Chapter 1: Introduction
Chapter Outline
1.1 What is Economics? Two Views
- Orthodox, neoclassical approach
- Heterodox; Keynesian – institutionalist – Marxist approach
- What do economists do?
- Implications for research and policy
1.2 What is Macroeconomics?
- The MMT approach to macroeconomics
- The macro model
- Fiscal and monetary policy
- Policy implications for sovereign nations
1.3 Macro and the Public Purpose
- Concluding thoughts on the public purpose
Appendix: Advanced Material
- 1. The minimum wage debate
- 2. The structure of scientific revolutions
Learning Objectives
1. Recognise that macroeconomics is a contested discipline with two broad schools of thought,
which differ in terms of their perspectives on the effectiveness of markets and the role of
Government.
2. Understand that macroeconomics analyses the behaviour of aggregates, such as employment,
unemployment, GDP and inflation, whereas microeconomics studies the behaviour of individual
economic agents, notably households and firms.
3. Acknowledge that social science disciplines (e.g economics and politics) and physical science
disciplines (e.g. physics and chemistry) each have their own language in the form of concepts
and theories, which provide the basis for understanding, not merely describing, relevant
phenomena.
1.1 What Is Economics? Two Views
US President Harry Truman is said to have sought a one-armed economist because he was so
frustrated by the propensity of economists to provide policy advice framed as ‘Well, on the one
hand, X, but on the other hand, Y’, where ‘Y’ typically would be the precise opposite policy path
to ‘X’.
The story is, of course, funny but it does bring up a problem that is ubiquitous to all social
sciences. Even if we know the result we would like to achieve (say, smarter and happier kids),
we do not know with certainty which policy choices would produce the desired outcome. Since
the main topic of the social sciences—human behaviour—is complex, we often do not
understand its causes, or even its nature, and much less do we know how to influence it in a
desired manner. Economics is as difficult as the other social sciences, such as psychology and
political science as it concerns human behaviour in a social sphere that we designate as ‘the
economy’, which itself is hard to define and to delineate from other spheres of social interaction.
Unfortunately, economics is sometimes equated to something like the ‘study of business
decision-making’, or even relegated to a narrow sub-discipline as a ‘decision science’ in a highly
artificial hypothesised world of hyper-rational automatons that maximise pleasure and avoid
pain. Some even see economics as just a branch of mathematics, a view fuelled in part by the
heavy use of mathematics and models in much of the discipline.
This textbook will take a broader perspective of the economics discipline, including it within the
social sciences. While we do think it is useful to carve off ‘the economy’ from the rest of social
life, and to apply ‘economics’ to the study of that area of life, we recognise that the division is
necessarily arbitrary. In truth, there is no completely separate sphere of ‘economic life’—so
economics is linked to, and incorporates findings from, the other social science disciplines.
Further, we want to stress that there is no single ‘right’ way to do economics. In this textbook we
will use a variety of methods and approaches to build our understanding of ‘the economy’. We
will occasionally bring in research and methods from other disciplines. We will use some
mathematics and modelling. As we believe that economic history as well as history of economic
thought helps us to understand our economy today, we will look back in time, both in terms of
economic events, but also to examine the insights of the great thinkers of the past.
In the rest of this section we will briefly outline the two main approaches to economics taken by
those thinkers, as well as by today’s economists. It is always risky to pigeon-hole individuals and
their theories into categories. Just as a politician in a particular political party (say, Labor in
Australia, or the Republican Party in America) will hold many views shared by most members of
that party, they will likely also hold some views more consistent with those of a rival party. This
is true of economists, too. Still, it is useful to identify two approaches to economics that have
dominated much of the debate over the past two centuries.
Recalling the story about President Truman’s frustration, we can think of the ‘two hands’ of
economics as the orthodox, or neoclassical approach and the Heterodox or
Keynesian/Institutionalist/Marxist approach. Let us examine each in turn, while recognising that
we must generalise.
Orthodox, neoclassical approach
In the neoclassical approach, there is a presumed, natural human nature: individuals maximise
pleasure and avoid pain. Pleasure is defined as ‘utility’, so individuals pursue utility maximising
behaviour, avoiding the ‘disutility’ of pain. Further, rational individuals are self-interested seeking
to maximise their own utility, and they do not receive either utility or disutility from the
experiences of others. Neoclassical economics presumes individuals are ‘rational’, meaning they
maximise utility given constraints. If there were no constraints, individuals would maximise with
infinite utility—but they are constrained by their resources that they have at their disposal, which
are referred to as ‘individual resource endowments’. Mutually beneficial exchange redistributes
resources according to preferences, increasing the utility of both parties to the trade.
