Here are the answers that discuss this weekend 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.
Question one:
One advantage of fiscal deficits is that the non-government sector is immediately richer as sovereign governments issue debt to private wealth holders.
the answer is Incorrect.
The basic principles that emerge in the fiat currency system are as follows.
- Central banks set short-term interest rates based on their policy wishes.
- Government spending is independent of borrowing, which is best thought of after spending.
- Government spending provides the net financial assets (bank reserves) that ultimately represent the funding of debt purchases by NGOs.
- Fiscal deficits that are not accompanied by corresponding monetary operations (debt issuance) put downward pressure on interest rates, contrary to the myth of “crowding out” in macroeconomics textbooks.
- The “penalty for not borrowing” is that if the central bank does not provide returns on reserves, interest rates will fall to the bottom of the country’s prevailing “corridor”, which could be zero.
- Government bond issuance is a “monetary policy” operation, not inherent to fiscal policy, although the traditionally defined distinction between monetary and fiscal policy is moot in the modern monetary paradigm.
Governments maintain cash operating accounts with their central banks. The exact arrangements vary by country, but the principles remain the same. When the government spends, it debits these accounts and credits various bank accounts within the commercial banking system. Therefore, deposits appear in many commercial banks as a reflection of spending. It might issue a check and mail it to someone in the private sector who will then deposit the check in their bank. As if it had all been done electronically.
That’s how all federal spending happens. You will notice:
- The government does not consume by “printing money”. They spend by creating deposits in the private banking system. Obviously, some of the currency in circulation is “printed”, but this is a separate process from the flow of daily spending and taxation.
- No mention of where they get their credits and debits from! The short answer is that spending is everywhere – some numbers are entered into bank accounts. It can be said that the federal government acts as the monopoly issuer of the national currency and its expenditure is not restricted by its income. That means it doesn’t have to “finance” its spending, unlike households that use fiat currency.
- Any concurrent issuance of government debt (bonds) has nothing to do with the “financing” of government spending.
Government spending adds net financial assets denominated in government currency to the non-government sector. If this spending does not match tax revenue, the net financial wealth of the non-government sector increases.
Thus, deficits increase the financial wealth of the non-government sector through spending.
All bond sales do is provide risk-free, interest-bearing securities (government debt) to the wealth portfolio of the non-government sector.
In other words, bond sales simply provide the non-government sector with portfolio options, rather than changing their net holdings of financial assets.
Therefore, debt issuance does not increase net financial assets held by the non-government sector.
After that, net financial assets will increase further as interest payments are made on outstanding debt.But the question is about immediate influence.
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Question 2:
In fixed-coupon government bond auctions, the higher the demand for the bond, the lower the yield on that asset at maturity, suggesting that higher fiscal deficits will eventually drive down short-term interest rates.
the answer is Incorrect.
The correct answer is that yields will be lower at maturity on that asset, but that doesn’t tell us anything about the impact of fiscal deficits on short-term interest rates.
So the proposition is only partially true – higher demand for bonds lowers yields.
By expanding your understanding of the basic principles of Modern Monetary Theory (MMT), you may have correctly answered the overall proposition, which includes government spending that provides net financial assets (bank reserves) and fiscal deficits that put downward pressure on interest rates Facts (without concomitant central bank operations), this is contrary to the myth of “crowding out” that appears in macroeconomics textbooks.
Of course, the central bank sets short-term interest rates according to its policy will and conducts necessary liquidity management operations to ensure that actual short-term market interest rates are consistent with expected policy rates. This does not mean that central banks are free to do so.
If it is to maintain a positive target rate, it must either provide a return on reserves comparable to the policy rate or sell government bonds. The “penalty for not borrowing” is that if the central bank does not provide returns on reserves, interest rates will fall to the bottom of the country’s prevailing “corridor”, which could be zero.
This happens because the central bank basically lacks control over the amount of reserves in the system.
So the correct answer is that changes in public bond yields during the main issuance phase tell us nothing about the central bank’s intentions in terms of monetary policy (interest rate setting).
Given that the correct answer includes lower yields, the logic developed will tell you why the option “The asset has a higher yield at maturity, suggesting that a higher fiscal deficit will eventually push short-term interest rates down” is incorrect .
