To understand the relation between savings, investments, fiscal balance, and trade balance, we will combine the income and expenditure approach to calculating GDP.
We know that,
GDP = C + I + G + (X – M)
We also know that,
GDP = C + S + T
Where,
C = Consumption spending
S = Government and household saving
T = Net taxes
We can equate the above two equations:
C + I + G + (X – M) = C + S + T
The government deficit (G – T) deficit can be expressed in terms of savings and investments as follows:
(G – T) = (S – I) – (X – M)
G – T represents government deficit
S – I represents excess of private savings over private investments
X – M represents trade surplus. A negative (X – M) represents trade deficit.
From the above equation we can conclude that:
Trade deficit (G – T >0) must be finance by:
- Excess of private savings over private investments (S – I > 0), or
- Trade deficit (X – M < 0), or
- Combination of both