In the hypothesised free market, exchanges take place at competitively determined relative
prices. (Relative prices are ratios; for example: 1 deer = 3 beavers = 6 rabbits = 2 bushels of
wheat = 10 hours of labour services.) Participants in markets take relative prices as signals.
Relative scarcity will cause the price to rise, inducing suppliers to produce more of a particular
traded commodity, and buyers to demand less. For example, if the supply of students trained in
economics is insufficient to meet the demand for economists, the relative wage of economists to
(say) that of historians, rises. This signals to students that they ought to switch from the study of
history to the study of economics. At the same time, employers try to find close but cheaper
substitutes—say, political science students. As the supply of economists increases, the relative
wage advantage for students trained in economics falls. Of course, other factors enter into
decisions, but the important point is that relative prices function as signals to both suppliers
(economics students) and demanders (employers of economists).
Equilibrium is defined as the set of relative prices that ‘clear’ markets; a ‘general equilibrium’ is
a complete set of prices to clear all markets. One interpretation of Adam Smith’s famous
‘invisible hand’ analogy is that by producing market-clearing prices, the market provides the
signals that guide individuals to maximise their utility while also providing the social or public
good of ensuring that demand and supply are equilibrated. The hand is ‘invisible’, guiding
individuals and the economy as a whole toward equilibrium, with no need of an authority. For
that reason, there is little need for government management of the economy.
Certainly government has some role to play in setting and enforcing rules, in providing national
security, and (perhaps) for providing a social safety net. But according to this interpretation of
Smith, there is no need for the government to direct individuals to serve the public interest
because by reacting to price signals and pursuing their own interests, individuals actually act in
the public interest.
There is one more important conclusion reached by neoclassical economics: ‘you deserve what
you get’. If we all come to the free market to make mutually beneficial exchanges, all seeking to
maximise our own individual utility subject to our resource constraints, then the equilibrium
allocation is in an important sense ‘fair’. That does not mean that the allocation is equal—some
will have more (and achieve greater utility) and others will have less. However, that is because
some start with greater endowments (of resources, ability, and drive).
Technically, the idea is that one receives an allocation of resources based on one’s own
contribution to the market. If your final allocation is low, it is because you did not bring enough
to market: maybe you were born with few resources, you made a constrained choice to obtain
little education, and you prefer leisure over work. In other words, you have no one to blame for
your meagre allocation but yourself.
To be sure, neoclassical economics also allows for bad luck, congenital disabilities, and so on.
Hence, there is a role for social policy to get involved in altering the allocation in order to protect
the poorest and least advantaged. However, generally speaking, allocations ought to be left to the
market because it will reward each participant according to productive contributions to the
market—a dimension of fairness.
In recent years, the neoclassical approach to economics has been invoked in support of the
conservative backlash against post-war economic and social reforms in Western nations (this is
generally called neoliberal outside the USA or neoconservative within the USA). This ‘antigovernment’
movement is closely associated with the terms in office of President Ronald Reagan
in the USA and Prime Minister Margaret Thatcher in the UK. When running for President in
1980, President Reagan promised to “get the government off the backs of the people”; Prime
Minister Thatcher was famous for arguing that there is no such thing as society, reflecting the
individualistic framework shared by neoclassical economics.
Downsizing government and especially reducing the social safety net, is consistent with the view
that government only needs to ‘get the incentives right’, and then the ‘free market’ would
maximise individual welfare while the invisible hand will ensure that signals coming from
markets guide individuals to do what is best for the economy as a whole.
While the neoliberal/neoconservative policies are most closely associated with conservative
political parties, even the moderate parties continued the policies throughout the 1990s and
2000s. For example, President Clinton (a Democrat) echoed President Reagan’s distaste for
social welfare programs when he promised to “end welfare as we know it” in his 1992 election
campaign, eliminating the biggest USA anti-poverty program (Aid to Families with Dependent
Children) and replacing it with a term-limited program that tries to force aid recipients to work
for their benefits (‘workfare’ rather than ‘welfare’).
Outside the USA the more left wing parties such as the Labour Party in the UK pursued similar
strategies (such as ‘work for the dole’). Neoclassical economic theory provided a strong
justification for these economic and social ‘reforms’ as policy would rely more heavily on
‘market outcomes’ while reducing ‘government interference’ into the workings of the ‘invisible
hand’.
Finally, let us turn to the neoclassical definition of economics, as it provides a very nice
summary of the approach taken.
Neoclassical Definition of Economics: the study of the allocation of scarce resources among
unlimited wants.
This is often framed as ‘the economic problem’: while resources are scarce, our wants are
unlimited. The ‘problem’ is that we cannot ever satisfy our wants. Many call economics ‘the
dismal science’, which comes from this statement of ‘the problem’. While we all try to
‘maximise utility’, resource constraints prevent us from ever achieving maximal bliss.
Another common statement attributed to economists is that ‘there’s no such thing as a free
lunch’, which also derives from the definition. Since resources are scarce, there is always a tradeoff:
if we move resources from one use to another, we necessarily reduce enjoyment in the first
use in favour of enjoyment in the second. For example, if we want to have more ‘guns’, we must
have less ‘butter’. Or if we want to improve the standard of living enjoyed by ‘Bob’, we must
reduce the living standard of ‘Jill’.
Strictly speaking, this would be true only at full employment of all resources. However, with the
invisible hand guiding the allocation of resources, flexible relative prices ensure that all scarce
resources are fully employed. The idea is that prices will always fall until supply equals demand
so that no resource is left idle.
Note also that the trade-off might only be temporary. For example, if we move resources out of
the production of consumption goods and into the production of investment goods that raise
productive capacity, then in the future we can have more consumer goods. Through economic
growth we can increase the quantity of resources so that both ‘Bob’ and ‘Jill’ can have more.
This does not violate the admonition that there is no free lunch, however. If we are to have more
production in the future, we need to sacrifice some consumption today—we suffer today with
lower consumption, but we are willing to endure the ‘pain’ on the promise that in the future we
can enjoy more consumption.
We will have much more to say about the neoclassical approach later in the text. However, it is
time to move on to the second approach to economics.
Heterodox, Keynesian-institutionalist-Marxist approach
There is a second, long, tradition in economics that adopts a quite different framework.
Unfortunately, there is no strong consensus about what to call it. Sometimes it is called
‘nonorthodox’, which appears to define it in opposition to ‘orthodox’ or neoclassical economics.
In recent years, many of those working in this tradition have settled on the term ‘heterodox’, but
that, too, is usually defined as ‘not in agreement with accepted beliefs’. Yet at one time, those
views now associated with ‘heterodox’ economics were dominant, while the ‘orthodox’ views
were considered by most economists as ‘unorthodox’ in the sense that they were not in
agreement with the beliefs held by most economists!
Further, unlike neoclassical theory, which is substantially accepted by all orthodox theorists,
‘heterodoxy’ is made up of a number of well-established and coherent economic schools of
thought1
. While these share a common approach, they also deviate from one another in important
ways. The three most important of these schools of thought are the Marxist (following the work
of Karl Marx), the Institutionalist (following the work of Thorstein Veblen), and the Keynesian
(followers of John Maynard Keynes)2
.
1
Note that the approach taken in this text, Modern Money Theory, falls within the heterodox camp. Indeed, it rests
upon the foundations of many of the heterodox traditions.
2
A caveat is necessary here. Many of those who call themselves ‘Keynesian’, as well as the approach that is often
presented in economics textbooks as ‘Keynesian theory’, are not heterodox. They are much closer to the neoclassical
approach. Indeed, one of the founders of orthodox macroeconomic theory, Paul Samuelson, called it the
“Neoclassical Synthesis” to indicate that its foundations are neoclassical but some of Keynes’s ideas are
What are we to do? In spite of the objections we raised, we will conform to the convention and
call this second approach the heterodox or Keynesian/Institutionalist/Marxist approach. Let us
examine the shared framework adopted.
First, according to this approach there is no ‘natural’ human behaviour; rather, it is shaped by
institutions, culture, and society. There is nothing ‘natural’ about self-interested (or, better,
‘selfish’) behaviour, nor would such behaviour be ‘rational’ in the neoclassical sense. Humans
are social animals and in many cultures, selfish behaviour is punished and selfish individuals are
ostracised. Since human survival requires cooperation, selfishness would actually be irrational as
it would reduce one’s chances of survival. In any event, in all known societies, elaborate rituals
and traditions are designed to promote cooperation and even sacrifice for the common good.
Human behaviour varies significantly across societies, and the economic system is one factor
that helps to determine appropriate behaviour within any particular society. Self-interested
behaviour is more acceptable in some societies than in others. It is not a coincidence that
neoclassical economic theory was developed largely in Western capitalist societies—and
particularly in England. The ‘rational’ behaviour attributed by neoclassical economists to all
humans actually comes reasonably close as a description of the behaviour of early British
capitalists. In the social environment in which they operated, pursuit of their own self-interest
without regard to the welfare of others (especially that of their employees), may have increased
their probability of success as capitalists. Further, they operated in a hostile political climate in
which the Crown and their feudal lord cronies wanted to increase their own share of the nation’s
rather feeble output. Government ‘intervention’ was almost always a bad thing, from the
perspective of the first capitalists because government operated substantially in the interest of the
Crown and the feudal lords.
