International trade and financial flows shape a nation's economic landscape. The national saving and investment identity links domestic saving, investment, and trade balances. This relationship explains how changes in saving and investment affect a country's trade position.

Understanding these connections is crucial for grasping macroeconomic dynamics. Factors like exchange rates, economic growth, and government policies influence trade balances. The interplay between domestic and foreign saving determines a nation's borrowing or lending position in the global economy.

The National Saving and Investment Identity

Factors in trade balances

• Trade balance measures the difference between a nation's exports and imports of goods and services (cars, electronics)
  • Positive trade balance indicates a trade surplus where exports exceed imports
  • Negative trade balance indicates a trade deficit where imports exceed exports
• Current account balance provides a more comprehensive measure by including the trade balance plus net income and net transfers
  • Net income accounts for earnings on foreign investments minus payments to foreign investors (dividends, interest)
  • Net transfers include gifts, foreign aid, and remittances sent between countries (humanitarian aid, workers sending money to families)
• Several factors influence trade and current account balances
  • Exchange rates impact the relative prices of exports and imports
    • Appreciation of domestic currency makes exports more expensive and imports cheaper leading to a deterioration in the trade balance
    • Depreciation of domestic currency makes exports cheaper and imports more expensive improving the trade balance
  • Domestic economic growth increases demand for imports as consumers and businesses spend more (construction materials, luxury goods)
  • Foreign economic growth in trading partners boosts demand for exports (agricultural products, manufactured goods)
  • Trade policies such as tariffs, quotas, and other trade barriers affect the flow of goods and services (steel tariffs, import quotas on textiles)
  • Capital flows between countries can influence trade balances through their impact on exchange rates and investment

Supply and demand of financial capital

• Supply of financial capital comes from two sources
  • Domestic saving ($S_d$) by households, businesses, and the government within the country
  • Foreign saving ($S_f$) from international investors and lenders
  • Total supply of financial capital is the sum of domestic and foreign saving: $S = S_d + S_f$
• Demand for financial capital
  • Comes from domestic investment ($I_d$) by businesses and the government within the country (factories, infrastructure)
  • Total demand for financial capital equals domestic investment: $I = I_d$
• Equilibrium in the financial capital market occurs when the supply of financial capital equals the demand
  • Represented by the equation $S = I$, or $S_d + S_f = I_d$
  • Interest rates adjust to balance the supply and demand for financial capital

Domestic savings vs trade balance

• The national saving and investment identity states that $S_d + S_f = I_d$
  • Rearranging the equation yields $S_f = I_d - S_d$, showing the relationship between foreign saving, domestic investment, and domestic saving
• This identity has important implications for a nation's trade balance
  • If domestic investment exceeds domestic saving ($I_d > S_d$), foreign saving is positive ($S_f > 0$)
    • The country is borrowing from abroad to finance the excess investment leading to a trade deficit (US trade deficit with China)
  • If domestic saving exceeds domestic investment ($S_d > I_d$), foreign saving is negative ($S_f < 0$)
    • The country is lending to other countries resulting in a trade surplus (Germany's trade surplus)

National saving and trade deficits

• Changes in domestic saving and investment affect the trade balance according to the national saving and investment identity
• An increase in domestic saving, holding domestic investment constant
  1. Reduces the trade deficit as less borrowing from abroad is needed
  2. Increases the trade surplus as more saving is available for lending abroad
• A decrease in domestic saving, holding domestic investment constant
  1. Increases the trade deficit as more borrowing from abroad is required
  2. Reduces the trade surplus as less saving is available for lending abroad
• An increase in domestic investment, holding domestic saving constant
  1. Increases the trade deficit as more borrowing from abroad is needed to finance the additional investment
  2. Reduces the trade surplus as less saving is available for lending abroad
• A decrease in domestic investment, holding domestic saving constant
  1. Reduces the trade deficit as less borrowing from abroad is required
  2. Increases the trade surplus as more saving is available for lending abroad
• Factors affecting domestic saving and investment also impact the trade balance
  • Government budget balance
    • Government budget deficit reduces national saving and tends to increase the trade deficit (US budget and trade twin deficits)
    • Government budget surplus increases national saving and tends to reduce the trade deficit or increase the trade surplus
  • Private saving and investment decisions by households and businesses
    • Influenced by interest rates, economic growth, and expectations about the future (consumer confidence, business sentiment)
    • Higher interest rates encourage saving and discourage borrowing for investment
    • Stronger economic growth and optimistic expectations boost investment spending relative to saving

Open vs Closed Economies and Balance of Payments

• An open economy engages in international trade and financial transactions, while a closed economy does not
• The balance of payments is a comprehensive record of all economic transactions between residents of a country and the rest of the world
• National income accounting in an open economy must consider international transactions, which affects aggregate expenditure
• The current account and capital account are key components of the balance of payments, reflecting the flow of goods, services, and capital between countries