Choose the correct response (all balances expressed as a per cent of GDP): (a) A nation can export less than the sum of imports, net factor income (such as interest and dividends) and net transfer payments (such as foreign aid) and run a government surplus of equal proportion to GDP, while the private domestic sector is spending less than they are earning. (b) A nation can export less than the sum of imports, net factor income (such as interest and dividends) and net transfer payments (such as foreign aid) and run a government sector surplus of equal proportion to GDP, while the private domestic sector is spending more than they are earning. (c) A nation can export less than the sum of imports, net factor income (such as interest and dividends) and net transfer payments (such as foreign aid) and run a government sector surplus that is larger, while the private domestic sector is spending less than they are earning. (d) None of the above are possible as they all defy the sectoral balances accounting identity.
Answer: Option (b)
The correct answer is the Option (b) - "A nation can run a current account deficit accompanied by a government sector surplus of equal proportion to GDP, while the private domestic sector is spending more than they are earning".
Note that the the current account is equal to the trade balance plus invisibles. The trade balance is exports minus imports and the invisibles are equal to the sum of net factor income (such as interest and dividends) and net transfer payments (such as foreign aid). So the question is asking about a current account deficit.
This is a question about the sectoral balances - the government budget balance, the external balance and the private domestic balance - that have to always add to zero because they are derived as an accounting identity from the national accounts.
First, you need to understand the basic relationship between the sectoral flows and the balances that are derived from them. The flows are derived from the National Accounting relationship between aggregate spending and income. So:
(1) Y = C + I + G + (X - M)
where Y is GDP (income), C is consumption spending, I is investment spending, G is government spending, X is exports and M is imports (so X - M = net exports).
Another perspective on the national income accounting is to note that households can use total income (Y) for the following uses:
(2) Y = C + S + T
where S is total saving and T is total taxation (the other variables are as previously defined).
You than then bring the two perspectives together (because they are both just "views" of Y) to write:
(3) C + S + T = Y = C + I + G + (X - M)
You can then drop the C (common on both sides) and you get:
(4) S + T = I + G + (X - M)
Then you can convert this into the familiar sectoral balances accounting relations which allow us to understand the influence of fiscal policy over private sector indebtedness.
So we can re-arrange Equation (4) to get the accounting identity for the three sectoral balances - private domestic, government budget and external:
(S - I) = (G - T) + (X - M)
The sectoral balances equation says that total private savings (S) minus private investment (I) has to equal the public deficit (spending, G minus taxes, T) plus net exports (exports (X) minus imports (M)), where net exports represent the net savings of non-residents.
Another way of saying this is that total private savings (S) is equal to private investment (I) plus the public deficit (spending, G minus taxes, T) plus net exports (exports (X) minus imports (M)), where net exports represent the net savings of non-residents.
All these relationships (equations) hold as a matter of accounting and not matters of opinion.
Thus, when an external deficit (X - M < 0) and public surplus (G - T < 0) coincide, there must be a private deficit. While private spending can persist for a time under these conditions using the net savings of the external sector, the private sector becomes increasingly indebted in the process.
Second, you then have to appreciate the relative sizes of these balances to answer the question correctly.
The rule is that the sectoral balances have to sum to zero. So if we write the condition above as:
(S - 1) - (G - T) - (X - M) = 0
And substitute the values of the question we get:
3 - (G - T) - 2 = 0
We can solve this for (G - T) as
(G - T) = 3 - 2 = 1
Given the construction (G - T) a positive number (1) is a deficit.
The outcome is depicted in the following graph.
This tells us that even if the external sector is growing strongly and is in surplus there may still be a need for public deficits. This will occur if the private domestic sector seek to save at a proportion of GDP higher than the external surplus.
The economics of this situation might be something like this. The external surplus would be adding to overall aggregate demand (the injection from exports exceeds the drain from imports). However, if the drain from private sector spending (S > I) is greater than the external injection then the only way output and income can remain constant is if the government is in deficit.
National income adjustments would occur if the private domestic sector tried to push for higher saving overall - income would fall (because overall spending fell) and the government would be pushed into deficit whether it liked it or not via falling revenue and rising welfare payments.
The following Table represents the three options in percent of GDP terms. To aid interpretation remember that (I-S) > 0 means that the private domestic sector is spending more than they are earning; that (G-T) < 0 means that the government is running a surplus because T > G; and (X-M) < 0 means the external position is in deficit because imports are greater than exports.
The first two possibilities we might call A and B:
A: A nation can run a current account deficit with an offsetting government sector surplus, while the private domestic sector is spending less than they are earn
B: A nation can run a current account deficit with an offsetting government sector surplus, while the private domestic sector is spending more than they are earning.
So Option A says the private domestic sector is saving overall, whereas Option B say the private domestic sector is dis-saving (and going into increasing indebtedness). These options are captured in the first column of the Table. So the arithmetic example depicts an external sector deficit of 2 per cent of GDP and an offsetting budget surplus of 2 per cent of GDP.
You can see that the private sector balance is positive (that is, the sector is spending more than they are earning - Investment is greater than Saving - and has to be equal to 4 per cent of GDP.
Given that the only proposition that can be true is:
B: A nation can run a current account deficit with an offsetting government sector surplus, while the private domestic sector is spending more than they are earning.
Column 2 in the Table captures Option C:
C: A nation can run a current account deficit with a government sector surplus that is larger, while the private domestic sector is spending less than they are earning.
So the current account deficit is equal to 2 per cent of GDP while the surplus is now larger at 3 per cent of GDP. You can see that the private domestic deficit rises to 5 per cent of GDP to satisfy the accounting rule that the balances sum to zero.
The final option available is:
D: None of the above are possible as they all defy the sectoral balances accounting identity.
It cannot be true because as the Table data shows the rule that the sectoral balances add to zero because they are an accounting identity is satisfied in both cases.
So if the G is spending less than it is "earning" and the external sector is adding less income (X) than it is absorbing spending (M), then the other spending components must be greater than total income.
You may wish to read the following blogs for more information: