Working Paper 23-01

An Introduction to Modern Monetary Theory

William Mitchell

October 2023

Centre of Full Employment and Equity
The University of Newcastle, Callaghan NSW 2308, Australia
Home Page: http://www.fullemployment.net
Email: Bill.Mitchell@newcastle.edu.au

The Centre of Full Employment (CofFEE) is an official research centre at the
University of Newcastle, NSW.
William Mitchell is Professor of Economics and Director of Centre of Full Employment
and Equity at the University of Newcastle, Australia and Docent Professor of Global
Political Economy, University of Helsinki, Finland. He is also an International Fellow
at Kyoto University, Japan.
CofFEE Home Page: http://www.fullemployment.net
Email: Bill.Mitchell@newcastle.edu.au2

1.

Introduction

This introduction to Modern Monetary Theory is based on a presentation the author
gave at Kyoto University, Japan on November 5, 2022.
The Global Financial Crisis (GFC) and the Covid-19 pandemic a decade or so later
exposed the unsustainability of the neoliberal era in terms of economic policy and theunderlying economics that guide that policy.
In most advanced countries, the last several decades have been marked by a reliance onhousehold debt to maintain economic growth with governments biasing fiscal policy
towards austerity. Governments also justified their lax oversight of financial markets
that allowed private debt to skyrocket through appeal to the ‘efficient markets’ theorem,
which denies that financial markets can act irrationally and misallocate investment
funds. The dominance of New Keynesian macroeconomics also assigned counterstabilisation responsibilities to monetary policy, even though that tool is largely
ineffective in fulfilling that function.
Before the GFC, the principle economic models used by mainstream economists did
not even include a financial sector. Denial and hubris prevailed in the economic debate.
The GFC exposed the folly of that approach and policy makers around the world
adopted very pragmatic approaches to stabilising their economies – implementing
significant fiscal stimulus.
What we learned from that crisis was that fiscal policy is very effective at supporting
aggregate spending in the face of a non-government spending withdrawal, a point that
had been denied by economists for years prior to the GFC. We also learned that large
deficits do not drive-up interest rates and that central banks, acting as an arm ofgovernment can always control yields on government debt should they desire to do so.
All the main precepts of the dominant New Keynesian theory were shown to be
erroneous during this period. Even Queen Elizabeth of Britain, on a visit to London
School of Economics in November 2008 asked the question: ‘If these things were solarge, how come everyone missed them?’
The reason why the mainstream economics profession was oblivious to the signals of
the impending crisis is because it increasingly exhibited what social psychologists
identify as Groupthink. This syndrome is a pattern of group behaviour that facilitates
resistance to change, even when the core theories no longer adequately explain the facts.
There are many examples of this phenomenon across many disciplines, where newknowledge is ignored, and the existing practices (policies) are sustained even when they
are based on false premises and undermine the intended goals. Typically, it is only when
the weight of evidence becomes so compelling that paradigm shift occurs.
The dissonance that was evident in economics during that period helped facilitate theemergence of Modern Monetary Theory (MMT), which challenged these dominantbelief systems in economics. The origins of MMT go back to the 1990s but it was not
until the GFC that its ideas started resonating in the public debate as more people sought
alternative understandings in the face of the poverty of mainstream economics.
MMT resonates more closely with the institutional and economic facts. The early MMT
economists in the 1990s warned that the financial market deregulation and the relianceon increasing household debt for economic growth was unsustainable and would end incrisis. Further, the experience of Japan after the massive property market collapse in3the early 1990s provided ample evidence of the failure of mainstream economists topredict policy outcomes.
This paper introduces the basic concepts of MMT and demonstrates how they provide
a better basis for understanding how modern, fiat monetary systems function. MMT
also provides a sound framework for understanding the capacities of a currency-issuinggovernment, the consequences of deploying those capacities, and the problems thatemerge when a nation surrenders those capacities (such as in the case of the Eurozone
Member States).
2.

