Question

3. Using words, describe the national savings and investment identity from the standpoint of a trade surplus. (20%)

4. Based on the material explain why the economists consider free trade as beneficial for countries (give at least two reasons) and explain if a current account deficit (or a trade deficit) is good or bad for the economy (40%)

Answer 1

Answer 3)
The national saving and investment identity provides with a very noteworthy way to understand the determinants of the trade and current account balance. The quantity of financial capital supplied at any given time must equal the quantity of financial capital demanded for purposes of making investments in a nation’s financial capital market.

A country’s national savings is the sum of its domestic savings by household and companies (private savings) and the government (public savings). If a country is running a trade deficit, it means money from abroad is entering the country and is considered part of the supply of financial capital.

The demand for financial capital (money) represents groups that are borrowing the money. The two groups are businesses and the govenrment. Businesses need to borrow funds to finance their investments in factories,etc. Secondly, when the federal government runs a budget deficit, it is also borrowing money from investors by selling Treasury bonds. So both business investment and the federal government can demand (or borrow) the supply of savings.

Answer 4)
Free trade is considered to be beneficial due to the specialisation of the goods which thus leads to economies of scale and lower avergae costs. This is true especially when high investments are required or there are high fixed costs. The benefits of economies of scale will ultimately lead to lower prices for consumers and greater efficiency for exporting firms. Free trade also enables a competitive advantage according to the theory of comparitive advantage. Countries which have a low opportunity cost to produce a good i.e they can produce at a lower opportunity cost than another country can then speciialise in the production of those goods and help in the economic welfare.

A current account deficit or a trade deficit is bad for the economy as it is an indication of an unbalanced economy. It may imply that there is dependence on the consumer spending and that the economy is unbalanced between the different sectors and also between short term consumption and long term investment. It may also indicate an uncompetitive economy with an overvalued exchange rate.

However, a trade deficit is not necessarily always bad for the economy as in the nineteenth century, the US imports exceeded exports and the US economy had a trade deficit. Yet, the trade deficits did not affect the economy at all; instead, the trade deficits contributed to the strong economic growth that gave the US economy the highest per capita GDP in the world.