The Weekend Quiz – November 5-6, 2022 – answers and discussion – Bill Mitchell – Modern Monetary Theory

Here are the answers with discussion for this Weekend’s Quiz. The information provided should help you work out why you missed a question or three! If you haven’t already done the Quiz from yesterday then have a go at it before you read the answers. I hope this helps you develop an understanding of Modern Monetary Theory (MMT) and its application to macroeconomic thinking. Comments as usual welcome, especially if I have made an error.

These were the Quiz questions for the fourth and final week of my edx MOOC – Modern Monetary Theory: Economics for the 21st Century – that recently concluded.

I promised students that I would provide answers and analysis for them after the course finished. So that is what the ‘Weekend Quiz’ for April 2021 will be occupied with.

Question 1

The MMT classification of exports as a cost means:

1. (a) Currency-issuing governments are not financially constrained.
2. (b) Foreign spending into the local economy can be inflationary.
3. (c) The resources that are embodied in exports are lost to the nation and are, instead, used by foreigners to enhance their material prosperity.
4. (d) Government debt interest payments have to be serviced.

Answer: Option (c)

Nations trade to expand their consumption possibilities.

In a world where we produce to consume, receiving goods and services is better in real terms than sending them elsewhere.

In that context, MMT characterises exports as a cost and imports as a benefit to a nation.

Exports require the nation incur an opportunity cost by sending real resources (embodied in products or raw) to foreigners which could be used locally.

Conversely, imports represent foreigners giving up their real resources (embodied in products or raw), which are then enjoyed by the importing nation.

Accordingly, external deficits (imports greater than exports) mean that a nation enjoys a higher material living standard.

Running external surpluses (exports greater than imports) effectively means that the nation is depriving its citizens of a higher material standard of living. They are working too hard, being paid too little, and/or under consuming.

Clearly, a nation that merely gives up material resources and gets nothing in return would be making itself poorer in material terms.

And certainly, the history of colonial nations is riven with examples of resource plunder from colonial masters.

That exports are a ‘cost’ suggests the motive to export.

The ‘cost’ is incurred to generate benefits – to enhance the material prosperity of the nation.

One reason that would lead a nation to relinquish access to its own real resources would be to get other real resources that it desires from other nations through trade.

Which means the export cost is best considered as an investment in generating an increased capacity to import.

The real terms of trade for a nation are defined in terms of what exports are required to acquire imports. A trade deficit is a sign that the real terms of trade are working in favour of the deficit nation.

Question 2

A rising child dependency ratio:

1. (a) Will ultimately lead to a falling standard dependency ratio once birth rates decline.
2. (b) Means that people of retirement age are increasing at a faster rate than children.
3. (c) Means that child care centres are becoming more dependent on government support.
4. (d) Means the aged dependency ratio is falling.

Answer: Option (a)

The population is divisible into the working age (say between 15-64 years) and non-working age.

Using that demarcation, several different dependency ratios can be:

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

2. Aged dependency ratio – 100 times Number of persons over 65 years of age divided by the number of persons of working age.

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

Most of the advanced nations have rising aged ratios whereas many African countries, for example, have rising child ratios.

The implications for the future are quite different.

For example, the nations with high child ratios, will soon experience falling standard ratios as the children move into the workforce.

They require first class primary education and childcare provision, while the former nations, require increased aged care and age-related health care.

But as time passes, the standard dependency ratio of a society dominated by a rising child dependency ratio will decline.

That is not the case for a nation with a rising Aged dependency ratio.

Question 3

When a nation’s exchange rate depreciates:

1. (a) The nation’s inflation rate accelerates.
2. (b) Imported motor vehicles become cheaper for residents to buy.
3. (c) Foreigners stop coming to the nation for holidays.
4. (d) Imported goods become more expensive in the local currency.

Answer: Option (d)

When the ‘exchange rate’ is quoted on the nightly finance report, it is the nominal exchange rate that is being 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 quoted in two different ways.

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

First, how many $As are necessary to purchase one unit of the US currency ($US1)?

In this case, the $US is the reference currency, and the other currency is expressed in terms of how much of it is required to buy one unit of the reference currency. So $A1.25 = $US1 means that it takes $1.25 of Australian currency to buy one $US.

