If the private domestic sector is locked into a process of deleveraging, then to avoid the employment losses arising from this lost private spending, governments have to expand public deficits.
Answer: False
The answer is False.
The answer also relates to the sectoral balances framework outlined in detail above. When the private domestic sector decides to lift its saving ratio, we normally think of this in terms of households reducing consumption spending. However, it could also be evidenced by a drop in investment spending (building productive capacity).
The normal inventory-cycle view of what happens next goes like this. Output and employment are functions of aggregate spending. Firms form expectations of future aggregate demand and produce accordingly. They are uncertain about the actual demand that will be realised as the output emerges from the production process.
The first signal firms get that household consumption is falling is in the unintended build-up of inventories. That signals to firms that they were overly optimistic about the level of demand in that particular period.
Once this realisation becomes consolidated, that is, firms generally realise they have over-produced, output starts to fall. Firms layoff workers and the loss of income starts to multiply as those workers reduce their spending elsewhere.
At that point, the economy is heading for a recession. Interestingly, the attempts by households overall to increase their saving ratio may be thwarted because income losses cause loss of saving in aggregate - the is the Paradox of Thrift. While one household can easily increase its saving ratio through discipline, if all households try to do that then they will fail. This is an important statement about why macroeconomics is a separate field of study.
Typically, the only way to avoid these spiralling employment losses would be for an exogenous intervention to occur - in the form of an expanding public deficit. The fiscal position of the government would be heading towards, into or into a larger deficit depending on the starting position as a result of the automatic stabilisers anyway.
So an intuitive reasoning suggests that a demand gap opens and the only way to stop the economy from contracting with employment losses if it the government fills the spending gap by expanding net spending (its deficit).
However, this would ignore the movements in the third sector - there is also an external sector. It is possible that at the same time that the households are reducing their consumption as an attempt to lift the saving ratio, net exports boom. A net exports boom adds to aggregate demand (the spending injection via exports is greater than the spending leakage via imports).
So it is possible that the public fiscal balance could actually go towards surplus and the private domestic sector increase its saving ratio if net exports were strong enough.
The important point is that the three sectors add to demand in their own ways. Total GDP and employment are dependent on aggregate demand. Variations in aggregate demand thus cause variations in output (GDP), incomes and employment. But a variation in spending in one sector can be made up via offsetting changes in the other sectors.
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