We will not go into economic history now. What we wish to emphasise is that human behaviour
is surprisingly malleable and complexly influenced by custom and tradition.
Further, most decisions are not ‘rational’ for another reason: the future is uncertain, and even the
present and past are uncertain in the sense that we do not fully understand what happened and
what is now happening. Clearly, we do not know the future, and we know that we do not. Hence,
we cannot know for certain that any action we take is truly ‘utility maximising’. Should I buy the
Renault or the Mazda? Once the decision is made and with the passage of time, I might have a
better idea of the best choice, but it is probable that even a decade down the road I will not know
which would have been best. Obviously, that choice is relatively unimportant and even simple
compared to most economic choices one must make. In truth, we almost never know whether we
are ‘maximising’ utility—indeed even with hindsight we often cannot tell if we made the right
decision.
According to the heterodox approach, most decisions are not ‘rational’ in the neoclassical sense
of the term. Decisions and behaviour depend on a range of other factors, including uncertainty,
power, discrimination, prejudice, and segregation. Options available depend on status, social
class, race, religion, and gender, for example. These ‘noneconomic’ factors heavily influence and
even constrain our choices.
‘synthesised’ or grafted onto that base. Heterodox followers of Keynes argue that such integration is not possible.
We will revisit these issues later in the text.
Heterodoxy rejects the notion that economic outcomes are arbitrated by an impersonal market
that only seeks to equilibrate ‘demand and supply’. Actually, market prices are largely
administered by firms with market power that allows them to discriminate. Wages are set not to
‘clear’ the labour market, but rather reflect the outcome of conflicted bargaining processes.
Capitalism is a system defined by class conflict. In general, workers want to earn as much as
they can for the effort they expend, while bosses want workers to produce as much as they can
but pay them as little as possible. And, as will be discussed later, unemployment cannot be
eliminated through wage reductions that eliminate relative excess labour supply; indeed wage
reductions can actually reduce the demand for labour and thus increase unemployment. More
generally, wages and other prices are not simply signals of the invisible hand, but rather
determine incomes and thus influence business sales and decisions going forward. For that
reason, price and wage determination are not usually left to the invisible hand of the market.
Heterodoxy holds a different view of the so-called ‘economic problem’ of scarce resources and
unlimited wants. Wants are largely socially created, and there is nothing natural about humans
having ‘unlimited’ wants. While it is true that modern advertising operates to continually expand
our desires, this can be countered through education. Further, resources are also largely socially
created. While it is true that some natural resources have a limited supply, innovations
continually produce substitutes. For example, Western societies faced their first major energy
crisis in the 19th century when whalers had significantly reduced the number of whales, the
source of whale oil used for lighting and other purposes. However, the production of petroleum
and then electricity quickly replaced whale oil.
Moreover, the most important resource in any economy is labour. Ironically, in capitalist
economies labour is virtually always in excess supply—that is, many workers are left
unemployed. It is ironic that neoclassical economics starts from the presumption that resources
are scarce, when the obvious empirical fact is that labour is unemployed. Any theory that begins
with the presumption that labour is always fully employed, and hence scarce, is ignoring a
glaring inconsistency.
Let us look at the heterodox definition of economics.
Heterodox Definition of Economics: the study of social creation and social distribution of
society’s resources.
Note that unlike the orthodox definition, this one focuses on the creation of resources. Further,
most of that creation is social, rather than individual: people work together to produce society’s
resources. Distribution, too, is socially determined, rather than determined by a technical relation
(one’s contribution to the production process). For example, labour unions engage in collective
bargaining with their employers, who also band together to keep wages low.
The political process is also important in determining distribution; not only does government
directly provide income to large segments of society, but it also puts in place minimum wages,
benefits, and working conditions that must be met by employers. Government is also a creator of
resources; it is not just a user of them. It organises and funds innovative research and
development (often in its own labs) that is then used to create resources (frequently by private
firms). It also purchases directly from firms, encouraging them to increase hiring and output. Not
only do these government activities increase production, but they also affect distribution. This is
well-understood by voters and their representatives in government as policy creates winners and
losers—and not usually in a zero-sum manner: some policies can create winners while others
might create more losers.
Power, discrimination, collusion, and cooperation all play a role in determining ‘who gets what’.
The point is that society does not have to let ‘the market’ decide that women should be paid less
than men, for example, or that those with less education should remain jobless and thus poor.
Economics, like all social sciences, is concerned with a society that is complex and continually
undergoing change. Since economists study human behaviour in the economic sphere, their task
is very difficult. Whatever humans do, they could have done something different. Humans have
some degree of free will, and their behaviour is largely based on what they think they ought to
do. That in turn depends on their expectations of an unknowable future—they do not know
precisely what the outcome of their actions will be, and they do not know what others will do.
Indeed, humans do not know exactly what happened in the past, nor do they fully understand
what is happening today. They must interpret the environment in which they live, and realise that
they cannot fully understand it. They can never know if they have truly ‘maximised’ their
pleasure. They make plans in conditions of existential uncertainty, and do the best they can do
given their circumstances. Their actions are almost always taken with consideration given to the
impacts on others—humans are above all social animals and that is why economics must be a
branch of the social sciences.
What do economists do?
Like sociologists and political scientists, economists are trying to understand particular aspects
of human behaviour – for example decisions about levels and patterns of spending, choices about
enrolment in post-school education and types of employment to pursue– which we argue above,
are influenced by institutions; culture; and society; in addition to economic variables, such as
income; the prices of goods; and prospective wage rates for different occupations. In
microeconomics our focus is the behaviour of individual consumers and firms, whereas in
macroeconomics the focus is the aggregate impacts of these decisions on outcomes, including
total output and employment and the rate of inflation. We elaborate on these definitions of
microeconomics and macroeconomics, below.
In trying to understand particular forms of economic behaviour, we need to develop theories that
require us to decide on those factors that we think influence the particular economic decisions of
interest. In other words, we need to make simplifying assumptions (engage in abstraction), which
means we necessarily ignore those factors that we consider to be irrelevant. Otherwise we are
trying to replicate the complex reality, as we see it, and we are engaging in description rather
than theorising. In the development of theory, concepts are formulated, which can be viewed as
the building blocks of theory. A model can be viewed as the formalisation of a theory (see
below). To understand any theory (model), it is important that students comprehend the
underlying concepts.
Social scientists seek to confront their abstract theoretical models, expressed in the form of
conjectures about real world behaviour, with the empirical data that the real world provides. For
example, we might form the conjecture that if disposable income rises, household consumption
will rise. We would then collect the relevant data for disposable income and household
consumption and any other information we thought might bear on the relationship and use
various statistical tools (for example, regression analysis) to enumerate the relationship between
disposable income and household consumption to see whether our conjecture was data
consistent. In engaging in this sort of exercise, the responsible social scientist is not seeking to
establish whether the theoretical model is true, for that is an impossible task, given there is no
way of knowing what the truth is anyway. Instead, we seek to develop theories or conjectures
that provide the best correspondence with the empirical world we live in. This means our current,
accepted body of knowledge comprises theories and conjectures that explain the real world data
in the most comprehensive way when compared to the competing theories.
Further, we can rarely refute a theory. As President Truman complained, there are two or more
sides to the most important economic questions, so there are competing theoretical approaches
yielding different conclusions. Even when a researcher resorts to the analysis of relevant data,
(which often entails the use of econometrics), they can never refute a theory with 100 per cent
confidence. Often the acceptance of a theory is driven by ideology and politics, rather than a
balanced assessment of the competing theories and associated evidence.
Implications for research and policy
Many students, like President Truman, find the inability of economists to come up with
definitive answers to economic questions to be rather frustrating. Here it is important to
emphasise that, like physical sciences and other social sciences, economics is a contested
discipline, as is illustrated by our brief discussion of the two schools of thought in Section 1.1.
Students will be exposed to some major contemporary debates in macroeconomics later in this
textbook, but below we outline a long-standing debate in developed economies, such as the UK,
USA and Australia, about the impact of an increase in the minimum wage on unemployment
(Advanced Topic 1 in the Appendix to this Chapter).
If there are longstanding debates in economics (and other disciplines), which appear to be
unresolved, how can there be progress in our understanding of economic phenomena? This is an
important question because decisions made by macroeconomic policymakers have profound
effects on the welfare of the population in terms of for example, employment opportunities and
wages. Thomas Kuhn developed a way of understanding how progress is made in the social and
physical sciences; see Advanced Material 2 in the Appendix to this Chapter.
1.2 What is Macroeconomics?
In macroeconomics we study the aggregate outcomes of economic behaviour. The word ‘macro’
is derived from the Greek word ‘makro’, which means large and so we take an economy-wide
perspective.
