If the current account (on balance of payments) is in deficit and household saving increases as a proportion of disposable income then the government could still run a surplus without a decline in output and income occurring.
Answer: True
The answer is True.
This question tests one's basic understanding of the sectoral balances that can be derived from the National Accounts. The secret to getting the correct answer is to realise that the household saving ratio is not the overall sectoral balance for the private domestic sector.
In other words, if you just compared the household saving ratio with the external deficit and the budget balance you would be leaving an essential component of the private domestic balance out - private capital formation (investment).
To understand that, in macroeconomics we have a way of looking at the national accounts (the expenditure and income data) which allows us to highlight the various sectors - the government sector and the non-government sector (and the important sub-sectors within the non-government sector).
So we start by focusing on the final expenditure components of consumption (C), investment (I), government spending (G), and net exports (exports minus imports) (NX).
The basic aggregate demand equation in terms of the sources of spending is:
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).
In terms of the uses that national income (GDP) can be put too, we say:
GDP = C + S + T
which says that GDP (income) ultimately comes back to households who consume, save (S) or pay taxes (T) with it once all the distributions are made.
So if we equate these two ideas sources of GDP and uses of GDP, we get:
C + S + T = C + I + G + (X - M)
Which we then can simplify by cancelling out the C from both sides and re-arranging (shifting things around but still satisfying the rules of algebra) into what we call the sectoral balances view of the national accounts.
There are three sectoral balances derived - the Budget Deficit (G - T), the Current Account balance (X - M) and the private domestic balance (S - I).
These balances are usually expressed as a per cent of GDP but we just keep them in $ values here:
(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.
You can then manipulate these balances to tell stories about what is going on in a country.
For example, when an external deficit (X - M < 0) and a public surplus (G - T < 0) coincide, there must be a private deficit. So if X = 10 and M = 20, X - M = -10 (a current account deficit assuming the invisibles are zero). Also if G = 20 and T = 30, G - T = -10 (a budget surplus). So the right-hand side of the sectoral balances equation will equal (20 - 30) + (10 - 20) = -20.
As a matter of accounting then (S - I) = -20 which means that the domestic private sector is spending more than they are earning because I > S by 20 (whatever $ units we like). So the fiscal drag from the public sector is coinciding with an influx of net savings from the external sector. 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. It is an unsustainable growth path.
So if a nation usually has a current account deficit (X - M < 0) then if the private domestic sector is to net save (S - I) > 0, then the public budget deficit has to be large enough to offset the current account deficit. Say, (X - M) = -20 (as above). Then a balanced budget (G - T = 0) will force the domestic private sector to spend more than they are earning (S - I) = -20. But a government deficit of 25 (for example, G = 55 and T = 30) will give a right-hand solution of (55 - 30) + (10 - 20) = 15. The domestic private sector can net save.
But if the external deficit is say -20 and the private domestic balance (S - I) is -20 then the government balance at that level of income would be zerp. So if households increased their saving and investment increased by more than that, the income level could remain unchanged yet the government balance would go into surplus.
So in focusing on the household saving ratio, the question was only referring to one component of the private domestic balance. Clearly in the case of the question, if private investment is strong enough to offset the household desire to increase saving (and withdraw from consumption) then no spending gap arises as households save more.
In the present situation in most countries, households have reduced the growth in consumption (as they have tried to repair overindebted balance sheets) at the same time that private investment has fallen dramatically.
As a consequence a major spending gap emerged that could only be filled in the short- to medium-term by government deficits if output growth was to remain intact. The reality is that the budget deficits were not large enough and so income adjustments (negative) occurred and this brought the sectoral balances in line at lower levels of economic activity.
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