Limited Time Offer: Save 10% on all 2021 and 2022 Premium Study Packages with promo code: BLOG10    Select your Premium Package »

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

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.

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.

Featured Study with Us
CFA® Exam and FRM® Exam Prep Platform offered by AnalystPrep

Study Platform

Learn with Us

    Subscribe to our newsletter and keep up with the latest and greatest tips for success
    Online Tutoring
    Our videos feature professional educators presenting in-depth explanations of all topics introduced in the curriculum.

    Video Lessons



    Sergio Torrico
    Sergio Torrico
    2021-07-23
    Excelente para el FRM 2 Escribo esta revisión en español para los hispanohablantes, soy de Bolivia, y utilicé AnalystPrep para dudas y consultas sobre mi preparación para el FRM nivel 2 (lo tomé una sola vez y aprobé muy bien), siempre tuve un soporte claro, directo y rápido, el material sale rápido cuando hay cambios en el temario de GARP, y los ejercicios y exámenes son muy útiles para practicar.
    diana
    diana
    2021-07-17
    So helpful. I have been using the videos to prepare for the CFA Level II exam. The videos signpost the reading contents, explain the concepts and provide additional context for specific concepts. The fun light-hearted analogies are also a welcome break to some very dry content. I usually watch the videos before going into more in-depth reading and they are a good way to avoid being overwhelmed by the sheer volume of content when you look at the readings.
    Kriti Dhawan
    Kriti Dhawan
    2021-07-16
    A great curriculum provider. James sir explains the concept so well that rather than memorising it, you tend to intuitively understand and absorb them. Thank you ! Grateful I saw this at the right time for my CFA prep.
    nikhil kumar
    nikhil kumar
    2021-06-28
    Very well explained and gives a great insight about topics in a very short time. Glad to have found Professor Forjan's lectures.
    Marwan
    Marwan
    2021-06-22
    Great support throughout the course by the team, did not feel neglected
    Benjamin anonymous
    Benjamin anonymous
    2021-05-10
    I loved using AnalystPrep for FRM. QBank is huge, videos are great. Would recommend to a friend
    Daniel Glyn
    Daniel Glyn
    2021-03-24
    I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
    michael walshe
    michael walshe
    2021-03-18
    Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.