The following points highlight the top three effects of Fiscal Policy on the Balance of Trade. The Effects are: 1. Domestic Fiscal Policy 2. Expansionary Fiscal Policy in the Rest of the World (ROW) 3. Effect of an Investment Tax Credit

Effect # 1. Domestic Fiscal Policy:

Suppose the government of the home country spends more. If G increases, S will now be less than the fixed level of investment at an unchanged r*.

Now the excess of domestic investment over domestic saving has to be covered by borrowing funds from abroad.

A fall in S auto­matically leads to a fall in NX = (S-1). This means that an increase in G creates a trade deficit in a small open economy, which initially started from a posi­tion of trade balance (i.e., neither a deficit nor a surplus).


A cut in taxes has the same adverse effect on trade balance. If the government reduces taxes (T), disposable income (Y – T) rises, consumption in­creases and national saving falls. Since NX = S – I, a fall in S reduces NX.

Fig. 6.2 shows how fiscal policy reduces national saving. A change in fiscal policy that in­ creases C or G reduces (Y – C – G). This shifts the vertical saving line leftward from S0 to S1. Now, NX, which is excess of S over I, falls. So, an expansionary fiscal policy creates a trade deficit.

Effect of an Expansionary Fiscal Policy on Saving

Effect # 2. Expansionary Fiscal Policy in the Rest of the World (ROW):

Now suppose the foreign governments increase their expenditures. This reduces saving of the ROW. As a result, the world rate of interest rises.


The increase in r reduces the volume of investment in the small open economy by raising the cost of borrowing. Since there is no change in S, S now exceeds I. Since financial capital has an extra temptation to go abroad, a portion of this excess domestic saving will now flow to ROW in search of higher return. Thus, a fall in I will also increase the balance of trade (or, NX = S – I).

Fig. 6.3 shows the effects of the adoption of an expansionary fiscal policy on a small open economy. In this case, domestic saving and investment curves remain unchanged. However, a rise in the world interest rate from r1* to r2* converts a situation of balanced trade to a surplus (measured by the distance EF).

The difference between the two situations is that in Fig. 6.2, the trade deficit (M – X = S – I) results at the original real rate of interest (r1*). But in Fig. 6.3, trade surplus results because of a rise in the world rate of interest from r1* to r2*. Since fiscal expansion abroad leads to a rise in r, it generates an excess of domestic saving over domestic investment and this is the trade surplus: X- M = S- I.

Effect of an Expansionary Fiscal Policy on the BOT

Effect # 3. Effect of an Investment Tax Credit:

An attractive fiscal concession offered by modern governments to business firms is invest­ment tax credit or an investment subsidy. This type of positive fiscal policy has a favourable effect on investment. Fig. 6.4 shows that if such a fiscal concession is offered, the investment demand curve shifts to the right. This means that investment demand increases at every rate of interest.


Thus, at the prevailing world interest rate (r1*) the volume of investment is now higher. So, there is an excess of I over S (since S remains unchanged). This has to be financed by foreign borrowing. This means that the net outflow of capital negative (or net capital inflow is positive). Alternatively interpreted, since: NX = S – I, an increase in I implies a fall in NX.

Adverse Effect of an Investment Tax Credit on BOT