Question

Imagine that the economy of Germany finds itself in the following situation: the government budget has a surplus of \(1 \%\) of Germany's GDP; private savings is 20\% of GDP; and physical investment is 18\% of GDP. a. Based on the national saving and investment identity, what is the current account balance? b. If the government budget surplus falls to zero, how will this affect the current account balance?

Short answer

The current account balance of Germany is 3% of its GDP in the given situation. If the government budget surplus falls to zero, the current account balance will decrease to 2% of Germany's GDP.

Step-by-step solution

Understand the national saving and investment identity

The national saving and investment identity states that the total amount saved in an economy must be equal to the total amount invested. Mathematically, it can be represented as: \[S = I\] Where S is the total national saving and I is the total domestic investment. National saving consists of both private savings and government savings. In our case, private savings are given as 20% of GDP and the government budget surplus as 1% of GDP.

Calculate the current national saving

Based on the given information, we can calculate the national saving (S) as follows: \[S = \text{Private savings} + \text{Government budget surplus}\] \[S = 20\% + 1\%\] \[S = 21\%\] Germany's total national saving is 21% of its GDP.

Calculate the current account balance

We know that the national saving and investment identity states \(S = I\). We know the national saving (S) is 21% of GDP and the physical investment (I) is 18% of GDP. Therefore, we can calculate the current account balance, which is the difference between the national saving and the physical investment: \[CAB = S - I\] \[CAB = 21\% - 18\%\] \[CAB = 3\%\] The current account balance is 3% of Germany's GDP.

Analyze the effect of the government budget surplus falling to zero

If the government budget surplus falls to zero, the national saving (S) will change because the government saving component will be zero. We can calculate the new national saving (New_S) as follows: \[New\_S = \text{Private savings} + \text{Government budget surplus}\] \[New\_S = 20\% + 0\%\] \[New\_S = 20\%\] The new national saving will be 20% of Germany's GDP when the government budget surplus falls to zero.

Calculate the new current account balance

Using the new national saving (New_S), we can calculate the new current account balance (New_CAB) as follows: \[New\_CAB = New\_S - I\] \[New\_CAB = 20\% - 18\%\] \[New\_CAB = 2\%\] The new current account balance will be 2% of Germany's GDP when the government budget surplus falls to zero. In conclusion, the current account balance of Germany is 3% of its GDP in the given situation. If the government budget surplus falls to zero, the current account balance will decrease to 2% of Germany's GDP.

Key concepts

Current Account Balance

The current account balance represents a country's transactions with the rest of the world, specifically its net trade in goods and services, its net earnings on cross-border investments, and its net transfer payments.

In the simplified world of the national saving and investment identity, the current account balance is effectively the difference between national saving and domestic investment. When a country saves more than it invests domestically, it has a surplus, which Germany demonstrates with its current account balance of 3% of GDP. This extra saving is typically invested abroad, potentially earning income through foreign investments.

As for the exercise, it's critical to grasp that the current account balance is not static. Should there be changes in either national saving or domestic investment, the current account balance will shift accordingly, as illustrated when the government budget surplus is reduced from 1% to 0%, hence decreasing the current account balance to 2% of GDP.

Government Budget Surplus

A government budget surplus occurs when a government's revenues exceed its expenses within a given time period. This indicates a healthy fiscal position and implies that the government is saving funds rather than accumulating debt.

As seen in the exercise, a government surplus contributes to the overall national saving. This can be loaned to the private sector or used to invest in other countries. Germany's initial budget surplus of 1% of GDP boosts the national saving, creating a buffer that enables a higher current account balance. However, if the surplus falls to zero, the available funds for such transactions decline, which directly impacts the country's current account. This demonstrates the interconnectedness of government fiscal policies and the nation's economic interactions with the rest of the world.

Physical Investment

Physical investment in an economy refers to the purchase of capital goods that are utilized to produce other goods and services in the future. This includes expenditures on infrastructure, machinery, and buildings.

In the context of the national saving and investment identity, physical investment must be balanced by national saving. This requirement is what induces the equilibrium that S = I. With Germany's physical investment at 18% of GDP, it's a signal of economic growth intentions. Yet, the total amount of physical investment can affect the current account balance, especially when contrasted against national saving levels.

Understanding this concept ensures that students can follow how the dynamics of investment, be it in factories, technology, or other assets, can influence a country's international financial position and vice versa.