The evolution of monetary systems

In August 1971, a major historical event occurred which changed the way monetarysystems worked and rendered much of the macroeconomic textbook knowledge aboutpublic spending and debt redundant. The international monetary system that had beencreated in 1946 to achieve currency stability at the end of World War 2 - the fixedexchange rate, Bretton Woods system – effectively collapsed in August 1971 when
President Nixon abandoned US dollar gold convertibility.
Under the Bretton Woods system, central banks were responsible for maintaining theagreed parities with other currencies and thus had to closely manage the amount of theircurrency circulating in the system. If a currency was in excess supply in the foreignexchange markets, the issuing central bank had to purchase that currency with foreign
currency reserves, and, increase domestic interest rates to attract foreign investment(and demand for the currency) to quell the downward pressure.
The problem was that the money supply contraction and higher interest rates pushed
unemployment up and if expansionary fiscal policy was used too aggressively to reduce
unemployment – putting currency back in the system – it would compromise the central
bank’s efforts to maintain currency stability. Thus, without an increase in gold reserves,increased government expenditure (which injected currency) had to be matched bytaxation (a currency drain). If the government was spending more than their tax
revenue, they had to issue debt (a further drain).
However, the demise of the Bretton Woods system and the emergence of fiat monetarysystems in most nations dramatically altered the opportunities available to currencyissuing governments.
First, unlike under the Bretton Woods system where all currencies could ultimately beconverted into gold via US dollar holdings, ‘state money’ no longer had any intrinsic
value. For an otherwise ‘worthless’ currency to be acceptable in exchange (buying andselling things) some motivation was required. The imposition of tax liabilities in thatcurrency by the government provided the motivation.
Second, as the monopoly issuer of the fiat currency, the Bretton Woods restrictions tooffset spending with taxation and/or borrowing were no longer binding because thecentral bank was freed from having to maintain currency parities. In other words,
governments issuing their own fiat currencies were no longer financially constrained intheir spending. Such governments were able to buy any goods and services for sale inits currency including all idle labour. The only meaningful constraint on spending
became the ‘inflationary ceiling’ that is reached when all productive resources are full
employed. This was a dramatic change. Any notion that such a government could ‘runout of money’ became inapplicable.

4

These changes provided the entrée for Modern Monetary Theory (MMT) and allowed
us to shift from thinking about financial constraints on government spending and all
analytics about the ‘government budget constraint’, to a focus on real resource
constraints defined in terms of available productive resources and available final goods
and services. Another dramatic shift in thinking.
Third, logically, the government no longer needed to issue debt, given it is the issuer of
its own currency. The continued practice of issuing debt became an ideological practicerather than a financial necessity.
Reflecting on these changes, we now understand that politics was strictly freed fromthe perennial: ‘How are we going to pay for it’ question. The continued use of thatchallenge to government spending signifies the extent to which the populace is ignorantof those historical changes rather than any financial reality. The questions that should
become the focus of the public debate about government spending and taxation are
different and relate to functional outcomes we desire from public spending andavailability of productive resources.
These insights about the modern fiat monetary systems are ignored by mainstream
macroeconomics and invalidates their analysis of public deficits and debt. Mainstream
analysis focuses purely on assertions about financial constraints and financial ratios (the‘deficit is too large’) rather than grounding the analysis in institutional reality and themechanics of the fiat currency system.
3.

What is MMT?

