Economists believe that any development in the US economy truly depends on its trading partners. This theory has been set up to understand that a co-relation between the US economy and its partners will lead to an increase in the current account deficit even though it might be witnessing depreciation. A thorough study of this concept also shows that only if there is a restructuring of the US economy such as increase in the amount of savings and opening up to the world for US exports would be able to solve the looming concern of current account deficit.


Based on the Keynesian income model, this theory believes:




Desired aggregate demand is the sum of consumption (C), investment (I), government spending (G) and the current account surplus (X-M)


E = C + I + G + X – M


Here, the most relevant component is consumption, which would eventually depend on the disposable income C = f(Yd) that is available for the user to be able to buy goods and services. In its common form, according to the Keynesian consumption function, consumption is:


C = a + b Yd


In such a scenario, it is also assumed that disposable income is income minus the taxes:


Yd = Y – T


Going by the consumption function, i.e. C = a + b Yd , two components to consumption exist that require thorough study. Where a represents autonomous consumption or the amount of money that people would splurge irrespective of how much they earn currently, bYd is the induced consumption.


C = a + b Yd

•          b represents the marginal propensity to consume


•         There is a similar propensity for savings:


•         Since all disposable income is either consumed or saved….

MPC + MPS = 1



With the use of an income and consumption function, it becomes easy to derive a savings function:

Income is: 


Yd = C + S


Consumption function is:

C = a + b Yd

So income is:


Yd = a + b Yd + S




Yd  - a – b Yd = S

 - a + (Yd  – b Yd) = S

S = -a + (1 - b) Yd






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