Macroeconomics is not concerned with analysing how each individual person, household or
business firm behaves or what they produce or earn – that is the terrain of the other major branch
of economic analysis, microeconomics. Macroeconomics focuses on a selected few outcomes at
the aggregate level and is rightly considered to be the study of employment, output and inflation
in an international context. A coherent macroeconomic theory will provide consistent insights
into how each of these aggregates is determined and change.
In this regard, there are some key macroeconomic questions that we seek to explore:
1. What factors determine the flow of total output produced in the economy over a given
period and its growth over time?
2. What factors determine total employment and why does mass unemployment occur?
3. What factors determine the evolution of prices in the economy (inflation)?
4. How does the domestic economy interact with the rest of the world and what are the
implications of that interaction?
A central idea in economics whether it is microeconomics or macroeconomics, is efficiency –
getting the best out of what you have available. The concept is extremely loaded and is the focus
of many disputes, some more arcane than others. But there is a general consensus among
economists that at the macroeconomic level, the ‘efficiency frontier’ (which defines the best
outcome achievable from an array of possible outcomes) is normally summarised in terms of full
employment. The hot debate that has occupied economists for years is the exact meaning of the
term – full employment. We will consider that issue in full in Chapters 11 and 12. But
definitional disputes aside, it is a fact that the concept of full employment is a central focus of
macroeconomic theory. Using the available macroeconomic resources including labour to the
limit is a key goal of macroeconomics. The debate is over what the actual limit is. The related
macroeconomic challenge is how to maintain full employment but at the same time achieve price
stability, which means that prices are growing at a low and stable rate.
The clear point is that if you achieve that goal then you will be contributing to the prosperity and
welfare of the population by ensuring real output levels are high within an environment of stable
prices.
This book develops a framework for understanding the key determinants of these aggregate
outcomes – the level and growth in output; the rate of unemployment; and the rate of inflation –
within the context of what we call a monetary system. All economies use currencies as a way to
facilitate transactions. The arrangements by which the currency enters the economy and the role
that the currency issuer, the national government, has in influencing the outcomes at the
aggregate level, is a crucial part of macroeconomics. Modern Monetary Theory (MMT), which is
briefly outlined below, develops a macroeconomic framework that incorporates the unique
features of the monetary system.
The MMT approach to macroeconomics
Modern Monetary Theory (MMT) is distinguished from other approaches to macroeconomics
because it places the monetary arrangements at the centre of the analysis. Learning
macroeconomics from an MMT perspective requires you to understand how money ‘works’ in
the modern economy and to develop a conceptual structure for analysing the economy as it
actually exists.
Most people are unaware that a major historical event occurred in 1971, when US President
Nixon abandoned gold convertibility and ended the system of fixed exchange rates. Under that
system, which had endured for about 80 years (with breaks for war), currencies were convertible
into gold, exchange rates were fixed, and governments could expand their spending only by
increasing taxes or borrowing from the private sector. After 1971, most governments issued their
own currencies by legislative fiat; the currencies were not convertible into anything of value, and
were floated and traded freely in foreign currency markets.
It is thus essential to understand the notion of a currency regime, which can range through a
continuum from fixed exchange rate systems to floating exchange rate systems with varying
degrees of exchange rate management in between. Understanding the way the exchange rate is
set is important because it allows us to appreciate the various policy options that the currency
issuer – the government – has in relation to influencing the main objects of our study;
employment, output and inflation.
A flexible exchange rate releases monetary policy from defending a fixed parity against a foreign
currency. Fiscal and monetary policy can then concentrate on ensuring domestic spending is
sufficient to maintain high levels of employment. A consequence of this is that governments that
issue their own currencies no longer have to ‘fund’ their spending. They never need to ‘finance’
their spending through taxes or selling debt to the private sector. The reality is that currencyissuing
governments such as those of Australia, Britain, Japan and the US can never run out of
money. These governments always have the capacity to spend in their own currencies.
Most of the analysis appearing in macroeconomics textbooks, which filters into the public debate
and underpins the cult of austerity, is derived from ‘gold standard’ logic and does not apply to
modern fiat monetary systems. Economic policy ideas that dominate the current debate are
artefacts from the old system, which was abandoned in 1971.
At the heart of macroeconomics is the notion that at the aggregate level, total spending equals
total income and total output. In turn, total employment is related to the total output in the
economy. So to understand employment and output determination we need to understand what
drives total spending and how that generates income, output and the demand for labour.
