MMT Macro Final Exam (1/3)

During the last two semesters, I taught Macroeconomics based on a new approach which re-incorporate the history that Economists forgot (See  Method or Madness?). The central idea of the course is that economic theories cannot be understood outside of their historical context. Conversely, economic history cannot be understood except by studying the economic theories (right or wrong) which were used by contemporaries to shape policy responses to historical events. The website for the entire course is Macroeconomics. In particular, Lecture 18B explains the principle of Entanglement. Below I provide Final Exam questions and answers, to give the flavor of the course. This post is about the first 4 out of 12 questions.

Q1: Stiglitz: “Ricardian equivalence is taught in every graduate school in the country. It is also sheer nonsense.” Explain the theory, and arguments for it. Then explain why it is sheer nonsense.

A1: The Theory:The Ricardian equivalence theory states that if government tries to increase aggregate demand through deficit spending, it will not succeed. The people will start saving because they expect that govt. will raise taxes to pay for the higher spending. As a result of saving, their current spending decreases, their current saving increases, hence resulting in no effect on aggregate demand.

Counter Argument: The assumption that govt. require taxation to generate resources and finance its spending is absurd as a sovereign govt. does not rely on taxes but can print its own money. There is no long run constraint on the government to balance budgets, and it can run any level of deficit forever. MMT states that the purpose of taxation is not to generate resources of govt. but to regulate consumption, redistribute income and in some cases to relieve inflationary pressure.

See also post on:   The Fallacy of Ricardian Equivalence .

Q2: Standard Theory: There are two ways to finance deficits – one is inflationary, while the other raises interest rates and reduces investments. Both methods cause economic harm. Explain the standard theory and explain the MMT view that this theory is sheer nonsense.

A2: There are two methods by which governments finance deficits.

  1. Printing Money: Printing more money will lead to increase in money supply resulting in inflation.
  2. Borrowing Money: It will increase in demand for loanable funds, leading to an increase in interest rate. This will increase cost of investment, as investment will go down. The so called “crowding out” for private investors, if they have to compete for finances.

MMT views: [i] Printing more money will not necessarily lead to inflation if full employment does not hold. In such cases, Govt. spending directed at the sectors with underemployment will increase employment which will raise output without increasing inflation.  Financing budget deficit by printing money will not create inflation because increased money is accompanied by increase output. Of course, government spending directed at sectors where full employment obtains will cause prices to rise in that sector (inflation). However, even this may not be harmful, since the increased price would signal excess demand, which would be met by an increase in productive capacity in the long run.  [ii]  Government borrowing does not cause “crowding out” as per traditional macro mechanism. The price of government borrowing from private sector is set by the policy rate determined by the Central Bank. This price is not affected by demand and supply considerations, since the Central Bank Open Market Operations ensure that the supply of money is adjusted to match inter-bank borrowing rate to the policy rate. Bank lending to private sector is done by money creation, and is not constrained by the money supply created by the Central Bank. Bank provide loans and then borrow reserves to meet the reserve requirements. The lending will depend on the demand for loans, the policy rate, and the market conditions (expectations). It will not be affected by government borrowing except indirectly. The indirect mechanism is that banks operate to maintain ROI at a certain minimum acceptable, or achievable level. If they can achieve the required rate of profits by utilizing certain investments in government bonds, they will not be motivated to lend to the private sector. This would a kind of “crowding out”, although the mechanism is very different from the standard theory.

Q3: The Central Bank cannot control both the overnight discount rate and the supply of money; it can only do one or the other. Explain this statement, and how it shows that the theory of the money multiplier is wrong.

A3: If the Central Bank decides on maintaining a particular discount rate, it will have to carry out open market operations to maintain this rate. If there are excess fund in the inter-bank borrowing market, there will be downward pressure on the inter-bank borrowing rate. The Central bank will have to mop up extra money by money market operations, to prevent the KIBOR from falling below a specified amount under the target policy rate. If the inter-bank borrowing rate rises above the target policy rate, the Central Bank must inject money to prevent the rate from rising above the specified target policy rate, The Central Bank injects reserves (HPM) by purchasing T-bills, and does mop-up operations by selling T-bills. The quantity of reserves being supplied or withdrawn depends on the policy rate, and cannot be varied independently.