A common misperception is that MMT is some sort of political regime or a set ofpolicies. Rather, MMT should be understood as a lens which provides a better
understanding of the monetary system and the capacities of currency-issuinggovernments. By linking the institutional reality of the fiat monetary system withbehavioural theories, it provides a more coherent framework for assessing theconsequences of policy choices.
By shifting the focus to real resource constraints, MMT allows us to understand thatmost choices that are couched in terms of ‘budgets’ and ‘financial constraints’ are, infact, just political choices. The mainstream metaphor of the government as an incomeconstrained household is shown to be erroneous. We understand that if the currencyissuing government can purchase whatever is for sale in their own currency including
all idle labour desiring work, then mass unemployment is a political choice rather thansomething ‘natural’ or inherent to the structure of the system.
It also makes no sense to talk about a suite of MMT policies. MMT is a framework forunderstanding policy choices that emerge from the currency capacity of government,
but the specific policy decisions will reflect the ideology (values) of the government
and the political reality it faces. In this sense, MMT is politically agnostic. The
relevance of MMT for policy making is that we shift from an obsession with ‘how to
pay for it’ to a focus on what the policy will achieve and whether it is the best use ofavailable resources.
4.

Understanding the constraints on government spending

When MMT economists note that a currency-issuing government faces no financial
constraints on its spending they are merely emphasising the fact that the government

5

can buy whatever is for sale in its own currency whenever it chooses. This insight thenleads to questions about what the constraints on such spending are.
To help answer this question, consider Figure 1, which is a 2x2 matrix with two broad
dimensions: (a) Is the nation operating at full capacity? and (b) Does the nation enjoy
monetary sovereignty. Figure 1 depicts 4 possibilities and allows us to summarise thedifferent constraints that a government faces when designing fiscal policy interventions.
A monetarily sovereign nation issues its own currency, floats it on foreign exchange
markets, does not borrow in foreign currency and sets its own interest rate. For example,
the US, Australia, Japan, the UK, and many other nations fit into this category.
Conversely, the 20 Member States that use the euro are not sovereign because they do
not issue the currency they use. Further, if a nation is operating at full capacity, then all
the available productive resources are currently being utilised and could only bereallocated through the market mechanism through increased price bids.
Figure 1 Government spending constraints
Is the nation operating at full capacity?
Yes
Does the nation enjoy
monetary sovereignty

Yes

1. Real

No

3.
Real
financialNo
2. Noneand 4. Financial

In Case 1 (Yes-Yes), a monetarily sovereign government overseeing a fully employedeconomy faces no financial constraints on its spending. But should it desire to increase
its use of the nation’s productive resources, say to introduce a large infrastructure
program, then it would have to compete with the non-government sector at market
prices for resources that are currently in use elsewhere. In that situation, demand-pull
inflationary pressures will arise. In other words, government spending comes up against
a real resource constraint.
To avoid inflationary pressures, the government would have to ‘free up’ someproductive resources for transfer into the public sector. Taxation is one policy option
because it reduces non-government purchasing power and creates the real resource
space which the government can spend into without creating inflation. However, unlike
the popular perception, the taxes do not provide any extra financial capacity to
government.
In Case 2 (Yes-No), the idle productive resources can be brought back into productive
use with higher fiscal deficits. There are no constraints – financial or resource – on suchgovernment spending. These resources have zero bid in the market and deploying them
introduces no inflationary pressures. The responsibility of government in this case is tospend up to full employment. Once the economy reaches full employment the situation
switches back to Case 1.
Case 3 (No-Yes) might define a Eurozone Member State operating at full employment.
Such a government faces two spending constraints – financial and real. Without
6monetary sovereignty, the government must raise tax revenue before it can spend, and,if that is insufficient to cover its spending ambitions then it must borrow funds from theprivate bond markets under conditions set by the investors. It also faces the same real
resource constraints as in Case 1.
Finally, Case 4 (No-No) is the dreaded case for a Eurozone nation enduring massunemployment and declining tax revenue. While there are no real resource constraints
in this situation, the financial constraints persist. As the automatic stabilisers increase
the fiscal deficit (lower activity reduces tax revenue and increases welfare spending
automatically), the nation must increasingly access funds from private investors. Given
the credit risk attached to such debt, the bond markets will require higher yields on
newly issued debt as the governments capacity to raise taxes to repay the outstanding
debt obligations becomes impaired when there is high unemployment.
So even though there is mass unemployment and chaos, the bond markets might refuse
to fund such a government at sustainable yields because of fear of debt default. This is
the situation that occurred in 2010 and 2012 in the Eurozone crisis as yields skyrocketedon the debt of various nations (for example, Italy and Greece). It was only theintervention of the ECB (as the currency issuer) that saved many nations from
insolvency as bond markets pushed up yields.
5.

