Question

A country is experiencing two types of deficits at the same time:
• a budget deficit of the government which is financed by the government’s borrowing, and
• a trade deficit.
Then what inferences can we make about the difference between domestic investment and the
private saving of the country?
Can we infer for sure that the domestic investment must be larger than / equal to / smaller than the
private saving? Or that we cannot have an unambiguous inference about the difference of the two
variables? Explain.

Answer 1

A budget deficit occurs when the government has to make expenditures worth more than the revenue it gets. In the specific context of this question, it is clear that the government decides to settle this deficit through borrowings. But, borrowings can be from the domestic private entities or from international sources like the world bank.

If government borrows from international sources, nothig can be said about the influence of this action on private savings and domestic investment.However, If government borrows from domestic private agencies, Private savings will decline. Since both government savings and private savings have declined, the domestic invesment falls to a larger extent than the private savings. Along with that , the country is facing a trade deficit which means Imports are greater than exports. This is also due to the fact that domestic investment in production and exports have declined.

So the inference that we can make from this situation is that both private savings and domestic investment is declining. However, private savings are greater than domestic investment.

But if the government borrows from international sources to meet the budget deficit situation, the relationship between private savings and domestic investment is ambiguous.