Tuesday, October 25, 2011

The Answers to my Economic Quiz

The Answers to my Economic Quiz

1. How much of the money supply exists as physical currency?
BTW, Banks only need to keep 5% in cash reserves under the fractional reserve system. Thus the inability to repay account holders if there is a run on the bank.

2. How exactly does Quantitative Easing work (hint--printing money is a failing answer)
A central bank buys financial assets to inject a pre-determined quantity of money into the economy. This is distinguished from the more usual policy of buying or selling government bonds to keep market interest rates at a specified target value.

A central bank implements quantitative easing by purchasing financial assets from banks and other private sector businesses with new electronically created money. This action increases the excess reserves of the banks, and also raises the prices of the financial assets bought, which lowers their yield.

In simple words, the government buys back the bonds it issued, instead of printing money.
3. What are the two types of government debt?
Government debt can be categorized as internal debt (owed to lenders within the country) and external debt (owed to foreign lenders).
4. What is a budget deficit?
the amount by which some measure of government revenues falls short of some measure of government spending.
5. What is the difference between government deficit and government debt?
Debt is the difference between all the money that a government
has ever spent and all the revenue that it has ever collected. (is the net accumulated indebtedness by a government.)

Deficit is the difference between what the government expenditures and
the revenue it receives during a particular year.

So each year's deficit is added to the existing debt. When revenue exceeds spending,it's called a surplus, which subtracts from the debt.
6. Define in relation to each other:
Primary deficit,
total deficit
The primary deficit is defined as the difference between current government spending on goods and services and total current revenue from all types of taxes net of transfer payments. The total deficit (which is often called the fiscal deficit or just the 'deficit') is the primary deficit plus interest payments on the debt.
7. What is a Structural deficit?
Structural deficit issues can only be addressed by explicit and direct government policies: reducing spending, increasing the tax base, and/or increasing tax rates. It can be described as more "chronic" or long-term in nature hence needing government action to remove it.
8. What are the forms of Government Indebtedness?
Governments usually borrow by issuing securities, government bonds and bills.

Public loans, the characteristic form of government debts in modern times, may be in the form of short-term instruments, e.g., tax warrants, treasury certificates, treasury notes, and other notes such as those of the Federal Reserve System; of long-term government bonds; and of various notes that promise yearly payment of interest but do not specify a date for payment of principal. Although governments in times of stress have often converted bonds to issues carrying lower interest rates, have depreciated the value of currency, or have defaulted entirely on their obligations, with disastrous results for the bondholders, the number of those holding government obligations has increased in recent history. Default on obligations held by foreigners has been a reason offered for past intervention by major powers in Latin America, Africa, and elsewhere.

Less creditworthy countries sometimes borrow directly from supranational institutions.
9. What is fractional reserve banking?
A banking system in which only a fraction of bank deposits are backed by actual cash-on-hand and are available for withdrawal.

10. What is full reserve banking?
100% of deposits are kept in reserve. It would be like a chequing account, there must be enough money present to pay obligations.

11. What are some of the potential policy solutions for budget deficits and critiques of each?
  • Increase Taxes--while increasing prices works in the private sector, people get upset if they have to pay more in taxes.
  • Reduce Government Spending--cuts in services can upset various segments of the population.
  • Increase Taxes and Reduce Government Spending: the best solution if you are inclined this way, but also has the two problems above.
  • Changes in Tax Code--anything to do with taxes will have one segment or another of the population upset.
  • Reduce Debt Service Liability: paying down the debt, or reducing the debt payments requires income.

I forgot to ask what are the sources of government "income", or revenue: Taxes of various kinds, Fees for services, and issuance of debt (bonds). The amount of the US government revenue which comes from taxes is 96%. Unfortunately, that was an important question. Government revenue is an important part of fiscal policy. Oh well!

