Income and Output Determination: Four Sector Economy

The Keynesian macroeconomic model with four sectors consists of the household sectors, business firms, government, and foreign sector. The four sector model depicts the overall macroeconomic model proposed by Keynes including the interaction between domestic and foreign market. Due to the presence of foreign sector, the determination of income/output equilibrium under four sector is influenced by net exports as well.

The inclusion of foreign sectors results in the exchange of goods and services from domestic industries to foreign countries in the form of imports and exports. Imports refer to any foreign produced goods that are purchased by the domestic economy. While, exports are any domestically produced goods that are sold to the foreign market. Imports are subtracted from exports to derive net exports, which is a contribution to aggregate expenditure from the foreign sector.

Determination of Equilibrium Output/Income

The determination of equilibrium income/output in the four sector is possible with both aggregate expenditure-aggregate output method as well as leakages-injections method.

The aggregate expenditure method in a four sector economy can be obtained by summing up the consumption expenditure of household sector (C), business investment expenditure (I), government purchase expenditure (G), and net foreign demand. Symbolically,

AE= C + I + G + (X – M)

Where, (X – M) = Exports – Imports

Three condition to be considered when including net exports in the determination of equilibrium income are

  • Exports greater than imports that is X – M > 0, result in foreign trade surplus. This means that the domestic economy is earning more from the transaction of goods and services with the foreign markets. Therefore, the value of domestic goods are greater than foreign goods.
  • Imports greater than exports that is X – M < 0, results in foreign trade deficit. This suggests that the domestic market is importing more goods and service than it is exporting to the foreign markets. Thus, the value of foreign goods are greater than domestic goods and services.
  • Net export is equal to zero that is X – M = 0, states foreign trade balance. This means that imports and exports are in balance with no surplus or deficit. In this case, the value of equilibrium output/income in a four sector economy will be equal to the value of equilibrium output/income in a three sector economy.

Other things remaining equal, the income and output of domestic economy will increase with the rise in the level of exports and decrease with the fall in imports. On contrary, the income and output levels fall with the increases in import levels and decrease with the fall in the level of exports. Thus, the factors that determine an economy’s exports and imports should be studied to know their effect on the equilibrium level of income and output.

Determinants of Exports (X)

A number of factors in an economy affect the export of goods and services. Generally, the volume of exports of an economy depends on the following factors

  • Prices of goods in the domestic economy relative to the prices of the same or substitute goods in other economies
  • The level of income in other countries
  • Tariff and other trade policies between the domestic and foreign economies
  • The level of imports made by the domestic economy

In determining the equilibrium level of income/output, the four sector assumes that exports are determined by the external factors outside of the domestic economy. So, exports are assumed to be autonomous variables that are bound to change only through the influence of external factors.

Symbolically, it is represented as

X = Xa

Where, Xa is the autonomous value of exports

Determinants of Imports (M)

Most factors that affect the imports of the economy are related to the conditions within the domestic economy. Other things remaining constant, imports made by an economy is a positive function of the economy’s income. So, the import levels of an economy increases with the growth in their income level. The import function based on the importing country can be expressed as

M= Ma + mY

Where, M = Level of Imports

                Ma = Autonomous import [Imports at theoretically zero level of income; factors affecting import other than income]

                m = Marginal propensity to import (MPM) [Ratio of change in imports to change in income; ΔM/ΔY]

The export and import functions can be explained with the following diagram

Figure: Export and Import function

The line XX1 represents autonomous export and is parallel to the income/output axis since export is assumed to be affected only by external factors which are not in control of the domestic economy. OX is the autonomous exports denoted by Xa. Since import is a positive function of a country wanting to import, it is an upward sloping line. The line with the equation M= Ma + mY represents autonomous imports.

OS represents autonomous imports denoted by Ma. The model assumes imports to be induced which increase with the aggregate level of output and income. The point P in the diagram is the equilibrium point where the import line SM intersects the export line XX1. Foreign trade is balanced at point P, while, the trade is running at deficit to the right of point P, and foreign trade is at surplus to the right of point P. When the income level increases beyond the point Y1, imports of an economy increase and trade deficit exists.