In this context, we will consider the behaviour and interactions of the two economic sectors –
that is, government and non-government. Then we will unpack the non-government into its
component sectors – the private domestic sector (consumption and investment) and the external
sector (trade and capital flows). In Chapter 4 we analyse in detail the so-called National
Accounts, drawing on these broad macroeconomic sectors. This approach is called the sectoral
balance approach, which builds on the accounting rule that a deficit in one sector must be offset
by surpluses in the other in the case of the government – non-government dichotomy. More
generally, the sum of the sectoral balances nets to zero when we consider the government,
private domestic and external sectors.
If one sector spends more than its income, at least one of the others must spend less than its
income because for the economy as a whole, total spending must equal total receipts or income.
While there is no reason why any one sector has to run a balanced budget, the National Accounts
framework shows that the system as a whole must. Often though, but not always, the private
domestic sector runs a surplus – spending less than its income. This is how it accumulates net
financial wealth. Overall private domestic sector saving (or surplus) is a leakage from the overall
expenditure cycle that must be matched by an injection of spending from another sector. The
current account deficit (the so-called external sector account) is another leakage that drains
domestic demand. That is, the domestic economy is spending more overseas than foreigners are
spending in the domestic economy. These concepts are developed in full in Chapter 5.
Here it is useful to differentiate between a stock and a flow. The latter is a magnitude per period
of time. For example, spending is always a flow of currency per period (for example, households
might spend $100 billion dollars in the first three months of 2016). On the other hand, a stock is
measured at a point in time. For example, a student’s financial wealth could consist of a deposit
account at a local bank, with a balance of $1000 on January 1, 2016. We explain stocks and
flows in more detail in Chapters 4 and 5.
The sectoral balances framework, outlined later, shows that a sectoral deficit (a flow, say per
year) accumulates, as a matter of accounting to a financial debt (a stock). On the other hand, a
sequence of sectoral surpluses accumulate to a financial asset which is also a stock. MMT is thus
based on what is known as a stock-flow consistent approach to macroeconomics where all flows
and resulting stocks are accounted for in an exhaustive fashion. The failure to adhere to a stockflow
consistent approach can lead to erroneous analytical conclusions and poor policy design.
From the perspective of fiscal policy choices, an important aspect of the stock-flow consistent
approach that will be explained in greater detail in Chapter 5, is that one sector’s spending flow
equals its income flow plus changes to its financial balance (stock of assets).
The textbook will show that a country can only run a current account deficit if the rest of the
world wishes to accumulate financial claims on the nation (financial debt). Often these claims
are in the form of government debt. The MMT framework shows that for most governments,
there is no default risk on government debt, and therefore such a situation is ‘sustainable’ and
should not be interpreted to be necessarily undesirable. Any assessment of the fiscal position of a
nation must be taken in the light of the usefulness of the government’s spending program in
achieving its national socio-economic goals. This is what Abba Lerner (1943) called the
‘functional finance’ approach. Rather than adopting some desired budgetary outcome,
government ought to spend and tax with a view to achieving ‘functionally’ defined outcomes,
such as full employment.
On matters of terminology, we avoid using the term ‘budget’ to describe the spending and
taxation outcomes for the currency-issuing government. Instead, we use to the term fiscal
balance. A government fiscal deficit occurs when its spending exceeds its taxation revenue,
whereas a fiscal surplus occurs when government spending is less than its taxation revenue.
The use of the term ‘budget’ to describe the fiscal balance invokes the idea that the currencyissuing
government faces the same ‘budget’ constraints as a household. A careful understanding
of the monetary system will make it obvious that the government is not a ‘big household’. The
government can consistently spend more than its revenue because it creates the currency.
Households use the currency issued by the government and must finance their spending. Our
access is constrained by the sources of available funds, including income from all sources, asset
sales, and borrowings from external parties. Whereas households have to save (spend less than
they earn) to spend more in the future, governments can purchase whatever they like, as long as
there are goods and services for sale in the currency they issue.
A sovereign government must spend first before it can subsequently tax or borrow. A household
cannot spend more than its revenue indefinitely because continuously increasing private debt is
unsustainable. The budget choices facing a household are thus limited and prevent permanent
deficits. A currency-issuing government can never be revenue constrained in a technical sense
and can sustain deficits indefinitely without solvency risk. In other words, our own personal
budget experience generates no knowledge relevant to consideration of government matters. The
alternative narrative, which we present in this book, highlights the special characteristics of the
government’s currency monopoly.
