Explain the Fundamental Relationship Among Saving, Investment, Fiscal Balance, and Trade Balance

Saving and investing are often used interchangeably, but there is a difference between them. Saving is setting aside money for emergencies or a future purchase. On the other hand, investing is buying assets such as real estate, stocks, or bonds with the expectation that your investment will grow.

Now, consider the basic economics formula of GDP:

$$GDP = C + I + G + (X – M)$$

Where:

\(C =\) Amount spent by consumers on final goods and services

\(I =\) Gross private domestic investment. It consists of business investments in capital goods as well as inventory changes.

\(G =\) Government expenditure on finished goods and services

\(X =\) Export

\(M =\) Imports

This section will have a closer look at some of these variables and how they affect other economic variables.

Trade Balance

Trade balance refers to the balance that should exist between the trade and capital between a country and the rest of the world. In the above formula, the trade balance of any given country is represented mathematically as \((X – M)\), or exports minus imports.

A country’s trade balance can be positive if the value of exports exceeds the value of imports.  Some of the countries that post positive trade balances include China, Germany, and many oil-exporting countries, the most notable being Saudi Arabia. These countries export goods across the world in exchange for foreign currencies.

Conversely, a country’s trade balance could be negative if the value of imports exceeds that of exports. France, Canada, Greece, and Israel are among net importers.

Saving and Investment

Saving can be absorbed in three different ways:

• it can be absorbed into investment spending (I);
• it can be absorbed into financing government deficits (G – T); and
• lastly, it can be absorbed into building up financial claims for or against other economies.

For a positive trade balance, \((X – M) > 0\); however, for a trade deficit, \((X – M) < 0\). This implies that domestic saving can be supplemented by inflowing foreign saving; hence overseas economies build up financial claims against the domestic economy. As such, the savings equation can be written as:

$$S = I + (G –T) + (X – M)$$

Fiscal Policy

Rearranging the saving function gives us an equation for the fiscal deficit:

$$G – T = (S – I) – (X – M)$$

Where \(G – T\) represents government spending minus the taxes the government collects.

A fiscal deficit shows that the private sector requires an increment of savings and a reduction of investment. In this case, \((S – I) > 0\). Alternatively, the country might resolve to run a trade deficit with respect to corresponding inflow in foreign saving, such that \((X – M) < 0\).

Question

When aggregate expenditure equals aggregate output, the government’s fiscal deficit is most likely equal to:

A. private saving – Investment – Net exports;

B. private saving – Investment + Net exports; or

C. investment – Private saving + Net exports.

Solution

The correct answer is A.

The relationship among saving, investment, fiscal balance, and trade balance can be expressed by the equation \(G – T = (S – I) – (X – M)\). This means that expenditures on investment, net exports, and the government fiscal balance must be funded by private savings.