Four sector model of circular flow in open economy
So far the circular flow of income and expenditure has been shown in the case of a closed economy. But the actual economy is an open one where foreign trade plays an important role. Exports are an injection or inflows in the economy.
They create incomes for the domestic firms. When foreigners buy goods and services produced by domestic firms, they are exports in the circular flow of income. On the other hand, imports are leakages from the circular flow. They are expenditures incurred-by the household sector to purchase goods from foreign countries. These exports and imports in the circular flow.
Take the inflows and outflows of the household business and government sectors in relation to the foreign sector. The household sector buys goods imported from abroad and makes payment for them which is a leakage form the circular flow The households may receive transfer payments from the foreign sector for the services rendered by them in foreign countries. Exports & Transfer Payments, Foreign Sector, Imports, Imports, Transfer Payment, Government Purchases, Government Sector, Taxes. Investment, Capital Market, Saving Taxes, Consumption Expenditure Transfer Payment Social Services, Product Market, Business Sector, Household Sector, Factor Market, Income Payments.
On the other hand, the business sector exports goods to foreign countries and its receipts are an injection in the circular flow. Similarly, there are many services rendered by business firms to foreign countries such as shipping, insurance, banking, etc. for which they receive payments from.
They also receive royalties, interests, dividends, profits, etc. for investments made in foreign countries. On the other hand, the business sector makes payments to the foreign sector for imports of capital goods, machinery, raw materials, consumer goods and services from abroad. These are the leakages from the circular flow. Like the business sector, modern governments also export and import goods and services, and lend to and borrow from foreign countries. For all exports of goods, the government receives payments from abroad.
Similarly, the government receives payments from foreigners when they visit the country as tourists and for receiving education, etc. and also when the government provides shipping, insurance and banking services to foreigners through the state-owned agencies.
It also receives royalties, interest, dividends etc. for investments made abroad. These are injections into the circular flow. On other hand, the leakages are payments made for the purchase of goods and services to foreigners. Figure 3 shows the circular flow of the four-sector open economy with saving, taxes and imports shown as leakages from the circular flow on the right hand side of the figure and investment, government purchases and exports as injections into the circular flow on the left side of the figure.
Further, imports, exports and transfer payments have been shown to arise from the three domestic sectors- the household, the business and the government. These outflows and inflows pass through the foreign sector which is also called the “Balance of Payments Sector”
If exports exceed imports, the economy has a surplus in the balance of payments. And if imports exceed exports, it has a deficit in the balance of payments. But in the long run, exports of an economy must balance its imports. This is achieved by the foreign trade policies adopted by the
The whole analysis can be shown in simple equations: Y-C+I+G (1)
Where Y represents the production of goods and services, C for cumption expenditure, I investment level in the economy and G for gemment expenditure respectively. Now we introduce taxation in the model to equate the government
Therefore, Y=C+S+T…(2) Where S is saving T is taxation by equating (1) and (2), we get
S+I+G=C+S+T I+G=S+T
With the introduction of the foreign sector, we divide investment into domestic investment (id) and foreign investment (1,) and get
But 1,-X-M
Where X is exports and M is imports
L₂+(X-M)+G=S+T +(X-M)=S+(T-G)
The equation shows the equilibrium condition in the circular flow of income and expenditure.
