Economic interdependence Notes

Economic Interdependence Means Choices In One Part Of The Economy Affect Others

1. Economic interdependence is the idea that households, firms, governments, banks, and the foreign sector are connected, so a change in one part of the system creates knock-on effects elsewhere.
2. When you buy something, you are not just satisfying a personal want.
   1. You are also creating revenue for a producer, income for workers, potential tax revenue for government, and possibly demand for imported inputs.
3. A practical way to understand interdependence is to track the economy as a set of linked flows: flows of goods and services, flows of resources used in production, and flows of money.

The Circular Flow Of Income Shows The Economy As A System

1. The circular flow of income is a model that represents (in a simplified way) all transactions between all buyers and sellers in an economy. It highlights two central exchanges:
   1. Households buy goods and services from firms, and firms receive revenue from consumer expenditure.
   2. Firms buy factors of production from households, and households receive income for supplying labour, land, and capital (for example wages, rent, interest, and profit).
2. People are therefore both workers and consumers.
   1. This creates feedback loops: if households reduce spending, firms earn less, which can lead to lower output and fewer jobs, which then reduces household income further.
   2. This is one reason economies can sometimes move into a vicious cycle.

Leakages And Injections Determine Whether The Economy Shrinks Or Grows

Leakages Are Flows Out Of Spending

1. Leakages reduce total spending in the economy. The most common leakages are:
   1. Savings (S): households set aside income instead of spending it now.
   2. Taxes (T): money paid to government reduces household or firm spending power (in the short run).
   3. Imports (M): spending on foreign-produced goods and services sends income abroad.

Injections Are Flows Into Spending

1. Injections increase total spending in the economy:
   1. Investment (I): spending by firms on capital goods, often funded by retained profits or borrowing.
   2. Government spending (G): government purchases of goods and services and public projects.
   3. Exports (X): spending by foreign buyers on domestically produced goods and services.
2. A common way to summarise the overall balance is:

$$\text{Total leakages} = S + T + M$$

$$\text{Total injections} = I + G + X$$

Government Links Households And Firms Through Taxes And Spending

1. Governments can "steer" the economy mainly using two connected tools:
   1. Taxation (direct and indirect), which raises revenue and changes how much income households and firms have available to spend.
   2. Government spending, which uses that revenue to purchase goods and services and fund projects such as schools, roads, and defence.
2. Because government both takes money out of the circular flow (taxes) and puts it back in (spending), it is a major source of interdependence: a tax change affects household consumption and firm revenue, while spending changes affect firm demand and employment.

Banks Create Interdependence Through Saving, Credit, And Investment

1. Banks are central to modern economies because they link savers to borrowers.
2. They channel surplus funds from people who do not currently need the money to households and firms that want to spend and invest.
   1. This is why banks are often described as financial intermediaries.
3. To reward lenders (and to cover risk and costs), banks charge an interest rate on loans.
4. In the circular flow model:
   1. Saving is a leakage because it reduces immediate consumption spending.
   2. But saving can return to the flow as investment when banks lend those funds to firms, which becomes an injection.
   3. This link is especially important for smaller firms that rely on bank loans to expand.

Foreign Trade And Exchange Rates Link Economies Together

How Exchange Rate Changes Spread Through The Economy

1. Trade balance effects: A currency depreciation makes exports cheaper for foreigners and imports more expensive for domestic consumers. Whether export revenue rises depends on what the country exports and how responsive foreign buyers are to price changes.
2. Employment effects: If exports rise, firms may increase output and hire more workers. But if firms rely heavily on imported inputs, higher costs can reduce production and jobs.
3. Inflation effects: Depreciation can raise the cost of imported raw materials (for example crude oil or copper). Firms may absorb the cost rise (lower profits) or raise prices, contributing to inflation.
4. Economic growth effects: If exports rise and non-essential imports fall, domestic production can increase and raise GDP, supporting economic growth.

Trade Can Support Development But Also Create Dependence

1. Trade can increase opportunities for production by opening access to larger markets.
2. Higher export demand can encourage entrepreneurship, job creation, and the growth of related support industries.
3. However, interdependence can also create vulnerability, especially when a country relies on a narrow range of exports.
4. Many developing countries export mainly primary goods (raw materials and agricultural products).
5. These markets can have volatile prices, and it can be difficult to generate a large surplus to finance diversification into higher value industries.

Putting It Together: Interdependence As A Chain Reaction

1. Households become pessimistic and increase saving.
2. Consumption falls, so firms’ revenue falls.
3. Firms cut output and employment, reducing household income.
4. Tax receipts fall, reducing the government’s ability to spend unless it borrows.
5. Imports fall as overall spending falls, affecting foreign exporters.
6. Banks face more loan defaults, tighten credit, and reduce investment.