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By the end of this section, you will be able to:

  • 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: (1) households might save more; (2) private firms might borrow less; and (3) 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, 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)

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 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 capital Private savings + Inflow of foreign savings  =  Private investment + Government budget deficit S + (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 deficit I  =  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. [link] shows the possible effects.

Questions & Answers

what are the shapes of an indifference curve?
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financial intermediaries are those who are link between borrowers and lenders for.eg bank... Bank is a financial intermediary
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the central bank may lend some money to banks if necessary
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is a tabular representation of the quantity demanded of a particular product at a particular price over a given period of time
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change in quantity due to change in its price
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degree of responsiveness of quantity demanded or supplied due to price.change
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Source:  OpenStax, Principles of economics. OpenStax CNX. Sep 19, 2014 Download for free at http://legacy.cnx.org/content/col11613/1.11
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