 5-6 November 2022 – Answers and Discussion – Bill Mitchell – MMT

Below are the discussion answers for this weekend’s quiz. The information provided should help you figure out why you missed a question or three! If you haven’t completed the quiz since yesterday, give it a try before reading the answers. I hope this helps you understand Modern Monetary Theory (MMT) and its application to macroeconomic thinking. Comments are welcome as usual, especially if I make a mistake.

These are the quiz questions for the fourth and final week of my recently concluded edx MOOC (Modern Monetary Theory: Economics in the 21st Century).

I assure my students that I will provide them with answers and analysis after the course is over. That’s what the April 2021 Weekend Quiz is all about.

Question 1

MMT’s classification of exports as costs means:

1. (a) Currency-issuing governments are not subject to fiscal constraints.
2. (b) Foreign spending on the local economy may lead to inflation.
3. (c) The resources embodied in exports are lost by the state and used by foreigners to promote their material prosperity.
4. (d) Interest on government debt must be repaid.

Reply: Option (c)

Countries trade to expand their consumption possibilities.

In a world where we produce for consumption, it’s actually better to receive goods and services than to send them elsewhere.

In this case, MMT describes exports as a cost and imports as a benefit for a country.

Exporting requires the country to incur opportunity costs by sending foreigners real resources (embodied in products or raw materials) that can be used locally.

Instead, imports represent foreigners giving up their actual resources (embodied in products or raw materials), which are then enjoyed by the importing country.

Therefore, an external deficit (imports greater than exports) means that a country enjoys a higher material standard of living.

Running an external surplus (exports greater than imports) effectively means that the country is depriving its citizens of a higher material standard of living. They work too hard, get paid too little, and/or spend too little.

Obviously, a country that only gives up material resources and gains nothing will only make itself materially poorer.

Of course, the history of colonial nations is littered with examples of colonial masters plundering resources.

Exports are “costs” indicating the motivation to export.

“Costs” are for generating benefits – enhancing the material prosperity of the country.

One of the things that causes a country to give up access to its own real resources is to obtain other real resources it wants from other countries through trade.

This means that export costs are best viewed as investments to increase import capacity.

A country’s actual terms of trade are defined in terms of which exports are required to obtain imports. A trade deficit is a sign that the actual terms of trade favor the deficit country.

Question 2

Child dependency ratio rises:

1. (a) Once the birth rate falls, it will eventually lead to a fall in the standard dependency ratio.
2. (b) means that people of retirement age are growing faster than children.
3. (c) means that childcare centres are increasingly reliant on government support.
4. (d) indicates that the old-age dependency ratio is declining.

Reply: Option (1)

The population can be divided into working age (eg 15-64) and non-working age.

Using this division, several different dependency ratios can be:

1. Standard dependency ratio – 100 times the ratio of non-working age to working age.

2. Old age dependency ratio – 100 times the number of people over 65 divided by the number of people of working age.

3. Child dependency ratio – 100 times the number of people under 15 divided by the number of people of working age

The proportion of the elderly population is rising in most developed countries, as is the proportion of children in many African countries.

The implications for the future are quite different.

For example, a country with a high proportion of children quickly sees a decline in the normative proportion as children enter the labor force.

They need top-notch primary education and childcare, while the first few countries need increased aged care and age-related health care.

But over time, the standard dependency ratio will fall in a society dominated by rising child dependency ratios.

Not so for a country with a rising old-age dependency ratio.

Question 3

When a country’s exchange rate depreciates:

1. (a) The country’s inflation rate accelerated.
2. (b) It becomes cheaper for residents to buy imported cars.
3. (c) Foreigners no longer come to the country for vacation.
4. (d) Imported goods become more expensive in local currency.

Reply: Option (d)

When “exchange rates” are referenced in nightly financial reports, the nominal exchange rate is referred to.

The nominal exchange rate is the number of units of one currency that can be purchased with one unit of another currency. It can be referenced in two different ways.

Consider the relationship between the Australian dollar ($A) and the United States dollar ($US).

First, how much $As does it take to buy one unit of US dollar ($US1)?

In this case, the U.S. dollar is the reference currency, and the other currency is expressed in terms of how much it takes to buy one unit of the reference currency. So $A1.25 = $US1 means it takes $1.25 AUD to buy a dollar.

