Learning Objectives

Learning Objectives

By the end of this section, you will be able to do the following:
  • Explain the national saving and investment identity in terms of demand and supply
  • Evaluate the role of budget surpluses and trade surpluses in national saving and investment identity

When governments are borrowers in financial markets, there are three possible sources for the funds from a macroeconomic point of view: (a) households might save more, (b) private firms might borrow less, and (c) the additional funds for government borrowing might come from outside the country, from foreign financial investors. Let’s begin with a review of why one of these three options must occur, and then explore how interest rates and exchange rates adjust to these connections.

The National Saving and Investment Identity

The National Saving and Investment Identity

The national saving and investment identity, first introduced in The International Trade and Capital Flows chapter, provides a framework for showing the relationships between the sources of demand and supply in financial capital markets. The identity begins with a statement that must always hold true: The quantity of financial capital supplied in the market must equal the quantity of financial capital demanded.

The U.S. economy has two main sources for financial capital: private savings from inside the U.S. economy and public savings

Total savings = Private savings (S) + Public savings (T – G).Total savings = Private savings (S) + Public savings (T – G).

These include the inflow of foreign financial capital from abroad. The inflow of savings from abroad is, by definition, equal to the trade deficit, as explained in The International Trade and Capital Flows chapter. So this inflow of foreign investment capital can be written as imports (M) minus exports (X). There are also two main sources of demand for financial capital: private sector investment (I) and government borrowing. Government borrowing in any given year is equal to the budget deficit, and it can be written as the difference between government spending (G) and net taxes (T). Let’s call this Equation 1.

Quantity supplied of financial capital = Quantity demanded of financial capitalPrivate savings + Inflow of foreign savings = Private investment + Government budget deficitS + (M – X) = I + (G –T)Quantity supplied of financial capital = Quantity demanded of financial capitalPrivate savings + Inflow of foreign savings = Private investment + Government budget deficitS + (M – X) = I + (G –T)

Governments often spend more than they receive in taxes and, therefore, public savings (T – G) is negative. This causes a need to borrow money in the amount of (G – T) instead of adding to the nation’s savings. If this is the case, governments can be viewed as demanders of financial capital instead of suppliers. So, in algebraic terms, the national savings and investment identity can be rewritten like this

Private investment = Private savings + Public savings + Trade deficitI = S + (T – G) + (M – X).Private investment = Private savings + Public savings + Trade deficitI = S + (T – G) + (M – X).

Let’s call this Equation 2. A change in any part of the national saving and investment identity must be accompanied by offsetting changes in at least one other part of the equation because the equality of quantity supplied and quantity demanded is always assumed to hold. If the government budget deficit changes, then either private saving or investment or the trade balance—or some combination of the three—must change as well. Figure 17.2 shows the possible effects.

Following from the national savings and investment identity, charts (a) and (b) show what happens to investment, private savings, and the trade deficit when the budget deficit rises (or the budget surplus falls). (a) If the budget deficit rises (or the government budget surplus falls), the results could be (1) domestic private investment falls or (2) private savings rise or (3) the trade deficit increases (or a trade surplus diminishes). The opposite results of each are achieved when the budget deficit fa
Figure 17.2 Effects of Change in Budget Surplus or Deficit on Investment, Savings, and the Trade Balance Chart (a) shows the potential results when the budget deficit rises—or budget surplus falls. Chart (b) shows the potential results when the budget deficit falls—or budget surplus rises.

What about Budget Surpluses and Trade Surpluses?

What about Budget Surpluses and Trade Surpluses?

The national saving and investment identity must always hold true because, by definition, the quantity supplied and the quantity demanded in the financial capital market must always be equal. However, the formula will look somewhat different if the government budget is in deficit rather than surplus or if the balance of trade is in surplus rather than deficit. For example, in 1999 and 2000, the U.S. government had budget surpluses, although the economy was still experiencing trade deficits. When the government was running budget surpluses, it was acting as a saver rather than a borrower, and supplying rather than demanding financial capital. As a result, the national saving and investment identity during this time would be more properly written as

Quantity supplied of financial capital=Quantity demanded of financial capitalPrivate savings + Trade deficit + Government surplus=Private investmentS + (M – X) + (T – G)=I.Quantity supplied of financial capital=Quantity demanded of financial capitalPrivate savings + Trade deficit + Government surplus=Private investmentS + (M – X) + (T – G)=I.

Let's call this Equation 3. Notice that this expression is the same mathematically as Equation 2, except the savings and investment sides of the identity have simply flipped sides.

During the 1960s, the U.S. government was often running a budget deficit, but the economy was typically running trade surpluses. Because a trade surplus means an economy is experiencing a net outflow of financial capital, the national saving and investment identity would be written as the following

Quantity supplied of financial capital=Quantity demanded of financial capitalPrivate savings=Private investment + Outflow of foreign savings + Government budget deficitS=I + (X – M) + (G – T).Quantity supplied of financial capital=Quantity demanded of financial capitalPrivate savings=Private investment + Outflow of foreign savings + Government budget deficitS=I + (X – M) + (G – T).

Instead of the balance of trade representing part of the supply of financial capital, which occurs with a trade deficit, a trade surplus represents an outflow of financial capital leaving the domestic economy and being invested elsewhere in the world.

Quantity supplied of financial capital=Quantity demanded of financial capital demandPrivate savings=Private investment + Government budget deficit + trade surplusS=I + (G – T) + (X – M) Quantity supplied of financial capital=Quantity demanded of financial capital demandPrivate savings=Private investment + Government budget deficit + trade surplusS=I + (G – T) + (X – M) 

The point to this parade of equations is that the national saving and investment identity is assumed to always hold. So when you write these relationships, it is important to engage your brain and think about what is on the supply side and what is on the demand side of the financial capital market before you put pencil to paper.

As can be seen in Figure 17.3, the Office of Management and Budget shows that the United States has run budget deficits consistently since 1977, with the exception of 1999 and 2000. What is alarming is the dramatic increase in budget deficits that has occurred since 2008, which in part reflects declining tax revenues and increased safety net expenditures due to the Great Recession. Recall that T is net taxes. When the government must transfer funds back to individuals for safety net expenditures such as Social Security and unemployment benefits, budget deficits rise. These deficits have implications for the future health of the U.S. economy.

The graph shows U.S. government budgets and surpluses from 1977 to 2014. The United States has only had two years without a government budget deficit. In the 1980s the deficit hovered above –$200 million, gradually becoming a surplus by the end of 1990s. From 2000 onward, the deficit grew rapidly to –$600 million. The deficit was at its worst in 2009, at close to $1.6 trillion, following the Great Recession. In 2014, it was around –$514 million.
Figure 17.3 United States On-Budget, Surplus, and Deficit, 1977–2014 (in millions of dollars) The United States has run a budget deficit for over more than 30 years, with the exception of 1999 and 2000. Military expenditures, entitlement programs, and the decrease in tax revenue coupled with increased safety net support during the Great Recession are major contributors to the dramatic increases in the deficit after 2008. (credit: Office of Management and Budget)

A rising budget deficit may result in a fall in domestic investment, a rise in private savings, or a rise in the trade deficit. The following modules discuss each of these possible effects in more detail.