Download National Income Accounts

Budget deficits, trade
deficits and global
capital flows
National Savings Identity
(NSI)

The NSI links trade and budget balances to
capital flows, interest rates and exchange rates.
 Periods of record budget and trade (twin deficits).
1980s and post 9/11 in the US bond financed
budget deficits.
 Germany: the early 1990s post-unification
spending.
Mexico and South East Asia: Currency crises in the
second half of the 1990s.

Current US trade and capital flows with China.
Y
+ Imp = C + I + G + Exp
Simplifying, we get
Y
= C + I+ G + (Exp – Imp)
(3.1)
This shows how the available output is distributed

The income from the sale of output is divided between
national consumption, private savings and net tax
revenues:
Y=C+S+T
(3.2)
Equating (3.1) and (3.2), we have
C + I + G + (Exp – Imp) = C + S + T
(G – T) = (S – I ) + (Imp – Exp)
This is the National Savings Identity (NSI)!

(G – T): National budget balance
If (G – T) > o : National budget deficit.
If (G – T) < o : National budget surplus.
 (Imp – Exp): Current account (CA) balance
If (Imp – Exp) > 0: Current account deficit
If (Imp – Exp) < 0: Current account surplus

The national budget balance and
the current account balance are
inextricably linked!
Assume the economy starts from a twin
deficit position (budget deficit and CA deficit)
Questions:
1. What mechanism links the two deficits?
2. What is the direction of causality
between the two deficits?
Deficit financing
3 broad methods:
1. Borrowing from domestic and foreign
residents
2. Monetization
3. Debt repudiation
Crucial assumptions:
1. Deficits are entirely bond financed.
2. Fiscal and monetary credibility is sound.
Microeconomic review (Fig. 3.1).
The NSI: (G – T) = (S – I ) + (Imp – Exp)
The LHS of the NSI ≡ demand for borrowing
 The RHS of the NSI ≡ supply of loanable funds
(lending)

Fig 3.2
To understand the macroeconomic intuition behind the
link between the two deficits, we follow these 7 steps.
1.
2.
3.
4.
5.
6.
7.
Deficits are financed by borrowing => demand for loanable funds
increases and the DD curve shifts to the right.
The increase in demand for loanable funds causes interest rates to
rise.
As a result of higher US interest rates, demand for US$ increases =>
US currency appreciates.
Appreciation of the US$ means imports are now cheaper and US
exports are more expensive.
=> the current balance (Exp – Imp) falls (more deficit)
Trade surplus countries accumulate US$ and re-invest where interest
rates are high. There is an inflow of capital to the US (move 6 on Fig.
3.2).
As a result of this capital inflow, interest rates in the US fall. Note that
they are still higher than their initial level (before the borrowing by the
government took place).
 Approx.
40-60% of US deficit in the 1980s
and post 9/11, and all of the US interest
expenses on government debt were
funded by large capital inflows associated
with US current account deficits.
How long can the US sustain the
deficits?

A loose rule of thumb for G7 economies:
Budget deficits < 5% of GDP

Maastricht treaty for membership in the
European Monetary Union:
Budget deficits < 3% of GDP
A non-sustainable deficit: Can no longer be bondfinanced.
• Massive monetization
• Real interest lost on government debt is higher than the
growth rate.
Criticism of large bond-financed
deficits
1.
2.
Crowding-effect
Trade deficits
-
Large government borrowing crowds-out private
capital investment
(G – T) = (S – I) [Ignoring the foreign sector]
So [(G – T) + I] = S
The LHS is total demand for borrowing.
The RHS is supply of loanable funds
(Fig 3.3)
But capital inflows alleviate (or eliminate) the crowdingout effect!
-
The second critique (trade deficits) argues
that Bond-financed budget deficits cause
deterioration of exports => lost jobs.
Fact: There is no positive correlation
between national unemployment and
increases in current account deficits!
e.g., (1) 1980s, CA and budget deficits, and
high growth and full employment; (2) Late
1990s and early 2000s, large CA deficits
but very strong growth and remarkably low
unemployment rates.
-
Two cases of the NSI
 US-type
economy: Safe haven economy
with large fiscal and CA deficits.
 China-type economy: Reasonably safe
haven economy with significant and
increasing CA surplus
Two major factors influence global capital
flows.
1. Higher interest rates relative to interest
rates in the ROW.
2. Stronger long-term macroeconomic
outlook for the domestic economy.
Hot capital: Mexico (1994), Southeast Asia
(1997-98) and Iceland (2006-07)
Discussion questions: Assigned for class
discussion/participation