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

Here, we can see the basic economic 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 changes in inventory.

G = Government expenditure on finished goods and services.

X = Export

M = Imports

In this section, we’ll have a closer look at some of these variables and how they affect other economic variables.

Trade Balance

The 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.

Given that trade balances can be seen as a zero-sum game, a country’s trade balance can be positive if the value of exports exceeds the value of imports. Such countries include China, Germany, or many oil-exporting countries, the most notable being Saudi Arabia. They export goods all 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. Firstly, it can be absorbed into investment spending (I). Secondly, it can be absorbed into financing government deficits (G – T). 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)

A fiscal deficit shows that the private sector requires increasing its saving and reducing 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 must be equal to:

A. Private saving – Investment – Net exports

B. Private saving – Investment + Net exports

C. Investment – Private saving + Net exports

Solution

The correct answer is A.

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

Reading 16 LOS 16e:

Explain the fundamental relationship among saving, investment, the fiscal balance, and the trade balance

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