This blog builds directly onto Part 2.<\/p>\n
A graphical framework for understanding the sectoral balances<\/strong><\/p>\n [NOTE: While the textbook exposition of this framework will be somewhat different in terms of the graphics used, the lack of space limitations here allow me to build the diagram sequentially. The actual explanation in the textbook will be very similar though].<\/p>\n From Equation (6.4) we learned that the sum of the sectoral balances is zero as a matter of accounting – so (I – S) + (G – T) + (X – M) = 0. Imagine that we construct an axis defining four quadrants. Figure 6.7 depicts the Budget balance on the vertical axis and the external balance on the horizontal axis.<\/p>\n So all points above zero on the vertical axis represent a budget surplus (G < T) and all points below zero on the vertical axis denote budget deficits (G > T).<\/p>\n Similarly, all points to the right of the zero line on the horizontal axis denote external surpluses (X > M) and all points to the left of zero on the horizontal axis represent external deficits (X < M).\n\nClearly, the origin of the axis denotes a position where all balances are equal to zero. From the insight gained from Equation (6.4), we also know that when the Private Domestic Balance is zero (S = I), then the Budget deficit (surplus) has to equal the External deficit (surplus). From Figure 6.7, the diagonal 450<\/sup> line thus shows all combinations of budget and external balances where the Private Domestic Balance is zero (S = I). We will refer to this as the SI line.<\/p>\n Figure 6.7 A Graphical Sectoral Balances Framework<\/strong> We can use that knowledge to determine the segments of the diagram where the Private Domestic Balance is in surplus (S > I) and in deficit (S < I). To make it easier, we can express the Sectoral Balances Equation (6.4) in a different way:\n\n(6.6) (S - I) = (G - T) + (X - M)\n\nEquation (6.6) is just another way of expressing the accounting rule but in this case isolates the Private Domestic Balance on the left-hand side.\n\nConsider the red dotted-line A0<\/sub>B0<\/sub> in Figure 6.7a, which cuts the horizontal axis where the External deficit is 2 per cent of GDP. All points on that line segment correspond to a Budget deficit of less than 2 per cent of GDP or a Budget surplus depending on which side of the horizontal axis we are considering.<\/p>\n The Private sector is in balance only at Point B0<\/sub> where the budget deficit equals the external deficit. So all points along A0<\/sub>B0<\/sub> correspond to Private Domestic deficits (S < I).\n\nNow consider the green dotted-line A1<\/sub>B1<\/sub>, which cuts the horizontal axis where the External surplus is 2 per cent of GDP. All points on that line segment correspond to a Budget surplus of less than 2 per cent of GDP or a Budget deficit depending on which side of the horizontal axis we are considering.<\/p>\n The Private sector is in balance only at Point A1<\/sub> where the budget surplus equals the external surplus. So all points along A1<\/sub>B1<\/sub> correspond to Private Domestic surpluses (S > I).<\/p>\n Now consider the blue dotted-line A1<\/sub>A2<\/sub>. At Point A1<\/sub>, the Private sector is in balance because the budget surplus equals the external surplus.<\/p>\n Moving along A1<\/sub>A2<\/sub> we encounter points where the external balance is less than the budget surplus and thus have to correspond to a Private Domestic deficit (S < I).\n\nSimilarly, along B0<\/sub>B2<\/sub>, we move from a Private sector balance at B0<\/sub>, to points where the external deficit is less than the budget deficit, which means the Private Domestic balance will be in surplus (S > I).<\/p>\n Figure 6.7a – Deriving the Private domestic sector balances<\/strong> We can thus generalise this knowledge and conclude that all points above the 450<\/sup> line on either side of the vertical axis correspond to Private Domestic sector deficits and all points below the 450<\/sup> line on either side of the vertical axis correspond to Private Domestic sector surpluses.<\/p>\n Figure 6.7b renders this conclusion graphically.<\/p>\n Figure 6.7b Private domestic surpluses and deficits<\/strong> This graphical framework thus allows us to examine the implications of different policy options.<\/p>\n For a sovereign, currency-issuing government any point in the four-quadrants is permissible<\/strong>. With private sector spending and saving decisions combining with the flows of income arising from trade with the external sector driving national income, the government sector can allow its balance to adjust to whatever magnitude is required to maintain full employment and price stability.<\/p>\n For example, if the external account was in deficit and the private sector was saving overall, then the drain on aggregate demand would require the government to run a deficit of sufficient size to ensure total spending was sufficient to absorb the real productive capacity available in the economy.<\/p>\n Alternatively, the external sector might be in surplus which would add to aggregate demand while the private sector might spending more than it is earning, that is, in deficit overall. In these situations the government would have to ensure it ran a surplus of sufficient size to ensure the economy did not overheat and exhaust its productive capacity.<\/p>\n The strong economy would be associated with robust tax revenue growth, which would help the government achieve its surplus. But discretionary adjustments in spending and taxation rates might also be required.<\/p>\n But while any point would be permissible, we know that the private sector cannot sustain deficits permanently. This is because the flows of spending which deliver deficits have to be funded. As we learned in the earlier section of this Chapter when we considered the flow of funds, private deficits ultimately manifest in an increasing stock of debt being held on the private sector’s balance sheet.<\/p>\n This process of debt accumulation is finite in capacity because at some point the susceptibility of the balance sheet to cyclical movements (for example, rising unemployment) rises and the risk of default increases. In some historical instances, this process has collapsed after serious debt defaults occurred (for example, in the early months of the Global Financial Crisis in 2007-08). In other times, the private sector starts to reduce the precariousness of its balance sheet by reducing spending and increasing saving in order to bring the debt levels it is carrying down to more sustainable levels.<\/p>\n In the long-term, the only sustainable position is for the private domestic sector to be in surplus. An economy can absorb deviations around that position but only for short-periods.<\/p>\n [NOTE: The following reflects the analysis presented by Avraham Baranes and Stephanie Kelton University – Bird Brains:From Austerity to Prosperity A Guided Tour Through the Deficit Aviary – at the 11th International Post Keynesian Conference Kansas City, September 2012]<\/p>\n Figure 6.8 shows what we might define as the sustainable space available to governments that issue their own currency.<\/p>\n
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