The International Sector

The final improvement necessary for the model to reflect the important features of a modern market economy is to include international trade by introducing the terms X (exports) and Z (imports), as shown here:

Imported goods and services, which may be purchased by our domestic households, firms and government, are produced by foreign resources and contribute to foreign aggregate demand. Exports, on the other hand, are purchased by foreign entities and represent an addition to domestic aggregate demand. Imports are analogous to household savings and taxation in that they represent a withdrawal from the circular flow of income, while exports are analogous to government expenditure and business investment in that they represent an injection to the circular flow of income. Equilibrium national income (GNP=GNI) is achieved when S+T+Z=I+G+X. As with balancing the government budget by comparing G and T, it may also be necessary to pay special attention to the balance between X and Z. When imports are higher than exports, foreign currency reserves will be falling, which cannot last indefinitely. When exports are higher, currency reserves will increase and eventually continued accumulation of reserves will serve no useful purpose.

The final relationships between changes in each variable and consequent changes in national income are:

·         A given change in S, T or Z causes national income to change in the opposite direction with magnitude of the original change times the multiplier minus one. This is because there is no initial change in demand caused by the change in S, T or Z itself.

·         A given change in I, G or X will cause national income to change in the same direction, with magnitude of the original change times the multiplier.

To build a model, we will make the same assumptions as above, and additionally we will assume that X is exogenous (it is determined by the level of demand in foreign nations), and that Z changes linearly with Y by a factor i, the marginal propensity to import. The following is a definition of the new model:

The solution to this model is:

                        

International trade causes the national income of any nation to be linked through imports and exports to the national incoe of other countries. The major factor influencing imports is likely to be the level and rate of growth of real incomes in other trading nations. Exports, on the other hand, are likely to be most influenced by domestic incomes. Changes to the national income of one nation are therefore likely to have an effect on national incomes in other nations. The magnitude of these resulting changes will depend on the level of national income in the economy considered and the proportion of national income which enters international trade.

In the post-WWII period, the degree to which the world’s economies are interlocked is reflected in the ‘convoy theory’ which states that sustained growth in any one economy is only possible if all the major economies of the world act in a concerted fashion. If all economies experience similar amounts of growth, then there are no unfavorable balance of trade problems. However, if one economy attempts to stimulate growth faster than that of the world as a whole, then its balance of trade will become problematic since exports will only increase at the ‘world’ growth rate, but more imports will be ‘sucked in’ by the faster domestic growth rate.