The international sector
The international sector includes exports (X), which add to to the value of aggregate demand, and are an injection into the circular flow of income, and imports (M), which reduce aggregate demand, and are a withdrawal from the circular flow. The more trade a country undertakes the ‘open’ it is said to be.
The UK is an important trading economy, with 50% of its trade being with the EU area, North American and Japan.
Exchange rates and equilibrium
Changes in exchange rates affect both imports and exports. A rise in the exchange rate will make exports more expensive and imports cheaper, and a fall in the exchange rate will reduce export prices, but increase import prices. Changes in exchange rates will encourage households and firms, at home and abroad, to alter their behaviour, as they would whenever price changes.
The Classical view is that if exports and imports become unbalanced, changes in the exchange rate will bring the international sector back into balance. For example, a temporary deficit, involving imports rising above exports, would lead to a fall in the value of the domestic currency. This is because the demand for the currency falls relative to the supply, reducing export prices, and raising imports prices. This should help to stimulate exports in the future and constrain imports, helping the economy to move back towards equilibrium.