How the experience of Japan shapes our thinking about MMT

The experience of Japan since the 1990s demonstrates why mainstream
macroeconomics is a degenerative paradigm in the Lakatosian sense. In the 1980s,
Japan embraced the neoliberal excesses of the time – a massive increase in private debt,
speculative asset bubbles and more. The commercial property collapse that followed in1991 required a substantial response from the government, which pushed fiscal andmonetary policy to the extreme of conventional limits – continuously high deficits, highpublic debt, large-scale government bond purchases by the Bank of Japan, and a zerorate monetary policy. Table 1 compares the predictions that mainstream economists
made in relation to these policy shifts and the reality that followed. None of thepredictions made by these economists came to pass.
The reason these predictions failed was that the ‘textbook’ models underpinning themignored the reality that a currency-issuing government can always meet any liabilities
in its own currency and never faces insolvency. Further, they failed to understand thatthe Bank of Japan can maintain yields and interest rates at very low levels, indefinitely.
A similar story played out during the GFC. Bond markets can never overpower thefinancial capacity of the treasury and the central bank. Bond investors only determine
yields if governments allow them to.
Undeterred, mainstream economists continue to promote their ‘fictional’ world,
keeping citizens in the dark about the true capacity of government and the consequencesof using that capacity to sustain full employment. They say fiscal deficits must be
repaid, requiring onerous future tax burdens on our children. They claim government
borrowing (to “fund” deficits) competes with the private sector for scarce available
funds, driving up interest rates and ‘crowding out’ (reducing) private investment. They
conclude that public use of scarce resources is wasteful because governments are notsubject to market discipline. Finally, they assert that if government ‘print money’inflation accelerates. Taken together, the mainstream litany supports a bias towards
fiscal austerity.

7

Table 1 Japanese economic reality
Macroeconomic outcome

Mainstream Prediction

Reality

Consistently large fiscal Rising interest rates and Short-term
interest
deficits often above 10% bond yields.
rates around zero sinceof GDP since 1991.
1991.
Bond
consistently
negative out
years.

yields
low
to 10

Low
unemployment
despite exposure to
many crises.
Gross public debt to GDP Bond
markets
at around 250% - largest demanding higher yields
to cover increasing risk,
in world.
leadingtoanunwillingness to makeloans to government andeventual insolvency

Yieldsacrossallmaturities consistently
managed by Bank ofJapan and kept close tozero in the 10-yearbond case.
Private bids in auctions
consistently multiples
of actual offer.
Huge demand for JGBs.
Short selling regularly
incurslossesfor
speculators.

Bank of Japan has Accelerating
inflation
expanded its purchase of from ‘money printing’.
JGBs
insecondarymarkets.
Loss of credibility ofHas been ‘funding’ fiscal central bank.
deficits since around2012.
Bank of Japan now owns
45% of all Japanese
government bonds.

Fighting
deflation(falling prices) since1991. Mostly zero orvery low inflation.
Bank of Japan maintains
total control of interest
rates and yields to suit
its policy purposes.

These claims are ingrained in public debate by decades of miseducation and daily
onslaughts from the conservative media. MMT provides a framework for understanding
why these predictions failed and why the mainstream assertions are inapplicable tounderstanding the way fiat monetary systems function.

8

6.