Why are yields inversely proportional to prices on the main issue? A standard bond has three parameters: (a) face value – say $A1000; (b) coupon rate – say 5%; (c) some maturity – say 10 years. In all, this public debt instrument will provide bondholders with interest income of $50 per year for 10 years, at which point they will receive a return of $1,000 at face value.
Bonds are issued by the government to the primary market, it is just an institutional mechanism for the government to “raise money” by selling debt. In a modern monetary system with flexible exchange rates, it is clear that the government does not have to finance its spending, so institutional mechanisms are voluntary, reflecting the prevailing neoliberal ideology – emphasizing fear of fiscal excess rather than any inherent need.
Governments are elected to advance a mission. If this includes maximizing the welfare of all citizens, then we should allow them to do so. If they underperform, then we can vote them. We do not need artificial constraints that impede the ability of governments to advance public purposes—these ideological constraints represent democratic repression.
Most primary market offerings take place through auctions. Therefore, the government will determine the maturity date of the bond (how long the bond will be around), the coupon rate (the interest return on the bond), and the quantity (the number of bonds).
The issued bonds will then be put to tender, and the market will then determine the final price of the issued bonds. Imagine a $1,000 bond with a 5% coupon, which means you’ll receive $50 per year until the bond matures, at which point you’ll receive $1,000.
Imagine the market wants a 6% yield to accommodate risk expectations (inflation or otherwise). So for them, the bond is not attractive, and under a bidding or auction system, they would make a purchase bid of less than $1,000 to secure the 6% return they were looking for.
Alternatively, if the market wants safety and considers the coupon rate offered to be competitive, then bonds will be very attractive. Under the auction system, they will bid above face value up to what they think is a market-based yield.Yields reflect last auction bids in bond offerings
The general rule for fixed income bonds is that when prices go up, yields go down and vice versa. Therefore, the price of bonds can change in the market based on interest rate fluctuations.
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Question 3:
With the private domestic sector deciding to increase its overall saving, the economy can still grow even if the central government decides to impose fiscal austerity.
the answer is real.
The answer also has to do with the sectoral balance framework. When the private sector decides to increase its overall saving, we usually think it means that households spend less relative to discretionary consumption. However, the decline in investment spending (building productive capacity) can also demonstrate this.
A normal inventory cycle view of what happens next looks like this. Output and employment are functions of total expenditure. Firms form expectations of future aggregate demand and produce accordingly. When the output emerges from the production process, they are not sure of the actual demand that will be fulfilled.
The first sign that companies get a drop in household consumption is an unexpected build in inventories. This signals to companies that they are overly optimistic about the level of demand for that particular period.
Once this realization is cemented that companies generally realize that they are overproducing, output will begin to decline. As those workers cut spending elsewhere, company layoffs and lost revenue began to multiply.
By then, the economy is heading for a recession. Interestingly, attempts by households to increase their savings rates in aggregate may be thwarted because a loss of income leads to a loss of aggregate savings—a paradox of thrift. While a family can easily increase their savings rate with discipline, all families will fail if they try to do so. This is an important statement about why macroeconomics is a separate field of study.
Often, the only way to avoid these spiraling job losses is through exogenous intervention—in the form of widening public deficits. In any case, due to the automatic stabilizer, the government’s fiscal position will move toward, into, or into a larger deficit depending on the starting position.
If nothing else changes in the economy, the answer will be wrong.
However, there is also an external division. It is possible that net exports will boom while households reduce consumption in an attempt to increase the savings rate. A net export boom increases aggregate demand (spending injected through exports is greater than spending leakage through imports).
Therefore, if net exports are strong enough, the public finance balance may actually move towards a surplus, while the domestic private sector savings rate may increase.
The important point is that these three sectors have increased demand in their own way. Total GDP and employment depend on aggregate demand. Therefore, changes in aggregate demand lead to changes in output (GDP), income, and employment. However, changes in spending in one sector can be compensated by offsetting changes in other sectors.
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Enough for today!
(c) Copyright 2022 William Mitchell. all rights reserved.
