Imagine an economy in which Ricardian equivalence holds. The economy has a budget of 50, a trade deficit of 20, private savings of 130, and investment of 100. If the budget deficit rises to 70, how are the other terms in the national saving and investment identity affected?
The correct answer and explanation is :
Correct Answer:
If the budget deficit rises from 50 to 70, and Ricardian equivalence holds, then private saving will increase by exactly 20, keeping national saving unchanged. Therefore:
- Private Saving: Increases from 130 to 150
- Investment (I): Remains 100
- Trade Deficit (NX < 0): Remains 20
Explanation (Approx. 300 Words):
The national saving and investment identity in an open economy is given by:
[
\text{National Saving} = \text{Investment} + \text{Net Exports}
]
[
S = I + NX
]
Or, rearranged:
[
(S_{\text{private}} + S_{\text{public}}) = I + NX
]
Where:
- (S_{\text{private}}) is private saving.
- (S_{\text{public}} = T – G) is public saving, which is the negative of the budget deficit when (G > T).
- (NX) is net exports, which equals the negative of the trade deficit.
In the initial scenario:
- Budget deficit = 50 → (S_{\text{public}} = -50)
- Private saving = 130
- Investment = 100
- Trade deficit = 20 → (NX = -20)
So:
[
(130 – 50) = 80 = 100 + (-20)
]
Now, suppose the budget deficit rises to 70 → (S_{\text{public}} = -70)
Under Ricardian equivalence, people understand that higher deficits today mean higher taxes tomorrow, so they increase private saving to offset the future tax burden. Hence:
- Private saving increases by exactly 20 (from 130 to 150)
- National saving remains at 80
- Investment stays at 100
- Trade deficit stays at 20
Rechecking:
[
(150 – 70) = 80 = 100 + (-20)
]
So, under Ricardian equivalence, increased government borrowing does not change national saving, investment, or the trade deficit — because households fully offset the fiscal expansion by saving more.