When there is an external deficit, the private sector can reduce its overall indebtedness as long as the government supports saving by running a deficit.
Answer: False
The answer is False.
This question relies on your understanding of the sectoral balances that are derived from the national accounts and must hold by definition. The statement of sectoral balances doesn't tell us anything about how the economy might get into the situation depicted. Whatever behavioural forces were at play, the sectoral balances all have to sum to zero. Once you understand that, then deduction leads to the correct answer.
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.
To refresh your memory the sectoral 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:
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 taxes and 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 taxes and transfers (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 (CAB). 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) + CAB
which is interpreted as meaning that government sector deficits (G - T > 0) and current account surpluses (CAB > 0) generate national income and net financial assets for the private domestic sector.
Conversely, government surpluses (G - T < 0) and current account deficits (CAB < 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) - CAB] = (G - T)
where the term on the left-hand side [(S - I) - CAB] 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.
To help us answer the specific question posed, we can identify three states all involving public and external deficits:
For the private sector reduce it overall indebtedness (that is a net result) it must spend less than it earns - that is, run a surplus. So we understand the question to be examining the conditions under which the private domestic sector can run a surplus when the external sector is in deficit.
The following Table shows three cases expressing the sectoral balances as percentages of GDP in each case there is an external deficit. So the constant external deficit then allows you to understand the relationship between the other two balances - government and private domestic.
In Cases A and B, the private balance is in deficit or balanced which means that no net debt repayments could occur even though the government sector is in deficit.
In Case C, we see that the deficit has risen to 3 per cent of GDP and larger than the external deficit as a percent of GDP (2 per cent). At that point, the private sector balance goes into surplus which facilitates reductions in debt levels overall.
So the coexistence of a fiscal deficit (adding to aggregate demand) and an external deficit (draining aggregate demand) does not necessarily lead to the private domestic sector being in surplus.
It is only when the fiscal deficit is large enough (3 per cent of GDP) and able to offset the demand-draining external deficit (2 per cent of GDP) that the private domestic sector can save overall (Case C).
The economics lying behind the accounting statements (which are true by definition) is that the fiscal deficits underpin spending and allow income growth to be sufficient to generate savings greater than investment in the private domestic sector.
But they can only do that as long as they can offset the demand-draining impacts of the external deficits and thus provide sufficient income growth for the private domestic sector to save.
| Sectoral Balance | Interpretation of Result | Case A | Case B | Case C |
| External Balance (X - M) | Deficit is negative | -2 | -2 | -2 |
| Fiscal Balance (G - T) | Deficit is positive | 1 | 2 | 3 |
| Private Domestic Balance (S - I) | Deficit is negative | 1 | 0 | -1 |
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