How does MMT help us understand the real-world economy

The definitive MMT textbook Macroeconomics (Mitchell et al., 2019) clearly shows
how MMT differs from the mainstream.
MMT rejects the household budget analogy that mainstream economists use as a
metaphor for understanding fiscal policy choices. While the household analogy
resonates strongly with voters because it attempts to relate the more amorphous financesof a government with our daily household finances, it is wrong at the most elemental
level.
We intuitively understand that we cannot indefinitely live beyond our means andneoliberals promote the analogy because they know we will judge government deficits
as reckless. But a currency-issuing government is not a big household. It canconsistently spend more than its revenue because it creates the currency.
Further, mainstream economists claim that governments must fund its spending via
taxation, bond issuance, or ‘money printing’, which all have negative consequences(taxes distort behaviour, bonds drive up interest rates, and money finance is
inflationary). As a result, fiscal deficits are largely eschewed.
MMT rejects this analysis. First, government spending is facilitated by central banks
typing in numbers to bank accounts. New currency is spent into existence. There is no
spending ‘out’ of taxes or out of bond sales. All the elaborate accounting structures andinstitutional processes, which make it look as though tax revenue and/or debt sales fundspending, are voluntary smokescreens. They are designed to impose political disciplineon government spending.
In March 2009, the US program 60 Minutes asked Federal Reserve Chairman Ben
Bernanke: ‘Is that tax money that the Fed is spending?’ He replied: ‘It’s not tax money.
The banks have accounts with the Fed … we simply use the computer to mark up thesize of the account’. The same applies for all government spending.
Second, in Section 4 we analysed the spending constraints facing a currency-issuinggovernment. We learned that if nominal spending growth outstrips the capacity of firms
to respond by producing goods and services for sale then there will be inflationarypressures. Won’t continuous deficits be inflationary? The basic rule of macroeconomics
is that spending equals income equals output. If the non-government sector desires tosave overall (that is, not spend all its income) then output will fall unless that desire isfunded by government deficits. As long as government deficits are scaled to fill the
non-government spending gap then they are both desirable and sustainable.
Third, mainstream economists claim that if central banks just credit bank accounts onbehalf of governments (erroneously called ‘money printing’) without bond issuance,then accelerating inflation will result. MMT notes that all government and nongovernment spending carries an inflation risk. If nominal spending growth outstrips the
productive capacity of the economy, then inflationary pressures will emerge,
irrespective of the source of that spending.
But the mainstream narrative argues that this risk is lower with bond issuance because,
allegedly, rising interest rates ‘crowd out’ private spending. But these conclusions are
not ground in the foundations of a fiat monetary system nor banking reality.
The crowding out story is based on Classical loanable funds doctrine, which claims thatcompetition for a finite pool of ‘savings’ from government bond sales drives up interest
rates and damages interest-sensitive non-government spending. John Maynard Keynes
9exposed the fictions of this story in the 1930s by showing that saving is a function ofincome and rises with net government spending.
Further, mainstream banking theory claims that bank lending is constrained by deposits(reserves). But in modern banking, loans create deposits. Banks will extend credit to
any credit worthy customers knowing they can always get reserves from the central
bank to satisfy payment system demands should they fail to get the reserves from othersources. Banks do not loan out reserves. There is no scarcity of ‘savings’, squeezed bygovernment debt auctions.
MMT also elucidates us about the dynamics that follow the issuance of government
debt. Fiscal deficits generate excess reserves in the banking system, which influences
the way the central bank manages monetary policy. The central bank has only two
choices if its desires to maintain a positive policy target interest rate: (a) it can offer areturn on excess reserves, or (b) it can drain the excess via open market operations.
Otherwise, it loses control of its policy target as banks try to rid their excess reserves in
the interbank market which drives the short-term rate down to zero. So, without an open
market operation or the functionally equivalent interest support, the interest rate isbiased downwards when there are fiscal deficits.
When the government issues bonds to match the deficit, the central bank marks down
reserve accounts and marks up a ‘treasury debt’ account. There is no reduction in bankdeposits created by the fiscal deficits. The bond sales do not alter the net worth in the
non-government sector. Only the asset portfolio composition held in the nongovernment sector changes.
If we understand that, then we more clearly see that bond issuance does not alter the
inflation risk inherent in government spending. Funds used to purchase the bonds are
not currently being spent on goods and services. Thus, bond sales do not ordinarily
reduce non-government spending. And the funds to purchase the debt came from past
deficits that had not yet been taxed away by government and were left in the nongovernment sector as accumulated net financial assets.
History supports the MMT depiction. Over the last three decades, central banks havesignificantly expanded their balance sheets through the purchase of government bonds
as a strategy to prevent deflation. The strategy was driven by recourse to the erroneous
mainstream notion that injecting reserves would increase the money supply and trigger
inflation – too much money chasing too few goods! The strategy failed.
While these bond-buying programs have effectively been funding fiscal deficits, there
were no inflationary consequences because spending was not pushed beyond the real
resource constraints that MMT places at the centre of its analysis of the constraints on
government spending. Only MMT economists articulated the causation correctly.
MMT stresses that the size of the fiscal deficit per se should never the focus.
Mainstream economists obsess over financial ratios (public debt to GDP, etc.). But a
responsible government will allow deficits to be whatever is required to maintainoverall spending at the level consistent with full employment. No more, no less. Fiscal
sustainability is about fulfilling the government’s responsibility to maintain an
inclusive society in which everyone who wants to work can.
7.

