Questions:
1. Explain Abba Lerner's three principles of functional finance.
Abba Lerner's three principles of functional finance:
- In the first principle, it requires the government to spend enough to eliminate unemployment, but not too much to cause inflation, so the way to do that is if total spending is too low to create full employment, spending increases. And if the expenses are too high to go and cause inflation, you must use tax. But both things may be necessary, such as expenses and taxes, for that you have to look at sector by sector. You look at the sectors where there is unused capital capacity and you spend on those and those sectors where there is too much money, so you should impose heavy taxes to prevent inflation.
- In second principle it prescribes that interest rate should be controlled at a level which leads to a desirable level in investment.
- And the third principle is that money prints and loans should be used when it is needed to execute the first two parts of the program.
2. Explain how government deficits work according to MMT -- that is what happens when government runs a deficit. In particular explain why running deficits does not necessarily lead to inflation.
The government deficit means that government spending is greater than earning. And as far as the government pays money (income), it does not tax; this income is collected by the private sector. Government budget deficits generate non-government surpluses that accumulate into the net financial assets of the non-government sector. Since there are more savings and more financial wealth, there is a lot of investment take place due to internal funds which are held by the firms so firms also have reserves in terms of cash savings and they want to use these savings to invest instead of borrowing as they have internal liquidity they will invest. The private surplus increases as the government deficits increase.
Government deficit = private surplus
So this happens when the government runs a deficit.
MMT indicates that if the government provides logical advice on spending, the functional financing principles of Lerner are simply followed. If employment and incomes are too low, this is due to a lack of effective demand, which means that the government can either reduce taxes or increase spending to increase demand. And for this purpose the government does not have to keep an eye on every sector of the economy to coordinate its stimulus exactly where it is needed. So when the government spends more in the sectors where there is effective demand, the deficit does not lead to inflation.
3. Explain how the necessaity for the Central Bank to maintain a discount rate at the policy level means that the money creation cannot be done freely by Central Bank. Instead, the money creation has to be done to maintain policy rate, whic also means that the multiplier story of how Central Banks control money supply in the economy is false.
- The necessity for the Central Bank to maintain a discount rate at the policy level means that if there are surplus reserves, market forces will bring inter bank interest rates below the policy level, as banks change the price they are willing to loan reserves. Banks with excessive reserves can pay off loans at the discount window, or they can purchase assets (usually treasury paper, although possibly foreign currency or private assets) from the central bank. Similarly, in the case of a shortage of reserves, the inter bank interest rate will be driven above its policy level. Reserves are added through discount events, through open market purchases by the central bank of government bonds and through purchases of gold, foreign currencies or even financial assets from the private sector. The central bank must add or remove reserves to ensure that the banking system has exactly the desired amount of reserves that is consistent with the policy level. And this policy level must therefore be reached, otherwise the financial system would be subject to great uncertainty, for example in the case of GFC (global financial crisis). So that’s the reason central bank needs to maintain discount rate.
- The money supply as an endogenous factor that depends upon the demand of the loans rather than the deposit supply. In other words, it can be said that the creation of money is demand pull (the loan requirements) rather than the supply of the initial currency / deposits in the banking channel. The money supply in the economy is not determined by the fraction reserves i.e. (fractional reserve system is as if the gold standards still work and the money is printed as per the fraction of the gold reserves) or the Money Multiplier factor. Hence, the central bank or the government cannot control the total money in the economy, rather it is controlled by the commercial banks who, while observing the needs of the borrowers, create money, just out of nothing, just by making few key strokes and making computer / electron entries. This clearly shows that the modern banking system is beyond the Central Bank’s control in sense of creation of money. The money is created based on the spread of the bank and also the credit worthiness of the borrower. So the money creation has to be done to maintain policy rate rather the multiplier story of controlling money supply by Central Banks.