The multiplier theory is wrong for two reasons. One is what has been pointed out above – the quantity of reserves being supplied to the private banking sector is not freely controlled by the Central Bank; rather it is varied to maintain the overnight discount rate at the target policy level. Secondly, private bank lending is not constrained by the reserves the that Central Bank creates. If the private bank finds a good loan (credit-worthy borrower with suitable collateral), it will not be constrained by lack of reserves. It will make the loan, and then borrow reserves to meet the reserve requirement. The Central Bank is required to provide these loans as demanded by private banking sector, so reserves will be generated as per needs of the private sector banks.

Q4: Explain the key identity of MMT: Government Injections + Foreign Injections = Private Surplus. Also explain the implications of this identity in terms of how we should think about government budget deficits and trade deficits (BOP).

A4: Government Injections into private sector money holdings are created by budget deficits, while Foreign Injections are created by Trade Surplus. Thus sum of these two injections equals the private sector surplus, which the sum of domestic household savings plus profits of domestic firms. This is further explained below

Budget deficit means that govt. expenditure is greater than govt. revenue. Govt. spending results in the earnings of the private sector while govt. revenue constitutes taxes collected from the private sector. Budget Deficit means that the government spends money into the private sector which it has not collected in taxes thereby injecting money into the economy. This money translates into a surplus in the private sector which creates profits and savings, and represents aggregate demand for goods and services coming from outside the private sector.

Trade surplus means that export receipts are greater than spending on imports. Domestic spending on imports is a leakage, and lowers the aggregate demand for domestic goods. Foreign demand is an injection which increases the aggregate demand, injecting foreign money into the domestic economy. The difference is the net increase in aggregate demand for domestic goods, which is paid for by foreign injections, which create private saving and firm profits.

This equality has enormous implications for fiscal and monetary policy. In an economy which runs a trade deficit, the private sector is spending more on imports than it is earning in exports. Thus net private surplus must be negative – the money being sent outside to foreigner can come from savings of households, or from losses (instead of profits) of firms. The government must run a deficit larger than this amount in order to make it possible for the firms to make profits and for the households to make savings. As MMT shows, and our classroom models confirmed, the government can run a deficit indefinitely, without worrying about sustainability. However this situation, with permanent trade deficit is not sustainable because the government and/or private parties must borrow foreign exchange to pay back foreign debt. That is, unless foreigners are willing to hold your currency in the long term. Only In situations of trade surplus is it possible for the government to balance the budget while the firms makes profits and household savings increase. Even in such cases, depending on particulars, it may be advisable for the government to run a deficit, in order to allow greater profits and savings in the domestic sector [There are many other ways to explain the implications of the fundamental sectoral balance equation of MMT]

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3 comments
  1. Greg Hannsgen said:

    Quoting you on MMT views:
    “Printing more money will not necessarily lead to inflation if full employment does not hold. In such cases, Govt. spending directed at the sectors with underemployment will increase employment which will raise output without increasing inflation. Financing budget deficit by printing money will not create inflation because…”

    I generally like your post, but at this point, you use non-MMT language and thinking in a way that bothers me a bit. To whit, given what you yourself say below, there is no way to decide to produce more fiat money; one makes it more or less on demand and sells it at the interest rate one sets. Excess goes back to the banking system per the Law of Reflux going back to Thomas Tooke and the Banking School. Also, I agree with the MMT phraseology that avoids the term “financing” for the issuance of government liabilities by a government with a sovereign currency. The government does not borrow to spend; it creates money as you yourself say. Last, I feel also that the case has been established for the textbook MMT and PK positions that the central bank can never really choose to hit a quantitative target such as nonborrowed reserves in the U.S. (I addressed this topic in an essay in my 2002 dissertation.)

    Kudos to you for your courage in using the MMT approach. I look forward to more updates. I hope you will follow my WordPress blog for some MMT teaching ideas and materials.

    • Thanks. You are absolutely right that the idea of “financing a deficit” does not make sense from MMT perspective. However, I am comparing standard and MMT so I start by accepting their terminology and speaking in their vocabulary, as a half-way house for students who have been exposed to conventional macro theory

      • So the reason is pedagogic. Helpful reply to my comment. Thanks.

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