But what about the current inflationary pressures?

Mainstream commentators seized on the price pressures that have manifest as a result,initially of the Covid-19 pandemic, and then exacerbated by the Russian invasion of the10

Ukraine and the oil price gouging by the Organization of the Petroleum ExportingCountries (OPEC) as evidence that MMT is deeply flawed.
They argue that the fiscal support provided by governments during the early stages ofthe pandemic created strong aggregate spending pressures which resulted in a demandpull inflation.
The problem with this narrative is that the major pressures driving this transitory
inflation experience have been on the supply-side. In the early months of the pandemic,
governments introduced many income-support schemes while also imposing
restrictions on businesses (for example, preventing large gatherings at some retail andhospitality locations). More extreme lockdowns were imposed in some nations. The
upshot was that the service sector contracted while the supply of goods faltered. The
problem was that the demand for goods remained high because of the on-going income
support and the reduced opportunities for households to spend. This temporary
imbalance was always going to generate inflationary pressures, which would ease once
factories resumed production and the service sector was reopened for business.
The mainstream approach to this problem has been for central banks to increase interest
rates in the hope of choking off what was considered to be a spending excess. Only the
Bank of Japan has eschewed this policy path.
However, the mainstream response was misguided because the main inflationary
drivers have not been interest rate sensitive and have been abating on their own accord.
What the central banks have done is produce a major redistribution of national income
from low-income mortgage holders to those who hold financial wealth.
The other aspect of the central bank policy shift towards higher interest rates is that
there is strong evidence that it has fuelled inflationary pressures itself. All businesses
with overdrafts or other debt have experienced cost pressures as a result of increased
borrowing costs and those with market power have passed those cost rises on as higher
prices. There has also been evidence that corporations are using the cover of theinflationary pressures to increase their profit margins – a practice that has been termed‘profit gouging’.
Central bank interest rate hikes have also made the cost of providing rental
accommodation more expensive for landlords and in tight housing markets (such as inAustralia, for example), these costs have been passed on in the form of higher rents. In
many nations, rents make up a significant component of the Consumer Price Index(CPI) and thus the interest rate rises have, themselves added to CPI pressure.
While central banks have attempted to justify their policy decisions by appealing to thefear of increasing wages, which was a phenomenon that drove inflation in the 1970s
after the OPEC oil price shocks, the evidence has been contrary. This inflationary
episode bears very little similarity to what happened in the 1970s.
In summary, the current inflationary episode does not negate the insights of MMT,
which always emphasises the inflation risk of excessive spending.
8.

Conclusion

This paper has provided a brief introduction to some of the basic concepts of MMT anddemonstrated how it departs from mainstream macroeconomics.

11

References
Mitchell, W.F., Wray, L.R. and Watts, M.J. (2019) Macroeconomics, Bloomsbury
Press, London.

1213