Fiscal surpluses provide no greater capacity to governments to meet future needs, nor do fiscal
deficits erode that capacity. Governments always have the capacity to spend in their own
currencies. The consequences of a fiscal surplus – the government spending less than it is taking
out of the economy by way of taxation – when a nation runs an external deficit will also be
outlined. In summary, budget surpluses force the non-government sector into deficit and the
domestic private sector is forced to accumulate ever-increasing levels of indebtedness to
maintain its expenditure. The textbook will explain why this is an unsustainable growth strategy
and how eventually the private domestic sector is forced to reduce its risky debt levels by saving
more and the resulting drop in non-government spending will reinforce the negative impact of
the government fiscal surplus on total spending.
The macro model
To organise the way of thinking in this regard we use a conceptual structure sometimes referred
in the economics literature as a model – in this case a macroeconomic model. A model is just an
organising framework and is a simplification of the system that is being investigated. In this
textbook, we will develop a macroeconomic model, which combines narrative and some algebra
to advance your understanding of how the real world economy operates. We will necessarily
stylise where complexity hinders clarity, but we will always focus on the real world rather than
an assumed world that has no relevance to the actual economy.
All disciplines develop their own language as a way of communicating. One might think that this
just makes it harder to understand the ideas and we have sympathy for that view. But we also
understand that students of a specific discipline – in this case macroeconomics – should be
somewhat conversant with the language of the discipline they are studying.
In the Appendix to this book – Methods, Tools and Techniques - we present the essential
analytical techniques and terminology that you will find used to specify and solve
macroeconomic models throughout this book. These tools and techniques are also deployed in
the practical exercises that accompany this text and are to be found on the internet home page for
the book. The Appendix should be regularly consulted.
A macroeconomic model draws on concepts and algebraic techniques to advance our
understanding of the main economic aggregates (such as output, employment and price level).
This textbook design is unique because it specifically develops the MMT macroeconomic model,
which will be applicable to the real-world issues including economic policy debates. The
application to policy is important because macroeconomics is what might be termed a policy
science.
By placing government as the currency issuer at the centre of the monetary system we
immediately focus on how it spends and how that spending influences the major macroeconomic
aggregates that we seek to explain. The framework will at first, provide a general analysis of
government spending that applies to all currency-exchange rate systems before explaining the
constraints (policy options) that apply to governments as we move from a flexible exchange rate
to a fixed exchange rate system. We will consider how the design of the monetary system
impacts on the domestic policy choices open to government and the outcomes of specific policy
choices in terms of output, employment and inflation.
Fiscal and monetary policy
The two main policy tools that influence what is termed the demand or spending side of the
economy are monetary and fiscal policy.
Fiscal policy is represented by the spending and taxation choices made by the government (the
‘treasury’). The net financial accounting outcomes of these decisions are summarised
periodically by the government fiscal position. Fiscal policy is one of the major means by which
the government seeks to influence overall spending in the economy and achieve its aims.
The textbook will show that a nation will have maximum fiscal space:
 If it operates with a sovereign currency; that is, a currency that is issued by the sovereign
government and its value is not pegged to foreign currencies; and
 If it avoids incurring debt in foreign currencies, and avoids guaranteeing the foreign
currency debt of domestic entities (firms, households, and state, province, or city debts).
Under these conditions, the national government can always afford to purchase anything that is
available for sale in its own currency. This means that if there are unemployed resources, the
government can always mobilise them – putting them to productive use – through the use of
fiscal policy. Such a government is not revenue-constrained, which means it does not face the
financing constraints that a private household or firm faces in framing its expenditure decision.
To put it as simply as possible – this means that if there are unemployed workers who are willing
to work, a sovereign government can afford to hire them to perform useful work in the public
interest. From a macroeconomic efficiency argument, a primary aim of public policy is to fully
utilise available resources.
The central bank in the economy is responsible for the conduct of monetary policy, which
typically involves the setting of a short-term policy target interest rate (Fed Funds in the USA,
also called bank rate in many countries). In the recent global economic crisis the ambit of
monetary policy has broadened considerably and these developments will be considered in
Chapter 15.
The typical roles of a central bank include not only the conduct of monetary policy via the
overnight interbank lending rate, but also operating the interbank clearing mechanism (so that
bank cheques clear among banks), acting as lender of last resort (to stop bank runs), and
regulating and supervising the banks.
MMT considers the treasury and central bank functions to be part of what is termed the
consolidated government sector. In many textbooks, students are told that the central bank is
independent from government. The MMT macroeconomic model will demonstrate how it is
impossible for the two parts of government to work independently if the monetary system is to
operate smoothly.
Policy implications for sovereign nations
MMT provides a broad theoretical macroeconomic framework based on the recognition that
sovereign currency systems are in fact public monopolies per se, and that the imposition of taxes
coupled with insufficient government spending generates unemployment.