The process of circular flow of income and product in a four sector opens economy explained

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An economy is normally a four sector Economy. In this economy there is another sector, called foreign trade or the trade with the rest of the world besides the other three sectors. Such an economy is called an open economy national income is computed by adding the difference between net export and net import. In the other words we add the value of our calculating national income in an open economy, we take into account the actual changes in net exports and imports when a country imports from the rest of the world it involves expenditure which constitutes a leakage from the circular flow.

The export of our country constitutes injection. Thus export receipt is called injection and import expenditure is called leakage. The flow of export and import pass through a sector called “balance of payments” sector which is influenced by various types of foreign trade policies. The equilibrium condition is restored when the total leakage must equal total injections. Thus in an open NNP is equal to C+I+G+(X-2) where NNP is net national product, C stands for consumption expenditure, I stands for investment and G stands for Govt expenditure, X and 2 refer to net export and net import.

Symbolically: NNP(Y) = C+I+G+(X-2)

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Under- four sector open economy injections must equal leakages to maintain the circular flow of economic activities. Under open economy the operation of the circular flow for bringing about macro equilibrium remains the same, only the nature of transactions and their adjustments undergo a change.

In the figure given below are shown the inflows and outflows of the household, business and Govt sectors in relation to the foreign sector. The household sector imports goods a broad for consumption and makes payment for them. The household may also receive transfer payments from foreign countries.

Business sector exports goods to foreign countries and receives income which constitutes an injection in the circular flow on the other hand; the business sector makes payments to the foreign sector for imports of capital goods and services from abroad. These are the leakages from the circular flow.

Government also exports and imports goods and services lend to and borrow from foreign countries. For exports Govt, receives income and for payment Govt makes payment to foreign countries. Besides export and lending operations Govt also earn incomes from foreigners from various sources.

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In the diagram given below the circular flow of the four sector open economy with saving, taxes and imports in one hand and investment, Govt purchases and exports on the other is shown, imports, exports and transfer payments have been shown to emerge from the three domestic exports such as household, the business and the Govt. If exports exceed imports, the economy has surplus balance of payments. And if imports exceed exports, it has a deficit in the balance of payments.

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