Government revenue may also include reserve bank currency which is printed. This is recorded as an advance to the retail bank together with a corresponding currency in circulation expense entry. The income derives from the Official Cash rate payable by the retail banks for instruments such as 90 day bills.There is a question as to whether using generic business based accounting standards can give a fair and accurate picture of government accounts in that with a monetary policy statement to the reserve bank directing a positive inflation rate. The expense provision for the return of currency to the reserve bank is largely symbolic in that to totally cancel the currency in circulation provision all currency would have to be returned to the reserve bank and cancelled.

Some countries and other jurisdictions with government owned industries can include profits from those as revenue.
  • Increase the tax base: this is the best solution in my opinion, but it requires getting more people working and being productive citizens. While some conservatives have mentioned this, they neglect the most important part--getting more people to work and who creates the jobs.
The problem is that the relationship of revenue to spending was sort of the point of this quiz. US Government revenue is pretty much limited to taxes and fees. How can one provide the the same amount of services (or who pays for the services) is one of the points I was trying to make.

In private industry, the seller can raise prices (or decrease the quality of the products or service). The public sector is limited in its ability to increase revenue without sacrificing services.

12. What is the difference between Gross Domestic Product (GDP) and Gross National Product (GNP)?
Gross domestic product (GDP) refers to the market value of all final goods and services produced within a country in a given period. GDP per capita is often considered an indicator of a country's standard of living.

Gross National Product (GNP) is the market value of all products and services produced in one year by labor and property supplied by the residents of a country. Unlike Gross Domestic Product (GDP), which defines production based on the geographical location of production, GNP allocates production based on ownership.

GNP does not distinguish between qualitative improvements in the state of the technical arts (e.g., increasing computer processing speeds), and quantitative increases in goods (e.g., number of computers produced), and considers both to be forms of "economic growth".
13. How much national debt is too much?
Trick question--some economists say there is no such thing as too much national debt. The real answer is that it is what the public will accept.

14. Is inflation a bad thing for an economy?
Another trick question, while it has adverse effects on an economy, some inflation is considered the sign of a healthy economy.
15. What is a commodity based monetary system?
It is one where the money is a certain amount of a commodity--e.g gold or silver.

Where the money is represented by a commodity, the currency is called representative. That is the monetary system in which the standard economic unit of account is a fixed mass of a commodity. But that can still suffer from inflation.

The difference between the two is that one is the actual commodity, the other the money is based on the commodity: hence representative.

In the early 1930s, the Federal Reserve defended the fixed price of dollars in respect to the gold standard by raising interest rates, trying to increase the demand for dollars. Its commitment and adherence to the gold standard explain why the U.S. did not engage in expansionary monetary policy. To compete in the international economy, the U.S. maintained high interest rates. This helped attract international investors who bought foreign assets with gold. Higher interest rates intensified the deflationary pressure on the dollar and reduced investment in U.S. banks. Commercial banks also converted Federal Reserve Notes to gold in 1931, reducing the Federal Reserve's gold reserves, and forcing a corresponding reduction in the amount of Federal Reserve Notes in circulation. This speculative attack on the dollar created a panic in the U.S. banking system. Fearing imminent devaluation of the dollar, many foreign and domestic depositors withdrew funds from U.S. banks to convert them into gold or other assets.

Some economic historians, such as American professor Barry Eichengreen, blame the gold standard of the 1920s for prolonging the Great Depression. Others including Federal Reserve Chairman Ben Bernanke and Nobel Prize winning economist Milton Friedman place some blame at the feet of the Federal Reserve. The gold standard limited the flexibility of central banks' monetary policy by limiting their ability to expand the money supply, and thus their ability to lower interest rates. In the US, the Federal Reserve was required by law to have 40% gold backing of its Federal Reserve demand notes, and thus, could not expand the money supply beyond what was allowed by the gold reserves held in their vaults.

A return to the Gold Standard would increase government regulation of the economy. With no Fed, inexpert Congress will bear the onus of alleviating economic suffering. With deeper, longer recessions, Congressmen will inevitably succumb to pressure for more spending and regulation of the economy--as they did during the Great Depression.

Indeed, Fed management of the money supply was originally meant to stave off calls for socialism by rendering free-market capitalism more resilient, flexible, and humane. Switching back to gold would breathe new life into anti-capitalist politics.

