Which of the following helps to explain why a country in a recession is more likely to run a trade surplus?

Question

BlackTom AI · Accepted Answer

Using the open-economy savings–investment identity: net exports (NX) = domestic saving (S) − domestic investment (I). A recession tends to reduce both income and demand for investment, but investment typically falls more sharply than saving. If I falls more than S, S − I rises, producing a larger NX (a trade surplus).

Step-by-step reasoning:
1. Key concepts: NX = S − I (current account/current trade balance equals national saving minus domestic investment). Investment is procyclical and highly sensitive to business expectations; saving is related to income but may be less volatile in the short run.
2. Consider a numerical illustration: before recession S = 100, I = 110 → NX = 100 − 110 = −10 (trade deficit). During recession suppose saving falls slightly to 95 (people cut consumption but not all saving) while investment collapses to 80 (firms postpone projects). Then NX = 95 − 80 = +15 (trade surplus). This shows how a larger drop in I than in S raises NX.
3. Interest-rate channel: Falling investment reduces demand for loanable funds, which pushes domestic real interest rates down. Lower domestic rates can reduce capital inflows (or increase outflows), exerting downward pressure on the currency and supporting net exports further.

Why the correct choice is correct:
- The statement “domestic savings will drop by less than domestic investment, lowering interest rates” matches the identity and mechanism above: ΔI < ΔS (in absolute terms) raises S − I and lowers interest rates via reduced loanable-fund demand.

Why the other options are incorrect:
- “Exports more expensive and imports less expensive” would reduce NX, not increase it.
- “Financial assets more attractive to foreigners” implies greater capital inflows, financing a deficit rather than a surplus.
- “The currency is likely to strengthen” would hurt exports and worsen the trade balance, contrary to a surplus.

Conclusion: The correct answer is that domestic savings drop by less than domestic investment, lowering interest rates, which accords with NX = S − I and matches the provided answer.

Which of the following helps to explain why a country in a recession is more likely to run a trade surplus?Single choice

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