Let us determine the equilibrium in an open economy in which the economic transactions takes place among different countries.
A four-sector model of economy includes households, businesses, government, and foreign trade.
In four-sector economy, exports are the injections in the national income, while import act as leakages or outflows of national income.
While determining national income, the difference between net exports and imports (X-M) is considered. The injections are responsible for increasing the national income while leakages or outflows result in decrease in national income. When X > M, there is net injection; therefore, there would be an increase in national income.
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On the other hand, in case X < M that is net leakages, the national income would decrease. For determining the national income with foreign sector in a four-sector economy, let us learn about export and import functions in next sections.
Export Function:
The growth of any economy and distribution of income and wealth in a country are directly associated with exports. Exports play a crucial role in internal trade and economic stability of a country. Moreover, it helps in increasing foreign exchange reserves in a country. The exports of a country are dependent on various factors.
Some of these factors are as follows:
a. The prices of domestic goods as compared to prices of goods in importing countries
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b. Trade and tariff policies of importing countries
c. Export subsidies
d. Income elasticity for import goods in importing countries
e. Level of imports by the domestic country
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Among the aforementioned factors of exports, only prices of domestic goods and export subsidies can be controlled by the domestic country. The other factors are related to the policies of importing countries.
Therefore, it is assumed that the export is determined by the factors that are outside the economy. Thus, while determining national income, export is taken as autonomous variable and denoted by X.
Import Function:
Similar to exports, imports also play an important function in the growth of an economy. It helps in strengthening the global presence of a country. The imports of a country are dependent on various factors.
Some of them are as follows:
a. Import prices in relation to domestic prices
b. Domestic tariffs level
c. Domestic trade policy
d. Income elasticity of imports
e. Income levels
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f. Export levels
For determining the national income, it is assumed that import depends on domestic income level (Y) and marginal propensity to import (MPM).
Therefore, the import function would be:
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In case b=g, then the foreign trade multiplier is equal to one.
Foreign Trade Multiplier with Tax Function:
Foreign trade multiplier becomes more complicated when tax function (T) is added to equation 9.
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After including the tax function in the national income of four-sector economy, the equilibrium equation would be: