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The Weekend Quiz – November 10-11, 2018 – answers and discussion


Question 1:

Government spending which is not accompanied by a bond sale to the non-government sector immediately adds more to total spending than would be the case if there was a bond sale.

The answer is False.


The chapters always introduces the so-called ‘Government Budget Constraint’ that alleges that governments have to ‘finance’ all spending either through taxation; debt-issuance; or money creation.

The narrative always fails to create an understanding among students that government spending is performed in the same way irrespective of the accompanying monetary operations.

That is, the government creates credits in bank accounts usually (but not always) via its central bank.

The standard mainstream claim is that money creation, which they construct as ‘borrowing from central bank’ or ‘money printing’ is inflationary while the latter (non-government bond sales) is less so.

These conclusions are based on their erroneous claim that ‘money creation’ adds more to aggregate demand than bond sales, because the latter forces up interest rates which crowd out some private spending.



Like all government spending, the Treasury instruct the central bank to credit the reserve accounts held by the commercial bank at the central bank.


The transactions are clear:

1. The commercial bank’s assets rise and its liabilities also increase because a new deposit has been made.


3. Taxation does the opposite and so a deficit (spending greater than taxation) means that reserves increase and non-government net worth increases.

4. 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 maintain a target interest rate and so it has to ensure that competitive forces in the interbank market do not compromise that target.






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.



Mainstream economists would say that by draining the reserves by selling bonds, the central bank has reduced the ability of banks to lend which then, via the money multiplier, shrinks the money supply.

However, the reality is that:

  • The money multiplier process, a central plank of mainstream monetary theory, does not describe the way in which banks make loans.




You may wish to read the following blogs for more information:

Question 2:

If the external balance is always in surplus, then the government can safely run a surplus and not impede economic growth.

The answer is False.

This is a question about the sectoral balances.


From the sources perspective we write:

(1) GDP = C + I + G + (X – M)



We also have to acknowledge that financial balances of the sectors are impacted by net government taxes (T) which includes all tax revenue minus total transfer and interest payments (the latter are not counted independently in the expenditure Expression (1)).




To render this approach into the sectoral balances form, we subtract total net taxes (T) from both sides of Expression (3) to get:










In English we could say that:






Expression (5) can also be written as:

(6) [(S – I) – CAD] = (G – T)

where the term on the left-hand side [(S – I) – CAD] is the non-government sector financial balance and is of equal and opposite sign to the government financial balance.






Second, you then have to appreciate the relative sizes of these balances to answer the question correctly.

Consider the following Table which depicts three cases – two that define a state of macroeconomic equilibrium (where aggregate demand equals income and firms have no incentive to change output) and one (Case 2) where the economy is in a disequilibrium state and income changes would occur.

Note that in the equilibrium cases, the (S – I) = (G – T) + (X – M) whereas in the disequilibrium case (S – I) > (G – T) + (X – M) meaning that aggregate demand is falling and a spending gap is opening up.

Firms respond to that gap by decreasing output and income and this brings about an adjustment in the balances until they are back in equality.

So in Case 1, assume that the private domestic sector desires to save 2 per cent of GDP overall (spend less than they earn) and the external sector is running a surplus equal to 4 per cent of GDP.

In that case, aggregate demand will be unchanged if the government runs a surplus of 2 per cent of GDP (noting a negative sign on the government balance means T > G).

In this situation, the fiscal surplus does not undermine economic growth because the injections into the spending stream (NX) are exactly offset by the leakages in the form of the overall private domestic saving and the fiscal surplus. This is the Norwegian situation.

In Case 2, we hypothesise that the private domestic sector now wants to save 6 per cent of GDP overall and they translate this intention into action by cutting back consumption (and perhaps investment) spending.

Clearly, aggregate spending now falls by 4 per cent of GDP and if the government tried to maintain that fiscal surplus of 2 per cent of GDP, the spending gap would start driving GDP downwards.

The falling income would not only reduce the capacity of the private domestic sector to save overall but would also push the fiscal balance towards deficit via the automatic stabilisers.

It would also push the external surplus up as imports fell. Eventually the income adjustments would restore the balances but with lower GDP overall.

So Case 2 is a not a position of rest – or steady growth. It is one where the government sector (for a given net exports position) is undermining the changing intentions of the private sector to increase their overall saving.

In Case 3, you see the result of the government sector accommodating that rising desire to save by the private domestic sector by running a fiscal deficit of 2 per cent of GDP.

So the injections into the spending stream are 4 per cent from NX and 2 per cent from the deficit which exactly offset the desire of the private domestic sector to save 6 per cent of GDP. At that point, the system would be in rest.

