Although we know that a country is running a small current account deficit and that the private domestic sector is saving overall, we are unable to draw any conclusions about the state of the fiscal balance until we know the relative magnitudes of the other balances.
Answer: False
The answer is False.
This question requires an understanding of the sectoral balances that can be derived from the National Accounts. Please refer to Question 1 for the conceptual background to this answer.
If the nation is running an external deficit it means that the contribution to aggregate demand from the external sector is negative - that is net drain of spending - dragging output down. The reference to a "small" external deficit was to place doubt in your mind. In fact, it doesn't matter how large the external deficit is for this question.
Assume, now that the private domestic sector (households and firms) seeks to increase its overall saving (that is, spend less than it earns) and is successful in doing so. Consistent with this aspiration, households may cut back on consumption spending and save more out of disposable income. The immediate impact is that aggregate demand will fall and inventories will start to increase beyond the desired level of the firms.
The firms will soon react to the increased inventory holding costs and will start to cut back production. How quickly this happens depends on a number of factors including the pace and magnitude of the initial demand contraction. But if the households persist in trying to save more and consumption continues to lag, then soon enough the economy starts to contract - output, employment and income all fall.
The initial contraction in consumption multiplies through the expenditure system as workers who are laid off also lose income and their spending declines. This leads to further contractions.
The declining income leads to a number of consequences. Net exports improve as imports fall (less income) but the question clearly assumes that the external sector remains in deficit. Total saving actually starts to decline as income falls as does induced consumption.
So the initial discretionary decline in consumption is supplemented by the induced consumption falls driven by the multiplier process.
The decline in income then stifles firms' investment plans - they become pessimistic of the chances of realising the output derived from augmented capacity and so aggregate demand plunges further. Both these effects push the private domestic balance further towards and eventually into surplus
With the economy in decline, tax revenue falls and welfare payments rise which push the public budget balance towards and eventually into deficit via the automatic stabilisers.
If the private sector persists in trying to net save then the contracting income will clearly push the budget into deficit.
So we would have an external deficit, a private domestic surplus and a budget deficit.
There will always be a budget deficit at any national income level, if the private domestic sector is succeessfully spending less than it earns and the external sector is in deficit.
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