Chapter 10: Problem 14

If domestic investment increases, and there is no change in the amount of private and public saving, what must happen to the size of the trade deficit?

Short Answer

Expert verified

In conclusion, if domestic investment increases and there is no change in the amount of private and public saving, the size of the trade deficit must increase. The increase in the trade deficit signifies that imports will increase relative to exports to finance the increased domestic investment.

Step by step solution

Understanding the National Income Identity

The national income identity equation shows the relationship between domestic investment, private and public saving, and the trade deficit. The equation is: \(Y = C + I + G + NX\) Where: Y = Gross Domestic Product (GDP) C = Consumption I = Domestic Investment G = Government Spending NX = Net Exports (Exports - Imports)

Analyzing the relationship between Savings, Investment and Net Exports

We can rearrange the national income identity equation to show the relationship between savings, investment, and the trade deficit. We know that overall savings is the sum of private savings (S) and government savings (T - G). Therefore, the equation becomes: \(Y - C - G = I + (S - I) + (T - G)\) Rearranging the terms, we get: \(S + (T - G) = I + NX\) Where: S = Private savings T = Taxes G = Government spending I = Domestic investment NX = Net Exports (Exports - Imports)

Setting the context of the exercise

From the exercise, we know that domestic investment increases (ΔI > 0) and there is no change in private and public saving (ΔS = 0 and Δ(T - G) = 0).

Finding the impact on the Trade Deficit

As we know that there is no change in private and public saving, the only thing that can adjust to maintain the equation is the trade deficit (NX). To cover the increase in domestic investment, the trade deficit has to increase (ΔNX < 0). This means that imports will increase relative to exports in order to finance the increased domestic investment. In conclusion, if domestic investment increases and there is no change in the amount of private and public saving, the size of the trade deficit must increase. The increase in the trade deficit signifies that imports will increase relative to exports to finance the increased domestic investment.

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