Economics » International Trade and Capital Flows » The National Saving and Investment Identity

# Exploring Trade Balances One Factor At a Time

## Exploring Trade Balances One Factor at a Time

The national saving and investment identity also provides a framework for thinking about what will cause trade deficits to rise or fall. Begin with the version of the identity that has domestic savings and investment on the left and the trade deficit on the right:

$$\begin{array}{r}\begin{array}{rcl}\text{Domestic investment – Private domestic savings – Public domestic savings}& \text{=}& \text{Trade deficit}\\ \text{I – S – (T – G)}& \text{=}& \text{(M – X)}\end{array}\end{array}$$

Now, consider the factors on the left-hand side of the equation one at a time, while holding the other factors constant.

As a first example, assume that the level of domestic investment in a country rises, while the level of private and public saving remains unchanged. The result is shown in the first row of this table under the equation. Since the equality of the national savings and investment identity must continue to hold—it is, after all, an identity that must be true by definition—the rise in domestic investment will mean a higher trade deficit. This situation occurred in the U.S. economy in the late 1990s. Because of the surge of new information and communications technologies that became available, business investment increased substantially. A fall in private saving during this time and a rise in government saving more or less offset each other. As a result, the financial capital to fund that business investment came from abroad, which is one reason for the very high U.S. trade deficits of the late 1990s and early 2000s.

Causes of a Changing Trade Balance

Domestic Investment  –Private Domestic Savings  –Public Domestic Savings  =Trade Deficit
IS(T – G)=(M – X)
Up No change No change Then M – X must rise
No change Up No change Then M – X must fall
No change No change Down Then M – X must rise

As a second scenario, assume that the level of domestic savings rises, while the level of domestic investment and public savings remain unchanged. In this case, the trade deficit would decline. As domestic savings rises, there would be less need for foreign financial capital to meet investment needs. For this reason, a policy proposal often made for reducing the U.S. trade deficit is to increase private saving—although exactly how to increase the overall rate of saving has proven controversial.

As a third scenario, imagine that the government budget deficit increased dramatically, while domestic investment and private savings remained unchanged. This scenario occurred in the U.S. economy in the mid-1980s. The federal budget deficit increased from $79 billion in 1981 to$221 billion in 1986—an increase in the demand for financial capital of $142 billion. The current account balance collapsed from a surplus of$5 billion in 1981 to a deficit of $147 million in 1986—an increase in the supply of financial capital from abroad of$152 billion. The two numbers do not match exactly, since in the real world, private savings and investment did not remain fixed. The connection at that time is clear: a sharp increase in government borrowing increased the U.S. economy’s demand for financial capital, and that increase was primarily supplied by foreign investors through the trade deficit. The following Work It Out feature walks you through a scenario in which private domestic savings has to rise by a certain amount to reduce a trade deficit.

### Solving Problems with the Saving and Investment Identity

Use the saving and investment identity to answer the following question: Country A has a trade deficit of $200 billion, private domestic savings of$500 billion, a government deficit of $200 billion, and private domestic investment of$500 billion. To reduce the $200 billion trade deficit by$100 billion, by how much does private domestic savings have to increase?

Step 1. Write out the savings investment formula solving for the trade deficit or surplus on the left:

$$\begin{array}{rcl}\text{(X – M)}& \text{=}& \text{S +}\text{(T – G)}\text{– I}\end{array}$$

Step 2. In the formula, put the amount for the trade deficit in as a negative number (X – M). The left side of your formula is now:

$$\begin{array}{rcl}\text{–200}& \text{=}& \text{S + (T – G) – I}\end{array}$$

Step 3. Enter the private domestic savings (S) of $500 in the formula: $$\begin{array}{rcl}\text{–200}& \text{=}& 500\text{+ (T – G) – I}\end{array}$$ Step 4. Enter the private domestic investment (I) of$500 into the formula:

$$\begin{array}{rcl}\text{–200}& \text{=}& 500\text{+ (T – G) – 500}\end{array}$$

Step 5. The government budget surplus or balance is represented by (T – G). Enter a budget deficit amount for (T – G) of –200:

$$\begin{array}{rcl}\text{–200}& \text{=}& 500\text{+ (–200) – 500}\end{array}$$

Step 6. Your formula now is:

$$\begin{array}{r}\begin{array}{rcl}\text{(X – M)}& \text{=}& \text{S + (T – G) – I}\\ \text{–200}& \text{=}& \text{500 + (–200) – 500}\end{array}\end{array}$$

The question is: To reduce your trade deficit (X – M) of –200 to –100 (in billions of dollars), by how much will savings have to rise?

$$\begin{array}{rcl}\text{(X – M)}& \text{=}& \text{S + (T – G) – I}\\ \text{–100}& \text{=}& \text{S + (–200)}\text{–}\text{500}\\ \text{600}& \text{=}& \text{S}\end{array}$$

Step 7. Summarize the answer: Private domestic savings needs to rise by $100 billion, to a total of$600 billion, for the two sides of the equation to remain equal (–100 = –100).

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