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Questions › GATE › GATE 2021 › Q17
1 mark, −0.333International Economics › Open-economy macroeconomics › Internal and external balance, twin deficitsHardabout 3 min

GATE 2021 Question 17: Open-economy macroeconomics

For an open economy, the 'twin deficits' can be expressed by: [where S = Savings; I = Gross Private Investment; G = Government Expenditures; TR = Transfer Payments; TX = Taxes; X = Exports; M = Imports and NFIA = Net Factor Income from Abroad]

Tap an option to check your answer.

Answer and worked solution

Answer: (C)

Starting from the national income identity: Y=C+I+G+X−MY=C+I+G+X-MY=C+I+G+X−M.

Private disposable income is Y−TX+TRY-TX+TRY−TX+TR, and private saving is what's left after consumption: S=(Y−TX+TR)−CS = (Y-TX+TR) - CS=(Y−TX+TR)−C, so C=Y−TX+TR−SC = Y-TX+TR-SC=Y−TX+TR−S.

Substituting into the national income identity:

Y=(Y−TX+TR−S)+I+G+X−MY = (Y-TX+TR-S)+I+G+X-MY=(Y−TX+TR−S)+I+G+X−M 0=−TX+TR−S+I+G+X−M0 = -TX+TR-S+I+G+X-M0=−TX+TR−S+I+G+X−M S−I=(G+TR−TX)+(X−M)S-I = (G+TR-TX)+(X-M)S−I=(G+TR−TX)+(X−M)

This says: the gap between private saving and investment equals the government's fiscal deficit (G+TR−TXG+TR-TXG+TR−TX, i.e. spending plus transfers minus tax revenue) plus the trade surplus (X−MX-MX−M) — the 'twin deficits' framing comes from rearranging this to show how a government deficit and a trade deficit tend to move together, other things equal.

This matches option (C) exactly (verified by direct algebraic derivation from the national income identity, not just formula recall).

The trap: (A) S−I=[G−TR−TX]+[X−M]S-I = [G-TR-TX]+[X-M]S−I=[G−TR−TX]+[X−M]

Option (A) is very close to the correct identity but has the sign on TRTRTR flipped (G−TR−TXG-TR-TXG−TR−TX instead of G+TR−TXG+TR-TXG+TR−TX) — since transfer payments are government spending from the perspective of the fiscal balance (money going out, alongside G, not against it), a sign error here is an easy slip for a student re-deriving the identity under time pressure.

Plain-text version

For an open economy, the 'twin deficits' can be expressed by: [where S = Savings; I = Gross Private Investment; G = Government Expenditures; TR = Transfer Payments; TX = Taxes; X = Exports; M = Imports and NFIA = Net Factor Income from Abroad] (A) S-I = [G-TR-TX]+[X-M] (B) I-S = [G+TX-TR]+[M-X] (C) S-I = [G+TR-TX]+[X-M] (D) I-S = [TX-G+TR]+[NFIA]

Open-economy macroeconomics has come up 55 times in 7 exams since 2006.

What this question tests

This question is on Internal and external balance, twin deficits, part of Open-economy macroeconomics in International Economics.

Reaching full employment and external balance together, and the link between budget and trade deficits.

TestStop has 5 past-paper questions on this subtopic; the nearest in year are below.

  • IIT JAM 2021 · Q46In a small open economy, desired domestic savings S^d = 10 + 100 r^w and desired domestic investment I^d =…
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