Question

If domestic investment increases, and there is no change in the amount of private and public saving, what must happen to the size of the trade deficit?

Short answer

In conclusion, when domestic investment increases and there is no change in private and public saving, the size of the trade deficit must widen. This indicates a higher dependence on imported goods and potentially a consumption of domestic savings or foreign borrowing to finance the increase in domestic investment.

Step-by-step solution

Understand the National Income Identity Equation

The National Income Identity Equation is given by: \(GDP = C + I + G + NX\) where: - GDP: Gross Domestic Product (the market value of all final goods and services produced within a country in a given period) - C: Consumption (total spending by households) - I: Domestic Investment (spending on new capital goods) - G: Government Spending - NX: Net Exports (Exports - Imports, also known as trade balance) For our problem, we are interested in understanding the relationship between Domestic Investment (I), private and public saving, and the trade deficit which can be represented as: \(S - I = NX\) where S represents the total saving in the economy (private and public saving combined).

Analyze the Effect of an Increase in Domestic Investment

Now, let's analyze what happens when there is an increase in domestic investment (I), while private and public saving (S) remains the same. In this case, the equation becomes: \(S - (I + ΔI) = NX'\) where ΔI is the increase in domestic investment. Since S remains the same, if I increases, the difference between S and I will decrease. Therefore, the right-hand side of the equation (NX') must also decrease.

Conclusion

When domestic investment increases and there is no change in private and public saving, the size of the trade deficit (or trade balance) represented by NX must also decrease. A decrease in the trade balance means that the trade deficit is widening, reflecting a higher dependence on imported goods and potentially a consumption of domestic savings or foreign borrowing to finance the increase in domestic investment.