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

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

Thus, if it takes $A1.25 to buy one $US, then $US0.80 is required to buy one $A.

The second quotation convention is typically used by the media.

A depreciation of the $A (as the reference currency) leads to:

1. Foreign goods becoming more expensive in terms of their $A price, which should lead to a fall in the quantity of imports demanded, if nothing else changes.

2. The price that foreigners must pay in their currency for Australian goods falls, which should lead to a rise in the quantity of exports demanded, if nothing else changes.

An appreciation of the $A leads to:

1. Cheaper foreign goods in terms of their $A price, which should lead to a rise in the quantity of imports demanded, if nothing else changes.

2. Foreigners having to pay higher prices, for a given $A price for Australian-produced goods. This should lead to a fall in the quantity of exports demanded, if nothing else changes.

Question 4

When a nation’s exchange rate appreciates, the debt servicing payments for debt denominated in a foreign currency:

1. (a) Fall in local currency terms.
2. (b) Rise in local currency terms.
3. (c) Are unchanged in local currency terms because the payments are fixed by contract.
4. (d) Rise because foreign governments require higher payments.

Answer: Option (a)

You can work out the correct answer from the previous discussion on interpretations of exchange rate changes.

If a nation is using the Australian dollar ($A) and borrows in euros, then the interest payments will be set in euros per period as per the contract.

Say a nation has to pay 100 euros per month and the exchange rate is currently 1:1, meaning that in local currency terms, it must exchange $A100 in the foreign exchange markets to get the 100 euros to service its debt under the contract.

Now, say the Australian dollar depreciates to 0.80, which means that it takes $A1.25 to buy one euro or 80 euro cents to buy $A1.

So now the debt servicing obligations under the loan contract would require the debtor to exchange $A125 in the foreign exchange markets to get the 100 euros necessary to service the debt.

Alternatively, when the Australian dollar appreciates to 1.25, which means it takes only 80 cents Australian to buy one euro (or 1.25 euros to buy one Australian dollar), the debt servicing obligations in Australian dollars fall to $80 per month.

Thus, Option (a) is correct.

Question 5

A nation will become more competitive in international trade if:

1. (a) Its nominal exchange rate is unchanged, but its inflation rate falls relative to other nations.
2. (b) Its nominal exchange rate is unchanged, but its inflation rate rises relative to other nations.
3. (c) Its nominal exchange rate appreciates, but its inflation rate is unchanged relative to other nations.
4. (d) Its nominal exchange rate depreciates, but its inflation rate is unchanged relative to other nations.

Answer: Options (a) and (d)

We often want to know whether local goods and services are becoming more or less competitive with respect to goods and services produced overseas.

Another concept – the real exchange rate – helps us in that respect.

It depends on two factors:

1. Movements in the nominal exchange rate; and

2. Relative inflation rates (domestic and foreign).

The following conclusions can be drawn:

1. If foreign and local prices are unchanged, then a depreciating (appreciating) nominal exchange rate, results in local goods becoming relatively cheaper (dearer) than foreign goods.

2. If the nominal exchange rate is constant, and foreign prices are rising faster (slower) than local prices, then local goods are becoming relatively cheaper (dearer) than foreign goods.

The real exchange rate measures the combined impact of these two influences.

A rise in the real exchange rate, which signals that a nation has increased its international trade competitiveness, can occur if:

1. The nominal exchange rate depreciates; and/or

2. Foreign prices rise more than local prices, other things unchanged.

A fall in the real exchange rate, which signals that a nation has decreased its international trade competitiveness, an occur if:

1. The nominal exchange rate appreciates; and/or

2. Foreign prices rises less than local prices, other things unchanged.

Nations often attempt to improve their international competitiveness by slashing wages, thinking this will reduce production costs and domestic prices relative to rest of world prices.

But this strategy not only undermines total spending but may also damage productivity through a decline in workplace morale. In that case, unit production costs rise, and the strategy becomes self-defeating.

Robust research evidence supports the notion that, by paying high wages and offering workers secure employment, firms reap the benefits of higher productivity which yields improvements in a country’s international competitiveness.

So the correct answer is both (a) and (d).

That is enough for today!

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