The Standard Accounting Identity for Economic Adjustment
We looked at this briefly in earlier posts, but to recap it is expressed as:
S − I = Y − E = X − M
where:
S = Savings
I = Investment
Y = Income
E = Expenditure
X = Exports
M = Imports
This can actually be expanded by breaking down “savings” into public and private savings such that:
( Sp + Sg ) − I = X − M
where:
Sp = Private savings
Sg = Government savings
Here, government “dis-saving” reflects having a budget deficit. Thus, from this, we can see immediately that there is a possible link between a budget deficit and a trade deficit. If a country’s budget deficit continues to rise, this is reflected on the left-hand side of the equation by an increasingly negative value for Sg . Unless this is offset by a rise in private savings or a fall in investment, this will eventually mean that the left-hand side of the equation turns negative. Of necessity in this circumstance, the right-hand side of the equation must also be negative, which in turn means that the country has a trade deficit. Thus, a budget deficit can lead to a trade or a current account deficit. The link is not necessarily automatic. However, it should be assumed that widening budget deficits, if sustained over time, lead to widening trade and current account deficits. If we extend this, we see that at some stage widening current account deficits will become unsustainable, requiring a real exchange rate depreciation. Thus, widening budget deficits may eventually require real (and thus nominal) exchange rate depreciation.
Economists are not generally thought of as prone to high emotion. Yet, one has to say that the accounting identity is like a work of great art, hiding great intricacy and complexity behind the veneer of apparent simplicity. From this accounting identity, we can see how economies adjust to changes in fundamental conditions and therefore how exchange rates should adjust to those conditions. Again, this is probably best shown through an example.