Investment Identity

Definition

The investment identity is an accounting identity that describes the relationship between national saving, investment, and the current account balance. It states that the difference between national saving and domestic investment must be equal to the current account balance, which represents the net flow of capital between a country and the rest of the world.

5 Must Know Facts For Your Next Test

1. The investment identity is an important concept in macroeconomics, as it helps explain the relationship between a country's saving, investment, and trade balance.
2. The investment identity can be expressed mathematically as: National Saving - Domestic Investment = Current Account Balance.
3. If a country's national saving exceeds its domestic investment, the excess saving is used to finance investment in other countries, resulting in a current account surplus.
4. Conversely, if a country's domestic investment exceeds its national saving, the country must borrow from other countries to finance the investment, resulting in a current account deficit.
5. The investment identity is a fundamental accounting identity that must hold true, as it reflects the basic national income accounting principles.

Review Questions

• Explain the relationship between national saving, domestic investment, and the current account balance as described by the investment identity.
  • The investment identity states that the difference between national saving and domestic investment must be equal to the current account balance. If national saving exceeds domestic investment, the excess saving is used to finance investment in other countries, resulting in a current account surplus. Conversely, if domestic investment exceeds national saving, the country must borrow from other countries to finance the investment, resulting in a current account deficit. This relationship is a fundamental accounting identity that must hold true, as it reflects the basic national income accounting principles.
• Describe how changes in national saving and domestic investment can affect a country's current account balance.
  • According to the investment identity, if a country's national saving increases relative to its domestic investment, the current account balance will improve (become more positive or less negative). This is because the excess national saving can be used to finance investment in other countries, leading to a current account surplus. Conversely, if a country's domestic investment increases relative to its national saving, the current account balance will worsen (become more negative or less positive) as the country must borrow from other countries to finance the additional investment, resulting in a current account deficit.
• Analyze the implications of a country persistently running a current account deficit in the context of the investment identity.
  • A persistent current account deficit, as described by the investment identity, indicates that a country's domestic investment is exceeding its national saving. This means the country must borrow from other countries to finance the additional investment, which can lead to a buildup of foreign debt over time. This can have several implications, such as increased vulnerability to external shocks, potential currency depreciation, and the need to service the growing foreign debt, which can constrain the country's economic growth and policy options. Understanding the investment identity can help policymakers address the underlying causes of persistent current account deficits and implement policies to improve the country's saving-investment balance.

Related terms

National Saving:

The total amount of saving by households, businesses, and the government sector within a country.

Domestic Investment:

The total amount of investment in physical capital, such as machinery, equipment, and structures, within a country.

Current Account Balance:

The difference between a country's exports and imports of goods, services, and net income from abroad.