The Fundamental Relatioship

Because of a sharp decline in real estate values, the household sector has increased the fraction of disposable income that it saves. If output and investment spending remain unchanged, which of the following is most likely?

  1. A decrease in the government deficit.
  2. A decrease in net exports and increased capital inflow.
  3. An increase in net exports and increased capital outflow.

Can anyone please explain to why Why the correct answer is C. I dont understand the explanation given in the curriculumn

Well, the decrease in market prices as a sign of market crisis generates capital outflows (capital portfolios go out to other markets to catch more profitable and stable market yields). They could eventually come back when the market is expected to recover. Knowing this, option C looks like a viable answer and hence, option B would be incorrect.

If we said that there is a market crisis, goverment deficit would increase because the supposed intervention of the public sector to recover the market or prevent a worse fall. Knowing this, option A would be incorrect.

Market crisis / higher savings / less consumption / less imports; and investment has not changed (question says), so net exports would increase (exports continue as always and imports decreased). B would be incorrect and C correct.

Option C is correct.


well explained.