Question

Using the national savings and investment identity, explain how each of the following changes (ceteris paribus) will increase or decrease the trade balance:

a. A lower domestic savings rate

b. The government changes from running a budget surplus to running a budget deficit

c. The rate of domestic investment surges

Short answer

All 3 reduces trade balance.

Step-by-step solution

Step1. Introduction

The savings-investment identity is-

(S-I) = (X-M)

S- Savings

I- Investments

X- Exports

M- Imports

X-M= Trade Balance

Step2. Explanation

a. Domestic savings rate declines which reduces the overall savings in the economy. The left hand side of the identity shall fall, and hence the trade balance shall fall too.

b. Government goes into budget deficit. The government will have to borrow funds to finance this deficit. So, the savings in the country shall decline and the investments shall go up. Therefore, left hand side of the identity falls, and hence the trade balance shall fall too.

c. Rate of domestic investment surges implies investment in the overall economy shall increase. This will push left hand side of the identity to decrease, hence trade balance falls as well.