Question

How can the US simultaneously finance a high level of domestic investment and have a large budget deficit and low private savings? Justify and explain your answer using equations from class.

Answer 1

SOLUTION:-

* Current account deficit in the Economy is accompanied by the Fincancial Account Surplus.

Now, in an open Economy,

(T–G)+ (S–I)= (X–Z)

Where, T= Taxes,

G= government spending

S= private savings

I= domestic investment

X= Exports

Z= imports

* Now, if the Domestic investment is more than private savings such that (S-I) is Negative and the budget is in Deficit such that (T-G is also negative, it implies that the left hand side in the above equation is Negative.

* Therefore, Right hand side has to be Negative also. Thus, (X-Z) is Negative. It means that the exports of the country fall short of the imports of the country.

* Thus, there is a Current Account Deficit in US. Now a Current Account Deficit is accompanied by a Financial Account Surplus in order for the overall balance of payment to balance.

* Hence, high Fincancial Account Surplus sustains(finances) the high Current Account Deficit. Its implication is that high financial account surplus(high inflow of capital to US) of US help US finance high level of domestic investment despite a large budget deficit and low Private savings.

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