If the household saving ratio rises and there is an external deficit then government must increase net spending to fill the private spending gap or else national output and income will fall.
Answer: False
The answer is False.
This is another examination of the sectoral sectoral balances logic used in Question 1. 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).
Taking the summary balances equation as a starting point in $ values:
(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). 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.
We use the term net save to refer to the saving overall of the sector (that is, the surplus of income above spending) rather than the saving flow that might be generated by households when they consume less than disposable income.
So by only focusing on the household saving ratio in the question, I 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.
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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