Of course, the domestic economy does not exist in isolation, with the United States floating in its own little economic bubble. The United States is part of the much larger world economy. The foreign sector refers to the rest of the world.
The U.S. economy interacts with the rest of the world in both the product and factor markets (not to mention the financial markets, discussed later in the book). The circular flow theory accounts for the interaction of markets throughout this larger world economy, not just domestically.
In the product market, not all goods and services flow to the domestic government and domestic households. Some of the domestically produced goods and services are exported to people in other countries. In the same manner, not all of the goods and services that are purchased by households and government are domestically produced. Americans import goods and services from the rest of the world.
Not only do Americans trade goods and services with the rest of the world in the product market, they also trade the factors of production with the rest of the world. Land, labor, capital, and entrepreneurship flow from the rest of the world in exchange for foreign factor payments. Also, the factors of production flow to the rest of the world in exchange for foreign factor income. If a U.S. citizen earns income abroad, that is foreign factor income. Payments to foreigners for the use of the factors of production incur a foreign factor payment. When domestic factors of production are employed abroad, they earn foreign factor income. Wages paid to American workers abroad from foreign employers are an example of foreign factor income.
The use of foreign capital requires that interest payments be submitted to the country of origin. This represents a foreign factor payment. In addition, dividends earned by Americans holding shares of stock in foreign companies are included as foreign factor income.
A considerable amount of money is transferred to other countries not in payment for goods and services but to help support family members. This type of transfer, called a remittance, affects the economy but does not constitute a direct exchange in a market. India is a prime example of a country dependent upon a large expatriate community. Many Indians living abroad remit money to their extended families back in India. Likewise, Mexico is heavily dependent upon remittances from emigrants working in the United States.
Remittances are the second largest source of income for Mexico after oil exports. As of 2006, Mexico and India received annual remittances of $25 billion each, much of which originated from the United States.
The goal of foreign investment is to earn foreign factor income in the form of interest and profits. A decision by American entrepreneurs to buy land and develop a theme park in Iceland, although not the best idea, would create an inflow of dollars to Iceland with the purpose of creating an outflow of kronur to America as foreign factor income.
Foreign investment can also be used to finance a trade deficit, as is the case with the United States. Currently, the United States is able to enjoy cheap Chinese imports in excess of U.S. exports to China because of a counterbalancing flow of savings from China to the United States. For every dollar spent on Chinese imports, there is a return flow as the Chinese use the same dollars to purchase both American exports and also American financial assets.