Links are the fabric of the web, both internal and external links are instrumental for moving from both one page to another or from website to website; but the real questions is, how do links impact SEO?
Internal links communicate prominence and preferred champion pages from orphaned (less important) pages within a website. External links from other sites communicate importance from the link graph and without enough links; your website will only be a legend in its own mind vs. a preferred destination from the web at large based on the footprint or inbound links / referral paths leading to it.
As an example, if you wanted to see which websites online have the most prominence from the link graph, just type in WWW in Google and hit return. This will display the sites in order of priority of which have “the most juice” within the Google index. A link from any one of these sources is a godsend for SEO.
Aside from using Google as a link barometer, Rand Fishkin and the SEOMoz team have been mapping out the web with their suite of phenomenal SEO tools in addition to the top 500 most linked to websites online. The importance for who you link to as well as who links to you is what many of the algorithms in search engines utilize to ascertain who you are as well as what value (based on that footprint) your site has within the ecosystem of its sphere of influence.
If your website is about cars and you acquire a link from a Ford or Chevy who has massive quantities of inbound links and authority, then the power of that link passes on a fraction of all of those links (and more importantly trust) to your web property.
Similarly, the number of links leaving a page to the number of internal and external links from other sites pointing to that page also play a major factor in what type of link flow and authority they pass on to the target site (they link to). This is known as theme relevance; the more theme relevance a website has by acquiring inbound links from other sites within their niche, the more trust it can acquire.
It is not to say that an authoritative site from another market, niche or segment does not pass along value, but just a different type of value than a themed link. This is also why internal links play such a prominent role within a website as well. If you use absolute links for internal links (including the entire URL) then each page can act as its own miniature oasis and pass along vital ranking factor to other pages within a website.
This is why it is important to audit the internal links from page to page in a site (from the standpoint of SEO) and not have too many links leaving a page (which can diffuse the buoyancy and percentage of link flow it can pass along). You can use tools such as Xenu Link Sleuth for this purpose to measure inbound to outbound links, assess the anchor text in addition to an array of other distinct SEO metrics.
For a more detailed perspective on how to measure this, check out this SEO Video on how to assess your competitors SEO strategies and gauge the barrier to entry into a market.
In closing, the takeaway here is (a) focus on quality more than quantity for inbound links from other sites (b) link contextually from the body area of pages which have keywords that are relevant to the target page to create preferred landing pages and (c) your own website is your own best source to supplement SEO ranking factors in tandem with trusted aged links from authority sites which share the same theme relevance as your own.