If net exports are running at 2 per cent of GDP, and the private domestic sector overall is saving an equivalent of 3 per cent of GDP, the government must be running a deficit equal to 1 per cent of GDP.
Answer: True
The answer is True.
This question tests your knowledge of the sectoral balances that are derived from the National Accounts.
To refresh your memory the balances are derived as follows. The basic income-expenditure model in macroeconomics can be viewed in (at least) two ways: (a) from the perspective of the sources of spending; and (b) from the perspective of the uses of the income produced. Bringing these two perspectives (of the same thing) together generates the sectoral balances.
From the sources perspective we write:
(1) GDP = C + I + G + (X - M)
which says that total national income (GDP) is the sum of total final consumption spending (C), total private investment (I), total government spending (G) and net exports (X - M).
Expression (1) tells us that total income in the economy per period will be exactly equal to total spending from all sources of expenditure.
We also have to acknowledge that financial balances of the sectors are impacted by net government taxes (T) which includes all tax revenue minus total transfer and interest payments (the latter are not counted independently in the expenditure Expression (1)).
Further, as noted above the trade account is only one aspect of the financial flows between the domestic economy and the external sector. we have to include net external income flows (FNI).
Adding in the net external income flows (FNI) to Expression (2) for GDP we get the familiar gross national product or gross national income measure (GNP):
(2) GNP = C + I + G + (X - M) + FNI
To render this approach into the sectoral balances form, we subtract total net taxes (T) from both sides of Expression (3) to get:
(3) GNP - T = C + I + G + (X - M) + FNI - T
Now we can collect the terms by arranging them according to the three sectoral balances:
(4) (GNP - C - T) - I = (G - T) + (X - M + FNI)
The the terms in Expression (4) are relatively easy to understand now.
The term (GNP - C - T) represents total income less the amount consumed less the amount paid to government in taxes (taking into account transfers coming the other way). In other words, it represents private domestic saving.
The left-hand side of Equation (4), (GNP - C - T) - I, thus is the overall saving of the private domestic sector, which is distinct from total household saving denoted by the term (GNP - C - T).
In other words, the left-hand side of Equation (4) is the private domestic financial balance and if it is positive then the sector is spending less than its total income and if it is negative the sector is spending more than it total income.
The term (G - T) is the government financial balance and is in deficit if government spending (G) is greater than government tax revenue minus transfers (T), and in surplus if the balance is negative.
Finally, the other right-hand side term (X - M + FNI) is the external financial balance, commonly known as the current account balance (CAD). It is in surplus if positive and deficit if negative.
In English we could say that:
The private financial balance equals the sum of the government financial balance plus the current account balance.
We can re-write Expression (6) in this way to get the sectoral balances equation:
(5) (S - I) = (G - T) + CAD
which is interpreted as meaning that government sector deficits (G - T > 0) and current account surpluses (CAD > 0) generate national income and net financial assets for the private domestic sector.
Conversely, government surpluses (G - T < 0) and current account deficits (CAD < 0) reduce national income and undermine the capacity of the private domestic sector to add financial assets.
Expression (5) can also be written as:
(6) [(S - I) - CAD] = (G - T)
where the term on the left-hand side [(S - I) - CAD] is the non-government sector financial balance and is of equal and opposite sign to the government financial balance.
This is the familiar MMT statement that a government sector deficit (surplus) is equal dollar-for-dollar to the non-government sector surplus (deficit).
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)) plus net income transfers.
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.
You may wish to read the following blogs for more information: