International Linkage

There are several economic flows that link one country’s economy to other national economies and these are:

• Resource flows or Capital and labor flows– One country can establish its capital in a foreign countries. Labor force also moves from one country to another. Each year millions of people move to other countries.
• Trade flows or Goods and service flows- To improve their economic situation countries import and export goods and services.
• Financial Flows- Money is transferred between countries because of several reasons: paying for imports, paying interest on debt, providing aid for some countries.
• Informational and technology flow- Countries transmit each other information about their prices of goods and services, investment opportunities. Countries use one others technology in order to have the most efficient output.

Let’s take for example Latvian economy.

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THE CIRCULAR FLOW MODEL with Government

In the following figure we have integrated government. What have changed?

Flows (5) through (8) illustrate that government make purchases in resource and product market. Flows (5) and (6) represent buying of products, but (7) and (8) represent buying of resource by government.

Government shall have money to pay its members, teachers, police, inspectors, bus drivers, doctors, fire fighters etc. Government might buy land to build a new school, expand a hospital.

Government offers public goods and services to both households and businesses, as shown by (9) and (10). Government gets paid for these goods and services by collecting taxes by flows (11) and (12).  Flow (11) represents different subsidies to airlines, doctors which are then paid back to government, because most of them are low-interest loans, taxes, or public facilities provided at prices below their real price. Flow (12) includes taxes collected by government from households and different kind of social insurance benefits offered by government. The structure of taxes and transfer payments affects income distribution. In flow (12), taxes drawn from “rich” households, combined with a system of transfer payments to low-income households, reduces income inequality.

Flows (5) through (8) imply that government takes away resources from private sector or use,  and directs them to constructing public goods. This resource reallocation is required for producing public goods and services.