There are three sectors that make up the national economy — the government sector, the private domestic sector and the external sector. The private domestic sector and the external sector can be consolidated as the non-government sector. Macroeconomics deals with these sectors in aggregate in describing the operations of the national economy as a whole based on reported data. These data are generally nominal amounts that reflect transactions involving real resources, The accounting reveals how real resources have been allocated through financial equivalents in a monetary economy. Real amounts are nominal amounts adjusted for inflation.
A basic principle of MMT is that non-government saving creates demand leakage, which can be offset by government deficits in order to prevent economic contraction due to demand lagging under output potential. Non-government saving includes both private domestic saving and saving denominated in dollars by the rest of the world (ROW).
The Sectoral Balance Approach
Income = Expenditure (def)
This means that everything that is sold is someone's income.
This implies that Y = GDP
1. Sources of national income (GDP):
Y = C + I + G + (X - M)
where Y is national income, and
GEP is Gross Domestic Product, or national output
where C is consumption of goods for that produce no return
I is investment in goods that produce a return
(Note: I is business investment, not financial investment, which is part of saving)
G is government expenditure net of taxes
(federal, state, and local)
(X - M) is the trade balance
X is exports
M is imports
2. Uses of national income:
Y = C + S + T
where S is private domestic saving
T is taxes
C + S + T = C + I + G + (X - M)
S + T = I + G + (X - M)
(I-S) + (G-T )+ (X - M) = 0
This says that the private domestic balance plus the government fiscal balance + the trade balance sums to zero as an accounting identity.
What this implies is that the various components of the identity will necessarily shift to preserve the identity as national income is allocated differently over time. These components can and do shift relative to each other, so the equation is not a statement of equilibrium.
The Government Sector
(G - T) is the difference between government expenditure and taxation over a period. This is generally fixed by government over a fiscal period.
The Private Domestic Sector
(I - S) is the relationship of saving and investment over a period.
Domestic private income is made up of what is spent on consumption and what is not spent on consumption. Saving is that portion of income that is not consumed.
Y = C + S
Domestic private output is made up of what is sold for consumer use (no return) and what is sold for capital use (return). Capital use is business investment, which includes capital goods, improving human resources, residential real estate, and inventory. (Remember inventory. It will be important later.)
O = C + I
Income equals expenditure
Y = O
C + S = C + I
S = I
Again this is an accounting identity. It does not imply equilibrium because saving and investment are shifting quantities.
What this says is that if consumers decide to save more, then investment must rise. since inventory is a component of investment, business may then find itself holding excess inventory that it did not plan for and cannot readily sell. This is a signal of lagging demand. In this way, saving contributes to demand leakage.
This is called the paradox of thrift. Saving is good for individuals but in aggregate saving can creates demand leakage that results in economic dislocation when it leads to unwanted inventory buildup. High aggregate saving during recessions results in demand leakage that business interprets as a signal not to expand to meet demand. As result, the economy continues to underperform, with high employment and an output gap.
When unplanned and unwanted inventory builds up due to falling demand, businesses can either reduce prices or cut back production. If they reduce prices, then they will experience margin compression and profit will suffer if wages do not fall. Businesses generally prefer to cut production and layoff the least productive, inefficient, and non-essential workers, maintaining prices to the degree they are able, rather than slash prices and wages across the board to maintain employment.
When businesses cut back in aggregate, unemployment rises, worker income falls, demand contracts further, consumption drops, and recession ensues. If there is significant private debt, liquidity problems develop from reduced cash flow, and defaults and bankruptcies mount.
Private saving desire aka "propensity to save" is a given that is determined by the public at large. Private saving desire is beyond the ability of government to control or influence directly. Government can only respond to it by accommodating it, or else ignore it. Therefore, according to MMT government fiscal policy should follow the private sector by accommodating private saving desire. Ignoring changes in private saving desire will result in fiscal drag that will impede the economy.
The External Sector
(X - M)
The external sector includes the trade balance (X-M) and other transactions with the ROW, such as foreign direct investment, payment of interest and dividends to foreigners (factor income), and transfer payments such as foreign aid. This is called the current account.
The capital account is the ROW's saving in dollars.
The capital account (KA) equals the current account (CA) as an accounting identity.
KA = CA
This means that all the dollars that foreigners obtain in a period are used either for consumption of US goods, investment in the US, or are saved in US dollars.
The trade balance as part of the current account show whether trade is balance, or foreigners are either saving dollars or borrowing dollars. Since the trade balance represents the bulk of the current account, if foreigners are buying from the US in the volume that they are selling to the US, the ROW is saving dollars.
Saving by the ROW also constitutes demand leakage, since the amount spent on imports that is not offset by exports is money not spent on US output in the period.
Sectoral Balances Sum To Zero As An Accounting Identity
(I - S) + (G - T) + (X - M) = 0
where (I - S) is the private domestic balance
(G - T) is the government fiscal balance
(X - M) is the trade balance
What this means is that the government fiscal balance is the inverse of the non-government balance (private domestic balance plus the external balance).
This implies that a private domestic surplus (net saving) and a trade deficit (ROW saving in dollars) necessitates a government fiscal deficit to offset this saving to keep the equation in balance at the present level of output, employment, and saving desire. If government fails to do this, then either output will adjust downward to balance the equation at a lower level, or the private sector will have to save less, or the trade deficit will have to decrease, or some combination of these adjustments.
When aggregate non-government saving increases, then less is spent than produced and inventory rises involuntarily. Then other components of the equation must adjust to maintain the identity, which as we have seen, reduces to an identity between income and expenditure.
Either the budget deficit increases, or the economy (GDP) contracts, or private sector borrowing increases, or the external deficit decreases, or some combination thereof.
The conclusion of MMT is that the non-government balance, which the government does not control, determines the appropriate size of the government fiscal balance in order to maintain full employment and price stability. The goal of MMT is to maintain equilibrium at full employment and price stability by using fiscal policy iaw the principles of functional finance, i.e., injecting net financial assets (NFA) into non-government though fiscal deficits to address demand leakage and withdrawing NFA through taxation to address inflation.
Note: This summary of the sectoral balance approach is only a part of MMT and it does not treat the role of debt in the economy, since the use of credit does not appear in the national accounting equations. The use of credit is also essential to MMT, which grows out of Hyman Minsky's analysis of financial instability. Because the private sector is revenue constrained, private sector borrowing becomes unsustainable over time. This happens when the budget is in surplus and net exports do not offset it. Then the private sector goes into deficit and dissaves in aggregate. "Budget surplus" sounds good to those not understanding sectoral balances. But if the budget surplus is not offset by net exports, then it results in private borrowing in aggregate, which is inherently unstable over time.
Bill Mitchell: Barnaby, better to walk before we run