Question

Imagine that the U.S. economy finds itself in the following situation: a government budget deficit of \(\$ 100\) billion, total domestic savings of \(\$ 1,500\) billion, and total domestic physical capital investment of \(\$ 1,600\) billion. According to the national saving and investment identity, what will be the current account balance? What will be the current account balance if investment rises by \$50 billion, while the budget deficit and national savings remain the same?

Short answer

The current account balance is calculated as follows: National Private Savings = \(1,500 billion - \)100 billion = $1,400 billion Current Account Balance = ($1,400 billion) - $1,600 billion = $-200 billion When investment rises by $50 billion: New Investment = $1,600 billion + 50 billion = $1,650 billion New Current Account Balance = ($1,400 billion) - $1,650 billion = $-250 billion So, the current account balance is $-200 billion, and when investment rises by $50 billion, the new current account balance becomes $-250 billion.

Step-by-step solution

Calculate National Private Savings

First, we need to calculate the national private savings. National Savings is the sum of private savings and government savings. Since we are given the total domestic savings(\$1,500 billion) and government budget deficit(\$100 billion), we can calculate the national private savings by subtracting the deficit from the total domestic savings: National Private Savings = Total Domestic Savings - Government Budget Deficit National Private Savings = \(1,500 billion - \)100 billion

Calculate the Current Account Balance

Using the national saving and investment identity, we can now calculate the current account balance: Current Account Balance = National Savings - Investment Current Account Balance = (National Private Savings + Government Savings) - Investment As Government Savings is negative (budget deficit), we can rewrite the equation as: Current Account Balance = National Private Savings - Investment -|Government Budget Deficit| Plug in the values from Step 1: Current Account Balance = (\(1500 billion - \)100 billion) - $1600 billion

step 3: Calculate Current Account Balance with Increased Investment

Now we'll calculate the current account balance when investment increases by $ 50 billion while keeping the budget deficit and national savings the same: New Investment = \(1600 billion + \) 50 billion Follow the same formula as earlier: New Current Account Balance = National Private Savings - New Investment - |Government Budget Deficit| Plug in the values: New Current Account Balance = (\(1500 billion - \)100 billion) - $1650 billion Now compute the values in these formulas to get the final answers.

Key concepts

Government Budget Deficit

A government budget deficit occurs when a government spends more money than it collects in revenues, such as taxes, during a particular period. This leads to a shortfall, known as a deficit. When a government has a budget deficit, it often needs to borrow money, which increases the national debt.

In terms of the national savings and investment identity, a government budget deficit plays a crucial role. It represents a negative number in the government savings component. Instead of contributing to national savings, a deficit subtracts from it. For instance, with a deficit of $100 billion, government savings are actually negative $100 billion. This effectively reduces the total available national savings that can be used for domestic investment and financing the current account balance.

Understanding the impact of the government budget deficit helps in comprehending how funds flow within an economy and how deficits can affect interest rates and investments.

Domestic Savings

Domestic savings refer to the part of a nation's income that is not consumed or spent by the government or individuals. It includes both private and public savings in an economy. Domestic savings are essential because they provide the financial resources necessary for investment in capital goods, which fuel economic growth.

In our exercise scenario, the total domestic savings were $1,500 billion. To calculate national private savings, the government budget deficit must be subtracted from this total. This step is vital because private savings alone don't reflect the government's financial activities. So, if the domestic savings total $1,500 billion and the government budget deficit equals $100 billion, the national private savings would be $1,400 billion.

This value represents what is purely saved by the private sector after accounting for the government's financial shortfall. Stronger domestic savings often indicate a robust economic situation, where more funds are available for investments, both domestic and abroad.

Current Account Balance

The current account balance is a critical component in an economy's balance of payments, which includes transactions in goods, services, income, and current transfers. It reflects the economic transactions between residents of a country and the rest of the world.

In the context of the saving and investment identity, the current account balance is determined by subtracting the domestic investment from national savings. This formula highlights how an economy is balanced between what it saves and what it invests domestically.

For example, if national private savings are $1,400 billion and domestic investment is $1,600 billion, the current account would initially be negative. This resulting negative current account balance, or deficit, indicates that the country is investing more than it is saving, making up the difference with foreign capital.

A positive current account balance suggests a country is a net lender to the rest of the world, while a negative balance portrays it as a net borrower. These balances fluctuate with changes in investment, savings, and external economic influences.