This is a highly stylised example and you could tell a myriad of stories that would be different in description but none that could alter the basic point.

If the drain on spending outweighs the injections into the spending stream then GDP falls (or growth is reduced).

So even though an external surplus is being run, the desired fiscal balance still depends on the saving desires of the private domestic sector.

Under some situations, these desires could require a deficit even with an external surplus.

You may wish to read the following blogs for more information:

Question 4:

Assume the government increases spending by $100 billion in the each of the next three years from now. Economists estimate the expenditure multiplier to be 1.5 and the impact is immediate and exhausted in each year. They also estimate the tax multiplier to be equal to 1 and the current tax rate is equal to 30 per cent (30 cents in the $). What is the cumulative impact of this fiscal expansion on GDP after three years?

(a) $135 billion
(b) $150 billion
(c) $315 billion
(d) $450 billion

The answer is $450 billion.

In Year 1, government spending rises by $100 billion, which leads to a total increase in GDP of $150 billion via the spending multiplier.

The multiplier process is explained in the following way. Government spending, say, on some equipment or construction, leads to firms in those areas responding by increasing real output.

In doing so they pay out extra wages and other payments which then provide the workers (consumers) with extra disposable income (once taxes are paid).

Higher consumption is thus induced by the initial injection of government spending. Some of the higher income is saved and some is lost to the local economy via import spending.

So when the workers spend their higher wages (which for some might be the difference between no wage as an unemployed person and a positive wage), broadly throughout the economy, this stimulates further induced spending and so on, with each successive round of spending being smaller than the last because of the leakages to taxation, saving and imports.

Eventually, the process exhausts and the total rise in GDP is the “multiplied” effect of the initial government injection. In this question we adopt the simplifying (and unrealistic) assumption that all induced effects are exhausted within the same year.

In reality, multiplier effects of a given injection usually are estimated to go beyond 4 quarters.

So this process goes on for 3 years so the $300 billion cumulative injection leads to a cumulative increase in GDP of $450 billion.

It is true that total tax revenue rises by $135 billion but this is just an automatic stabiliser effect. There was no change in the tax structure (that is, tax rates) posited in the question.

That means that the tax multiplier, whatever value it might have been, is irrelevant to this example.

Some might have decided to subtract the $135 billion from the $450 billion to get answer (c) on the presumption that there was a tax effect. But the automatic stabiliser effect of the tax system is already built into the expenditure multiplier.

Some might have just computed $135 billion and said (a). Clearly, not correct.

Some might have thought it was a total injection of $100 billion and multiplied that by 1.5 to get answer (b). Clearly, not correct.

You may wish to read the following blogs for more information:

That is enough for today!

(c) Copyright 2018 William Mitchell. All Rights Reserved.

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    This Post Has 6 Comments
    1. Hello Dr. Mitchell,
      If the non-government sector cannot create net financial assets, then how should I think about stock issuance? When a company issues stock, it creates an asset (the certificate) and a liability (the entry on the balance sheet). However, the liability has very little financial significance to the company. Hasn’t the company created an asset with no effective corresponding liability?
      Thanks, Joel

    2. Forgive my ignorance, but I am shocked by the inclusion of ‘drain on demand’ in your explanation to Q2. I thought the sectoral balance always held, come what may?

    3. @at Joel S,
      I’m no expert, so until someone who is one replies, I hope this helps.
      The keyword there is ‘financial’.
      I think financial assets have a fixed value. Dollars, and IOU, a loan agreement, an insurance policy.
      Cars can be make but they are ‘real’ assets.
      Shares of common stock are in the middle,but they have no fixed value so the are considered real assets.

    4. Joel S: The asset and the liability are the same thing, two ways of looking at the same thing. The liability is a right to a future stream of income from dividends, a share in proceeds of a liquidation or buyout or stock buyback etc. This is not meaningless to either the company or the stockholder. It can vary wildly in value which is why bonds with more stable values are more money-like than stocks. If the company issued pieces of paper that said “the holder has no claim whatsoever on the company” – they would not be worth anything – but that is not what stocks are.

      But the real point is that when you net out, by only considering the government vs the private sector, by definition the private asset and the private liability cancel out – that is what “net” means. Which is why they are not net financial assets as the term is used in MMT. If the federal government issued something like stock certificates, then they would be considered NFA.

    5. Joel,
      Not really so. Sears in the U.S. is going bankrupt right now because the law allows that Sears owes the shareholders everything it has, and over the last few years the shareholders have been collecting.

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