MacroeconomicsScience and Technology
How Government Borrowing Affects Investment and the Trade Balance
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.
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.
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:
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.
What about Budget Surpluses and Trade Surpluses?
The national saving and investment identity must always hold true because, by definition, the quantity supplied and 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:
Let's call this equation 3. Notice that this expression is mathematically the same 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. Since a trade surplus means that an economy is experiencing a net outflow of financial capital, the national saving and investment identity would be written:
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.
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 [link], the Office of Management and Budget shows that the United States has consistently run budget deficits 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 like Social Security and unemployment benefits, budget deficits rise.) These deficits have implications for the future health of the U.S. economy.
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.
Key Concepts and Summary
A change in any part of the national saving and investment identity suggests that if the government budget deficit changes, then either private savings, private investment in physical capital, or the trade balance—or some combination of the three—must change as well.
In a country, private savings equals 600, the government budget surplus equals 200, and the trade surplus equals 100. What is the level of private investment in this economy?
We use the national savings and investment identity to solve this question. In this case, the government has a budget surplus, so the government surplus appears as part of the supply of financial capital. Then:
Assume an economy has a budget surplus of 1,000, private savings of 4,000, and investment of 5,000.
- Write out a national saving and investment identity for this economy.
- What will be the balance of trade in this economy?
- If the budget surplus changes to a budget deficit of 1000, with private saving and investment unchanged, what is the new balance of trade in this economy?
- Since the government has a budget surplus, the government budget term appears with the supply of capital. The following shows the national savings and investment identity for this economy.
- Plugging the given values into the identity shown in part (a), we find that (X – M) = 0.
- Since the government has a budget deficit, the government budget term appears with the demand for capital. You do not know in advance whether the economy has a trade deficit or a trade surplus. But when you see that the quantity demanded of financial capital exceeds the quantity supplied, you know that there must be an additional quantity of financial capital supplied by foreign investors, which means a trade deficit of 2000. This example shows that in this case there is a higher budget deficit, and a higher trade deficit.
Based on the national saving and investment identity, what are the three ways the macroeconomy might react to greater government budget deficits?
How would you expect larger budget deficits to affect private sector investment in physical capital? Why?
Critical Thinking Questions
Assume there is no discretionary increase in government spending. Explain how an improving economy will affect the budget balance and, in turn, investment and the trade balance.
Explain how decreased domestic investments that occur due to a budget deficit will affect future economic growth.
The U.S. government has shut down a number of times in recent history. Explain how a government shutdown will affect the variables in the national investment and savings identity. Could the shutdown affect the government budget deficit?
- Welcome to Economics!
- Choice in a World of Scarcity
- Demand and Supply
- Labor and Financial Markets
- The Macroeconomic Perspective
- Economic Growth
- The International Trade and Capital Flows
- Introduction to the International Trade and Capital Flows
- Measuring Trade Balances
- Trade Balances in Historical and International Context
- Trade Balances and Flows of Financial Capital
- The National Saving and Investment Identity
- The Pros and Cons of Trade Deficits and Surpluses
- The Difference between Level of Trade and the Trade Balance
- The Aggregate Demand/Aggregate Supply Model
- Introduction to the Aggregate Demand/Aggregate Supply Model
- Macroeconomic Perspectives on Demand and Supply
- Building a Model of Aggregate Demand and Aggregate Supply
- Shifts in Aggregate Supply
- Shifts in Aggregate Demand
- How the AD/AS Model Incorporates Growth, Unemployment, and Inflation
- Keynes’ Law and Say’s Law in the AD/AS Model
- The Keynesian Perspective
- The Neoclassical Perspective
- Money and Banking
- Monetary Policy and Bank Regulation
- Exchange Rates and International Capital Flows
- Government Budgets and Fiscal Policy
- The Impacts of Government Borrowing
- Macroeconomic Policy Around the World
- International Trade
- Globalization and Protectionism
- Introduction to Globalization and Protectionism
- Protectionism: An Indirect Subsidy from Consumers to Producers
- International Trade and Its Effects on Jobs, Wages, and Working Conditions
- Arguments in Support of Restricting Imports
- How Trade Policy Is Enacted: Globally, Regionally, and Nationally
- The Tradeoffs of Trade Policy
- The Use of Mathematics in Principles of Economics
- The Expenditure-Output Model