The compilation of these Open Economy Macroeconomics Notes makes students exam preparation simpler and organised.
Trade Deficits, Savings and Investments
You must have often heard politicians and economists talk about the growing trade deficit of our country. They always seem extremely concerned about it. What is this trade deficit and why is it such a headache for the government? Come let us take a look.
Trade Deficit
A healthy balance of trade plays an important role in sustaining the economy of a country. And a country’s savings and investments play an important role in maintaining this balance. But there are times when the balance of trade tilts towards a trade surplus or a deficit. A trade deficit occurs when a country’s total imports exceed its exports. A trade surplus, on the other hand, occurs when a country’s total exports outweigh its imports.
So trade deficit represents a negative balance of trade. However, it is not exactly harmful to the economy. When do imports increase? They increase when a country’s production of domestic goods and services is not enough to meet the local demand. Imports also increase when the consumers’ purchasing power increases to create a demand for expensive foreign products.
In such a case, a trade deficit then provides opportunities for domestic businesses to produce quality goods and services to match foreign products. With domestic products available at lower prices, the inflation rate decreases. And a market with a wide variety of both domestic and imported goods provides the element of choice to the consumers. In such a case, an increase in imports indicates a fast, growing economy. And a growing economy attracts more foreign investment.
However, a trade deficit, in the long run, may not be beneficial. And that’s where a healthy balance of imports and exports is required. When imports increase beyond a certain extent, prices of goods and services reduce due to high competition. Consequently, domestic companies are not able to manufacture and produce goods at such low prices. As a result, employees lose jobs and companies manufacture fewer goods and services. The dearth of domestic goods and services results in more imports and as a result, more trade deficit.
Savings and Investments
Next, let’s look at savings and investments. Both terms are closely related and important in macroeconomics. In generic terms, savings refers to money left over after accounting for expenses. People generally use the term “savings” interchangeably with “investments”. But it is quite different. While savings is the excess income after expenditure, investment is the money earmarked or intended for conversion into capital. Savings do not involve risks. On the other hand, investments are subject to a certain amount of risk.
In economic terms, the savings and investments balance (I = S) refers to the balance of national savings and national investments, which is equal to the current account. According to the Keynes theory, an economy is in equilibrium only when saving is equal to investment. When savings translate into investments, capital is generated. And during trade deficits, this capital is of utmost importance as it drives economic growth.
An increase in savings doesn’t always indicate an increase in investments. This is where the equilibrium comes into play. Savings should be deposited into intermediaries like banks and financial institutions so that they can be converted into investments for business. An increase or decrease of savings as against investments, again, has long-term and short-term effects on the economy.
When an economy faces a trade deficit, the balance of savings and investments becomes all the more important. We already discussed that a trade deficit isn’t always detrimental. However, if a country has enough savings and investments, then it can offset its deficit using those savings.
Example:
Question:
Identify whether the following statement is true or false.
“Trade deficit is always harmful to a country’s economy.”
Answer:
The correct answer is option “b”.
A trade deficit may actually be beneficial in the short run since it indicates higher imports due to consumer consumption. This, in turn, brings down inflation.