Fundamental Relationship

[mrb102189]

I’m having touble with the fundamental relationship…whenever I come across problems asking about the deficit, I can only reason my way through it if I start with:
GDP=C+I+G+X-M=C+S+T….both these make sense to me…then I cancel the Cs and get to G=(S-I) - (X-M), but I still can’t seem to concptually make sense of this relationship? Can someone try and explain it in a very big picture way and then maybe with an example? I guess I’d just like to reason my way through it- why would very high savings lead to a deficit- is it because people’s savings (in savings accounts) don’t generate tax? I guess I don’t even see the connection between high exports and a defcit…is that too related to taxes?

 

[mrb102189]

Shoot- so sorry- I do know the correct formula is G-T=S-I - X-M….typo there…still having trouble with the logic tho

 

[mrb102189]

…or is it because is Investment is higher than savings, then there must have been net borrowing?

 

[daharmattan1]

Honestly, the way you’re combining IS/LM and the GDP equation in and of itself is confusing. Can you give more info?

 

[Harrogath]

This equation
(G-T) = (S-I) - (X-M)
tells you how a goverment deficit or surplus is financed. If there is a fiscal deficit, then (G-T)>0. So, that fiscal deficit must be financed by a combination of savings in excess of investment (S-I)>0 and with a deficit in the trade balance (X-M)<0. However, there could be more cases where the final impact of both sources must be calculated.
Lets see an example:
Suppose S=40, I=20, X=30 and M=15
Knowing this you can know how is the fiscal balance going.
(G-T) = (40-20) - (30-15) = +5
The result of (+5) indicates a fiscal deficit because taxes were 5 below the goverment spending.
The idea behind all this concept is that how would you finance those 5 units of deficit? Note that this means that the Goverment owes money. Look at each part:
(S-I) = (40-20) = +20 This means that savings were above investment by 20. Positive means that those savings were used by the goverment to finance its spendings through treasury notes, or another kind of debt papers.
-(X-M) = -(30-15) = -(+15) = -15 This means that those excess exports over imports were not a way to finance the fiscal deficit, because it is an inflow of capital or resources to the private sector, not to the public sector. If (X-M) < 0 then it would be a source of financing because you making an outflow of resources.
I know this is against common sense, but this is how you must see it to understand why in this case a trade balance surplus were not a source of financing the fiscal deficit. In net terms, the +20 net savings against the -15 net exports (as a source of financing) gives you a +5 use of resources by the goverment. This means 5 fiscal deficit.
Hope this could help. If you have any question, please ask.
Regards