In the circular flow model that I use for labor income and capital income, as imports rise so does gross saving. How does this happen?
Here is the model as a closed economy without imports and exports.
This graph uses 1st quarter 2011 data and then simply takes out imports and exports. Now look at gross saving, $3,059 billion. Part of that money is then lent to the government, $1,391 billion. The remainder is used for investment. So we have the equality...
S - I = G - T
G = govt. spending... T = net taxes... S = gross saving... I = investment
Let's look at it another way. The row for leakages is equal to the row for injections. Here is the equation and then simplified. (C = consumption)
C + T + S = C + G + I
T + S = G + I
(S - I) = (G - T)
Now we will open up this model to foreign markets. Here is the data from 1st quarter 2011 including imports and exports.
I want you to see that gross saving increased from $3,059 billion to $5,370 billion. The increase was $2,311 billion... the same amount as imports.
So how do imports directly raise gross saving?
When we buy an import, where does our money go? It goes into the foreign exchange market. The exporter then receives their own currency from the foreign exchange market. And our dollars remain in the foreign exchange market.
But now what happens with the dollars sitting in the foreign exchange market? Theoretically they must come back to the United States to either purchase US assets, goods and services (exports) or to be invested in the United States. Theoretically, those dollars sitting in the foreign exchange markets are part of the gross saving of the United States. Thus, gross saving in graph #2 includes money in the foreign exchange market.
So what do we see happen in graph #2? Of the $2,311 billion that went into the foreign exchange market from imports, $1,855 billion came back from the foreign exchange market when foreigners bought US goods and services. We see that $1,855 billion leaving the "Lend (-)/borrow" entry going to the export entry.
So what happened with the $456 billion difference between imports and exports that was still left in the foreign exchange market? That $456 billion moved right down into the investment entry of $2,124 billion. That $456 billion was eventually invested in the United States.
In effect, exports lowered investment, while imports raised gross saving for investment.
So then what does the entry for net exports of -$456 billion mean? In effect, the entry of -$456 billion of net exports is an accounting entry to close the books at the end of the year representing the money that flowed back from the foreign exchange market for investment in the US.
Correcting the Twin Deficits Hypothesis
In the circular flow model above, look at the row where the leakages are. The equation there is...
C + T + S - M
C = consumption... T = net taxes... S = gross saving... M = imports
Now look at the row for "injection returns/expenditures". The equation is...
C + G + I + X - M
C = consumption... G = govt spending... I = investment... X - M is net exports
Now the two equations above are equal.
C + T + S - M = C + G + I + X - M
We now cancel out C and M from both sides.
T + S = G + I + X
(S - I) + (T - G) = X
Some of you should be saying... "That can't be right, the correct equation is..."
(S - I) + (T - G) = (X - M)
This is the equation usually seen. It comes from the Twin Deficits Hypothesis. The implication of this equation is that as the govt budget deficit increases, G>T, holding saving constant, that either investment must fall to maintain the trade balance, imports must rise or exports must fall. Basically, government deficits worsen the economy.
However, once you realize that imports create an equal amount of savings for investment, you will realize that the correct equation is...
(S - I) + (T - G) = X
Imports are inside saving, S. From the above graph, the equation comes out like this...
(5370 - 2124) + (1621 - 3012) = 1855
1855 = 1855
One way to understand this equation is like this... If you increase the government deficit by raising G in the equation, holding exports constant since it is determined by foreign demand, investment falls. However, a country does have the option to raise saving by importing more. Then investment will not fall.
This concept is not understood in the Twin Deficits hypothesis because it sees increased imports as bad. Where in fact, increased imports create the extra saving to keep investment stable.
Currently, people want to support investment. Maybe by increasing imports, we can support investment. But really, raising labor income is still the best way to raise domestic investment. The result would be increased consumption and increased saving through more imports.