Now we shall discuss the equilibrium level of national income in a four sector economy. The fourth important sector of an economy is the external sector or the foreign trade sector. All the economies of the world today are open economies which interact with the rest-of-the world. A country imports items (goods and services) sheikh are in short supply or which are produced at a comparatively higher cost. In order to import, a country has to export. Overseas or foreign buyers also make demand for the domestic goods.

Net exports are defined as exports minus imports. This is also know as balance of trade. Balance of trade is a statement showing the exports and imports of merchandise (material goods) of a country in year’s time. Balance of trade also affects the level of GDP.

Net export faction is estimated as a difference between (A) export function (X) and (B) import function (m

How much a country can export depends upon the spending decisions made by the foreign households and firms that purchase domestic goods and services. Thus, exports are influenced by the outside forces or exogenous spending.

There are many reasons for this, like incomes of other countries: price differences in the goods produced by the domestic economy and its competitors; quality differences in the goods produced by the domestic economy and its competitors: tastes, preferences, customs and traditions of the consumers abroad; various commercial policies (like tariffs, quotas, exchange restrictions, etc.); availability of exchange reserves; natural resources; political factors and trading blocs. etc. Many of these factors are not determined in or by the domestic market. In addition. Some of them are slow to change and can be considered to be constant in the short run. The implication is that exports can be regarded as autonomous – independent of the domestic level of income.

Accordingly, export function s shown by a horizontal straight line, as in (i) below. It indicates that exports remain constant at different level f domestic GDP).

Imports of a country, however, depend upon the spending decisions of the domestic residents. Residents of country often make demand for foreign made goods and services. As the GDP rises, the residents of a country can spend more on the imported goods implying positive relationship between imports and real GDP. Import function may be stated as follows.

M= mY

where m is marginal propensity to import or slope of the import function.
This is shown in as an upward rising curve. At ‘O’ income level, import is also zero. As income increase, imports also increase. Line M is the import function. It starts from the origin and increases as income increases. Slope of the import function indicates marginal propensity to import (m). Lower the m, steeper the import function to X-axis and vice-versa.

Net exports refer to the difference between exports and imports. Desired net exports are negatively related to GDP because of the positive relationship between desired impost and GDP.

The negative relationship between net exports and GDP is called the net exports function.

This negative relationship can be easily explained as follows.
Export function (which is an injection t the flow of income) is assumed to be autonomous, and hence a horizontal straight line. Imports increase (this is treated as a withdrawal) as level of real income raises. Obviously, when increasing values of import are deducted from a constant value of exports we will get decreasing values of net exports in relation to increasing level of real income. Diagrammatically, net export function has been derived as the net of export and import function. This is shown in.

At Zero income, exports = 50, imports = 0. As real income increases, autonomous exports assumed to remain constant at 50. Imports increase; marginal propensity to import is assumed to be 0.25. Therefore, the trade surplus falls. As imports keep increasing, M and X become equal when level of income is 200. With a further increase in real income. net exports become negative, i.e., balance of trade turns, negative.

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