Second, if $A is the reference currency, then we’re asking how many US dollars are needed to buy one unit of Australian currency ($A1).

So in the example above, this is written as $US0.80 = $A1.

So if it takes A1.25 to buy a dollar, it takes $0.80 to buy a dollar.

Media usually uses the second citation convention.

A devaluation of $A (as the reference currency) results in:

1. The dollar price of foreign goods becomes more expensive, which, if nothing else changes, will lead to a decrease in the quantity of imported goods.

2. The price at which foreigners must buy Australian goods in their home currency falls, which, if nothing else changes, will lead to an increase in demand for exports.

The appreciation of $A results in:

1. Foreign goods are cheaper at $1, which, if nothing else changes, will lead to an increase in the amount of imported demand.

2. Foreigners must pay higher prices for goods produced in Australia. If nothing else changes, this should lead to a drop in export demand.

Question 4

Debt service payments for debt denominated in foreign currencies when a country’s exchange rate appreciates:

1. (a) Decrease in local currency.
2. (b) Increase in local currency.
3. (c) Unchanged in local currency as payment is determined by contract.
4. (d) Rising because foreign governments demand higher payments.

Reply: Option (1)

You can get the correct answer from the previous discussion on the interpretation of exchange rate changes.

If a country uses Australian dollars ($A) and borrows in euros, according to the contract, interest payments will be set in euros.

Suppose a country has to pay 100 euros per month, and the current exchange rate is 1:1, which means that in local currency, it has to exchange 100 dollars in the foreign exchange market to get 100 euros to pay off the debt under the contract.

Now, let’s say the Australian dollar depreciates to 0.80, which means it costs $1.25 to buy 1 euro or 80 cents to buy 1 dollar.

Therefore, the debt service obligation under the loan contract will now require the debtor to exchange USD 125 in the foreign exchange market to obtain the EUR 100 needed to service the debt.

Or, when the Aussie appreciates to 1.25, which means that just 80 cents can buy 1 euro (or 1.25 euros to buy 1 Australian dollar), the Australian dollar’s debt service obligation drops to $80 per month.

Therefore, option (a) is correct.

Question 5

A country will be more competitive in international trade if:

1. (a) Its nominal exchange rate has not changed, but its inflation rate has fallen relative to other countries.
2. (b) Its nominal exchange rate has not changed, but its inflation rate has risen relative to other countries.
3. (c) Its nominal exchange rate appreciates, but its inflation rate is unchanged relative to other countries.
4. (d) Its nominal exchange rate has depreciated, but its inflation rate has not changed relative to other countries.

Reply: Options (a) and (d)

We often wonder if local goods and services are more competitive with those produced overseas.

Another concept – the real exchange rate – helps us in this regard.

It depends on two factors:

1. Changes in nominal exchange rates; and

2. Relative inflation rate (domestic and foreign).

The following conclusions can be drawn:

1. If foreign and local prices are constant, then depreciate (appreciate) the nominal exchange rate, causing local goods to become relatively cheaper (expensive) than foreign goods.

2. If the nominal exchange rate is constant and foreign prices rise faster (slower) than local prices, local goods become relatively cheaper (expensive) than foreign goods.

The real exchange rate measures the combined effect of these two effects.

A rise in the real exchange rate indicates that a country has improved its international trade competitiveness if:

1. Depreciation of the nominal exchange rate; and/or

2. The increase of foreign prices is greater than that of local prices, and other things remain unchanged.

A decline in the real exchange rate indicates a decline in a country’s competitiveness in international trade if:

1. Appreciation of the nominal exchange rate; and/or

2. The foreign price increase is less than the local price, and the others remain unchanged.

Countries often try to increase their international competitiveness by cutting wages, arguing that this will lower production costs and domestic prices relative to prices in the rest of the world.

But this tactic not only undermines total spending, but it can also hurt productivity through a drop in workplace morale. In this case, unit production costs would rise and the strategy would be self-defeating.

Strong research evidence supports the idea that by paying high wages and providing workers with secure employment opportunities, businesses can benefit from higher productivity, thereby increasing a country’s international competitiveness.

So the correct answers are (a) and (d).

Enough for today!

(c) Copyright 2022 William Mitchell. all rights reserved.