Our initial Circular Flow Model
After we added government it looked like this:
And now we add “Other nations” sector which interacts with our country(Let’s say Italy):
Let’s place icon “Other Countries” so that it interacts with Italian Product Markets. This sectors represents all countries (individuals, firms, governments) with which Italy has some economic relationship.
Flow (13) shows that people, firms and governments that buy Italian products, all exports from product market. This goods and services flow from Italian resource market to other nations is in contrast with (14) flow that represent an opposite monetary revenues.
Flow (15) represents Italian households, businesses, and firm’s expenditure on foreign products and services, these are also called imports (16). Purchases of foreign goods make possible those countries to buy Italian goods.
Italian imports and exports are not only goods, but also resources. Also we should take in consideration that some Italian firms activate in production abroad, which means that they are part of resource market from other countries.
There are also international flows of labor. Each year, thousands of people enter Italy. This activity increase availability of Italian labor resources, which increase Italian total output and income and decrease wage for labor force in some industries.
This figure shows that a nation which is related economically with other nations won’t face some source of instability (recession and inflation) that wouldn’t affect a “close nation”. Let’s think that Germany suffers a recession. Its incomes decline then its purchases of Italian goods will fall. Then flows (13) and (14) decline and more goods remain unsold. Italian firms would respond to this situation by limiting the supply quantity by limiting their employments, and this will reduce flow of revenues to households. Recession in Germany can create a recession in Italy.
We may also see that this “other nations” system change resource allocation and income in Italian economy. With this system Italia produce more of some goods (exports) and few of other (imports).