CIRCULAR FLOWS OF INCOME AND EXPENDITURE WITH FOREIGN SECTOR: A FOUR-SECTOR MODEL : 

Q.4 Explain circular flows of income and expenditure in a four-sector model. 

Ans: The four-sector model is formed by adding the foreign sector to the three-sector model. 

The foreign sector includes two types of international transactions : 

(i) Foreign Trade i.e. export and import of goods and services, and 

(ii) Inflow and Outflow of capital. 

For the purpose of simplicity, we make the following assumptions : 

(a) The foreign sector includes only exports and imports of goods and services; 

(b) Only firms make exports and imports of goods and non-labour services; and 

(c) The households export only labor. 

The four-sector model is shown in the following figure :

Exports (X) [ Injection ]: 

In the case of exports, there is 

-- outflow of goods and services from the economy, and 

-- inflow of money (foreign exchange) in the form of “receipts from export” into the economy. 

This is the flow of foreign incomes into the economy. Thus exports (X) represent injections into the economy. 

IMPORT (M) [WITHDRAWAL]: 

In the case of imports, there is 

-- inflow of goods and services into the economy, and, 

-- outflow of money (foreign exchange) in the form of “payment for imports” from the economy. 

This is the flow of expenditure out of the economy. Thus, imports (M) represent withdrawals from the economy.

EXPORT OF MANPOWER [INJECTION]:

The households export manpower to the foreign sector. In return, they get foreign remittances in terms of foreign exchange. This is another inflow of income into the economy. So it is injected into the economy.

Effect of Foreign Trade : 

The effect of foreign trade on the magnitude of circular flows depends upon the trade balance. The trade balance is defined as X – M

If X > M, the inflow of foreign income is greater than the outflow of money (expenditure). There is a net gain from foreign trade. This increases the magnitude of circular flows. 

But if X < M, the inflow of foreign income is less than the outflow of money (expenditure). There is net loss from foreign trade. This reduces the magnitude of circular flows. 

And If X = M, the inflow of foreign income is equal to the outflow of money (expenditure). There is no net effect from foreign trade. The magnitude of circular flows remains unchanged.

The Equilibrium Condition : 

 The total expenditure (E) of the economy is the sum of consumption expenditure(C), Investment(I), Government expenditure(G), and, Exports(X). Symbolically, E = C + I + G + X ….(I) 

 The total income (Y) received is allocated between Consumption(C), Saving(S), Taxes(T) and Imports(M). Symbolically, Y = C + S + T + M …. (ii) 

 If total expenditure (E) is equal to total income(Y) received, (i.e. E = Y), then C + I + G + X = C + S + T + M …(iii) 

 The term C is common on both side, therefore C is cancelled out. Therefore, I + G + X = S + T + M …(iv) 

The equation(iv) clearly says that injections such as investment expenditure(I), Government expenditure(G), and Exports (X) are equal with total withdrawals such as Savings(S), Taxes(T) and Imports(M). Thus, re-arranging the equation (iv) we have, (I – S) + (G – T) + (X – M) = 0 

The equilibrium level of income is determined when total leakages are equal to total injections.