The foreign sector is perhaps the hardest part of the circular flow to understand because we have to know how international transactions are carried out.
Some of the goods produced in an economy are not consumed by domestic households or firms in an economy but are instead exported to other countries. Whenever one country sells something to another country, it acquires an asset from that country in exchange. For example, suppose a US movie company sells DVDs to an Australian distributor. The simplest way to imagine this is to suppose that the distributor hands over Australian dollar bills to the movie company. The movie company—and, more generally, the US economy—has now acquired a foreign asset—Australian dollars.
Because these Australian dollars can be used to purchase Australian goods and services at some time in the future, the US economy has acquired a claim on Australia. In effect, the United States has made a loan to Australia. It has sent goods to Australia in exchange for the promise that it can claim Australian products at some future date.
Similarly, some of the goods consumed in our economy are not produced locally. For example, suppose that a US restaurant chain purchases Argentine beef. These are imports. We could imagine that the restaurant chain hands over US dollars to the Argentine farmers. In this case, the United States has borrowed from Argentina. It has received goods from Argentina but has promised that it will give some goods or services to Argentina in the future.
Of course, international transactions in practice are more complicated than these simple examples. Yet the insight we have just uncovered remains true no matter how intricate the underlying financial transactions are. Exports are equivalent to a loan to the rest of the world. Imports are equivalent to borrowing from the rest of the world.
If we import more than we export, then we are borrowing from the rest of the world. We can see this by looking at the flows in and out of the foreign sector:
borrowing from abroad = imports − exports.
If we export more than we import, then—on net—we are lending to the rest of the world, and there is a flow of dollars from the financial markets to the rest of the world.
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