It would increase our reliance on foreign credit and ship yet more jobs overseas. Adopting the gold standard would actually exacerbate the problem of reliance on foreign credit, not alleviate it.

Assuming we're not in a recession, economic growth would then continually cause deflation, making domestically-produced products more expensive and foreign imports cheaper--increasing consumption of imports. The trade deficit would continue to balloon at the expense of American jobs. In a recession, this would be catastrophic.

Insofar as it helps anybody, the gold standard would favour Wall Street bankers over entrepreneurs, businesses, and workers. The major economic gains would be made by such big gold producers as Russia and South Africa.

The inflexibility of the gold standard during the 1890s spawned the anti-Washington Populist movement, led by William Jennings Bryan (read his eloquent attack on the gold standard here).
16. What is a share of stock?
It is debt. While it is defined as a fractional share of ownership in a business--it still represents an obligation to pay for money granted as part of investment in the business.
Extra Credit--Why does Ron Paul dislike the Federal Reserve Bank?
Among other reasons. The Bretton Woods system officially ended and the dollar became fully "fiat currency," backed by nothing but the promise of the federal government: he favours the gold standard. Additionally, he dislikes the fractional reserve system of banking for creating money from nothing.

BTW, The Nixon Shock of 1971 ended the direct convertibility of the United States dollar to gold. Since then all reserve currencies have been fiat currencies, including the dollar and the euro.
Sort of economically related: In the the Westminster, or Parliamentary, system, the defeat of an appropriations bill (a bill that solely concerns taxation or government spending) has what result? Why does this not have the same effect under the US Constitution?
It results in the resignation of the government and/or dissolution of Parliament, much like a non-confidence vote, since a government that cannot spend money is hamstrung. This is called loss of supply. Since the executive is not the head of government, the government does not collapse.

The points I was trying to make with this quiz were:
  1. Not much money physcially exists--in fact, most people are surprised by the limited amount of currency that is REALLY out there.
  2. Most of the Capitalist system runs on debt: things would grind to a halt if everyone got out of debt.
  3. The difference between government revenue and spending.
  4. the difference between who addresses economic issues: government or private industry.
  5. that the New Deal Programmes which are being dismantled were intended to PREVENT Socialism.
  6. That a lot of the things economists say are mumbo-jumbo.


  1. Laci - do you know why States are not allowed to operate at a deficit? Is this something states could choose to change or is it a Federal regulation?

    Also, while the capitalist system depends on debt, aren't you in a better position personally if you have no debt or very little debt? I guess the real problem is people have taken on debt not to make more money such as a business looking to raise capital to expand operations. Instead the personal debt was used to acquire things that mostly lose value (a house normally being the exception to this). So while debt taken on to generate more business can be a good thing, debt to buy that new TV is probably not a good thing right?

    In an ideal capitalist economy, people who borrow money would use it to generate more money than the amount borrowed plus interest repaid. That would be a win win situation. The system breaks down when people or businesses borrow money and can't generate the revenue to come out ahead. Not sure what the answer to that situation is and unfortunately that is a big part of the current economic problems.

  2. Some US states have balanced budget clauses. It is particular to the States.

    while the capitalist system depends on debt, aren't you in a better position personally if you have no debt or very little debt?

    Good question.

    On an individual level this is true. In fact, it makes a whole lot more sense than the system of debt.

    But, if everyone paid off their debts, the system comes to a crashing halt--as happened in 1837.

    So while debt taken on to generate more business can be a good thing, debt to buy that new TV is probably not a good thing right?

    Or if the government operates at a deficit.

    The problem is not so much going into debt as making sure that people have enough money to service the debt. If people had jobs that ensured they could pay their debts and keep them under control.

    Ideal whatever economies are just that ideals.

    The real issue in economics is to see that resources are allocated in a manner which is most efficient. Too much in one place is not good (capitalism), but having it all spread out (communism) is just as bad.

    Although, it seems that the 1% can also be subject to economic fluctuations.

    The best economy would be one that is stable, but so far, short of command economies, no one has come up with a system that is stable.