Domestic Saving and Investment Determine the Trade Balance
One insight from the national saving and investment identity is that a nation’s balance of trade is determined by that nation’s own levels of domestic saving and domestic investment. To understand this point, rearrange the identity to put the balance of trade all by itself on one side of the equation. Consider first the situation with a trade deficit, and then the situation with a trade surplus.
In the case of a trade deficit, the national saving and investment identity can be rewritten as:
\(\begin{array}{rcl}\text{Trade deficit}& \text{=}& \text{Domestic investment – Private domestic saving – Government (or public) savings}\\ \text{(M – X)}& \text{=}& \text{I – S – (T – G)}\end{array}\)
In this case, domestic investment is higher than domestic saving, including both private and government saving. The only way that domestic investment can exceed domestic saving is if capital is flowing into a country from abroad. After all, that extra financial capital for investment has to come from someplace.
Now consider a trade surplus from the standpoint of the national saving and investment identity:
\(\begin{array}{rcl}\text{Trade surplus}& \text{=}& \text{Private domestic saving + Public saving – Domestic investment}\\ \text{(X – M)}& \text{=}& \text{S + (T – G) – I}\end{array}\)
In this case, domestic savings (both private and public) is higher than domestic investment. That extra financial capital will be invested abroad.
This connection of domestic saving and investment to the trade balance explains why economists view the balance of trade as a fundamentally macroeconomic phenomenon. As the national saving and investment identity shows, the trade balance is not determined by the performance of certain sectors of an economy, like cars or steel. Nor is the trade balance determined by whether the nation’s trade laws and regulations encourage free trade or protectionism (see Globalization and Protectionism).