Relationship between Gross Fiscal Deficit and Current Account Defi

Recall the demand side equation Y = C + I +G + X – M

~ Here we assume that the economy is open for foreign trade.
99 Re-writing the equation ® Y – C = I +G + X – M
Tweaking it further ® Y – C – T = I + G – T + X – M [We are bringing ‘– T’ on both sides]
Now, (Y – C – T) Þ (Income – consumption – tax) = Savings denoted as ‘S’
Hence we have, S = I + G – T + X – M
Here G = Government expenditure and T = Tax (or otherwise Government Income)
Therefore, G-T Þ Gross Fiscal Deficit (GFD)
In Similar vein, X = Income from exports and M = Expenses towards imports
Please understand that X – M is the same as writing – (M – X) [just a mathematical sign play]
What is (M – X)? It’s nothing but Current Account Deficit (CAD). When our expenses from
imports exceed income from exports). This can be done only through ‘Foreign Borrowings’
From the above arguments, we have (X – M) = – CAD (If you don’t understand, read over
again and again)
Finally, we have the equation, S = I + GFD – CAD

With this backdrop, we are good to explain the relationship between GFD and CAD
In general, for any economy, we assume I = f (S) ~ Investment is a function of Savings
(through rate of interest ‘i’). The story is ® investors borrow money to make productive
investments. And they borrow from banks. Where do banks get money from? It’s from the
people like us who save our extra income. So higher the savings, higher will be the money
available for investments (with banks working as intermediaries). So to make life simple we
assume for now that S = I.
In such a scenario, if the GFD s because of increased government expenditure (over and
above its revenue), how do they finance it? Look at the equation, we have to have the LHS =
RHS. The only way to do it is by ing CAD.
This ed CAD could be through ed foreign borrowing (to finance imports) or simply through
foreign loan (to finance increased domestic government expenditure).
Now, what does this ing CAD mean for an economy?
CAD ® higher demand for dollar in exchange of domestic currency. Higher the demand for
$ ® lower the value of domestic currency (otherwise known as depreciation of domestic
currency against dollar). If this happens, imports become even more costlier as we have to
pay more INR for our imports.
Further, ed GFD ® more supply of money in the economy. If this money is spent by the
government on unproductive avenues (non-income generating avenues) without any increase
in real output, it will lead to inflation.