Chapter 6: Problem 15

Use the national income identity GDP \(=C+I+\) \(G+X\) to explain what a current account deficit (negative net exports) means in terms of domestic spending, production, and borrowing.

Short Answer

Expert verified

Answer: A current account deficit implies that domestic spending on goods and services exceeds domestic production, leading to a higher demand for imported goods and services. This means that the country consumes more than it can produce, which must be financed by borrowing from other countries or drawing on its foreign reserves, resulting in an increase in external debt or reduction in foreign reserves. In the context of the national income identity, a current account deficit occurs when C+I+G > GDP and X < 0.

Step by step solution

Understand the National Income Identity

The national income identity states that GDP, which represents the total value of goods and services produced within a country, can be calculated by the formula: GDP \(=C+I+G+X\). Here, C represents consumption, I represents investment, G represents government spending, and X represents net exports (exports minus imports).

Identify the meaning of a Current Account Deficit

A current account deficit occurs when a country has negative net exports, which means the country imports more goods and services than it exports. In terms of the national income identity, this means that \(X<0\).

Relate Current Account Deficit to Domestic Spending

A current account deficit indicates that domestic spending on goods and services is greater than domestic production. In other words, the country is consuming more goods and services than it can produce, which leads to a higher demand for imported goods and services. This can be seen in the national income identity as \(C+I+G >\) GDP when \(X<0\).

Relate Current Account Deficit to Domestic Production

A current account deficit implies that domestic production is insufficient to meet domestic demand. As a result, the country needs to import goods and services to satisfy its consumption, investment, and government spending needs.

Relate Current Account Deficit to Borrowing

A current account deficit means that a country is spending more on imports than it is earning from exports, which must be financed by borrowing from other countries or drawing on its foreign reserves. This leads to an increase in the country's external debt or a reduction in its foreign reserves. In the context of the national income identity, borrowing can be seen as a way to finance the difference between GDP and \(C+I+G\) when \(X<0\).