The Foreign Sector

The foreign sector includes households, businesses, and governments that reside in other countries. The domestic economy trades goods with the foreign sector through exports and imports. This foreign trade is an extension of regular market activity, except the buyers and sellers reside in different countries.

• Exports: Goods produced by the domestic economy that are purchased by the foreign sector are exports.


• Imports: Goods produced by the foreign sector and purchased by the domestic economy are imports.

Aggregate Expenditures: The C + I + G + (X - M) Line

C + I + G + (X - M) Line

• The three-sector aggregate expenditures line, labeled AE = C + I + G is displayed in this diagram. It contains expenditures by the three domestic sectors.


• Net exports add another layer to this stack. Click the [Add Net Exports] button to add this layer. In this model, imports are realistically assumed to be induced and increase with the level of aggregate production. Because induced imports are subtracted from exports, this net exports layer shrinks with larger aggregate production levels and even becomes negative. This is the four-sector aggregate expenditures line.


• The induced nature of net exports means that the slope of the four-sector aggregate expenditures line is less than the slope of the three-sector aggregate expenditures line, which (assuming that investment, government purchases, and taxes are all autonomous) is the marginal propensity to consume .

By way of contrast, net exports do not highlight any comparable aspects of the macroeconomy. As such, the foreign sector and net exports are not needed for most of analyses of the macroeconomy.

An Equilibrium Guide: The 45-Degree Line

45-Degree Line

The most important feature of the 45-degree line is that is contains every point in the diagram in which aggregate production is equal to aggregate expenditures. In other words, if you pick an aggregate production value, such as $5 trillion, move vertically to the 45-degree line, then take a right turn to the vertical axis, you reach an equal $5 trillion value for aggregate expenditures.

Because this 45-degree line contains EVERY potential equilibrium value for the four-sector Keynesian model, equilibrium MUST take place somewhere ON this line. Exactly where equilibrium occurs, however, depends on the aggregate expenditures line.

We often find it convenient to give this guide line the label of Y = AE, where Y is the common designation for aggregate production and AE is the abbreviation for aggregate expenditures. Such a label descriptively indicates that this is, in fact, the equilibrium guide line for the Keynesian model.

The Equilibrium Intersection

Equilibrium

Equilibrium is achieved at the intersection of the 45-degree line and the aggregate expenditures line. Click the [Equilibrium] button to identify this point and corresponding aggregate production.

• Equilibrium is achieved with $15.5 trillion of aggregate production. At this level, aggregate expenditures are also $15.5 trillion.


• Only at $15.5 trillion are aggregate expenditures equal to aggregate production. At every other production level, aggregate expenditures are either greater than or less than aggregate production.


• At this $15.5 trillion level, there are no economy-wide surpluses or shortages because buyers buy all they want and sellers sell all they have.


• The lack of surpluses and shortages means that we have equilibrium. Neither buyers nor sellers are dissatisfied with this condition, and thus have no reason to alter the production level.


• A key indicator of this equilibrium is business inventories -- stockpiles of raw materials and finished goods. The business sector has no unexpected, or unplanned, changes in inventories.

Two Other Variations

• Two-Sector Model: The simplest Keynesian model includes the household and business sectors. Also termed the private sector Keynesian model, this variation is often used to illustrate the basic operation of the model, including adjustment to equilibrium and the multiplier process. The two-sector model captures the role of induced expenditures through household consumption and the role of autonomous expenditures through business investment.


• Three-Sector Model: Perhaps the most commonly analyzed variation of the Keynesian model adds the government (or public) sector to the household and business sectors contained in the two-sector model. This variation is used to analyze government stabilization policies, especially how fiscal policy changes in government purchases and taxes can be used to close recessionary gaps and inflationary gaps.