23.4 The National Saving and Investment Identity

The national saving and investment identity links a country's trade balance to its domestic saving and investment. This relationship shows how factors like exchange rates, income levels, and trade policies impact exports and imports, ultimately affecting the trade balance.

International financial capital flows are driven by investment opportunities, economic growth, and stability. The balance between domestic saving and investment, along with government budgets, determines whether a country has a trade surplus or deficit, shaping its economic interactions globally.

The National Saving and Investment Identity

Trade Balance and Current Account

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• Trade balance
  • Exports minus imports of goods and services
  • Trade surplus: exports exceed imports
  • Trade deficit: imports exceed exports
• Current account
  • Includes trade balance, net income from abroad (interest and dividends), and net current transfers (foreign aid and remittances)
• Determinants of trade balance and current account
  • Exchange rates
    • Domestic currency appreciation makes exports more expensive and imports cheaper, reducing trade balance (Japan's yen appreciation in the 1990s)
    • Domestic currency depreciation makes exports cheaper and imports more expensive, increasing trade balance (China's yuan depreciation in the 2000s)
  • Domestic income levels
    • Higher domestic income raises demand for imports, reducing trade balance (U.S. economic boom in the 1990s increased imports)
    • Lower domestic income lowers demand for imports, increasing trade balance (U.S. recession in 2008-2009 reduced imports)
  • Foreign income levels
    • Higher foreign income raises demand for the country's exports, increasing trade balance (U.S. exports to China increased as China's economy grew)
    • Lower foreign income lowers demand for the country's exports, reducing trade balance (European recession in 2012-2013 reduced demand for U.S. exports)
  • Trade policies
    • Tariffs, quotas, and other trade barriers can reduce imports, increasing trade balance (U.S. tariffs on imported steel in 2018)
    • Subsidies for domestic industries can increase exports, increasing trade balance (European Union's Common Agricultural Policy subsidizes agricultural exports)

International Financial Capital Flows

• Demand factors for international financial capital
  • Investment opportunities
    • Countries with higher expected returns on investments attract more foreign capital (high-growth emerging markets like India and Brazil)
  • Economic growth prospects
    • Countries with strong economic growth potential are more attractive to foreign investors (China's rapid economic growth in the 2000s)
  • Political and economic stability
    • Stable political and economic environments reduce risk and attract foreign capital (developed countries like the U.S. and Germany)
• Supply factors for international financial capital
  • Domestic saving
    • Higher domestic saving increases the supply of funds available for international investment (Japan's high saving rate in the 1980s)
  • Interest rates
    • Higher domestic interest rates make a country's assets more attractive to foreign investors (U.S. high interest rates in the 1980s attracted foreign capital)
  • Financial market development
    • Well-developed financial markets facilitate the flow of capital across borders (London and New York as global financial centers)
  • Capital controls
    • Restrictions on capital flows can limit the supply of international financial capital (China's capital controls limit foreign investment)

Domestic Saving, Investment, and Trade

• National saving and investment identity
  • $(X - M) = (S - I) + (T - G)$
    • $X$: Exports
    • $M$: Imports
    • $S$: Private saving
    • $I$: Private investment
    • $T$: Tax revenue
    • $G$: Government spending
• Implications of the identity
  • Trade balance $(X - M)$ is determined by the difference between national saving $(S + (T - G))$ and domestic investment $(I)$
  • Trade surplus occurs when national saving exceeds domestic investment
  • Trade deficit occurs when domestic investment exceeds national saving
• Domestic saving
  • Higher private saving $(S)$ increases national saving, improving the trade balance (Singapore's high saving rate and trade surpluses)
  • Lower private saving $(S)$ decreases national saving, worsening the trade balance (U.S. low saving rate and trade deficits)
• Domestic investment
  • Higher private investment $(I)$ increases domestic investment, worsening the trade balance (Australia's investment boom and trade deficits)
  • Lower private investment $(I)$ decreases domestic investment, improving the trade balance (Japan's low investment and trade surpluses)
• Government budget
  • Government budget surplus $(T > G)$ increases national saving, improving the trade balance (Germany's budget surpluses and trade surpluses)
  • Government budget deficit $(G > T)$ decreases national saving, worsening the trade balance (U.S. budget deficits and trade deficits)