Circular Flow and GDP

Flashcards of key terms and concepts from the lecture notes.

Circular Flow of Economic Activity

Shows how money, goods, services, and resources move between different sectors in an economy—mainly households, businesses, product markets, and factor/resource markets.

Households Role in Circular Flow

Provide resources to the resource/factor market (land, labor, capital, entrepreneurship) and receive income (wages, rent, interest, profit) in return. They use income to purchase goods and services.

Businesses Role in Circular Flow

Buy resources from the resource market to produce goods and services, pay households through the factor market, and sell goods and services in the product market to households, receiving revenue.

Resource/Factor Market

Where households sell and businesses buy resources like labor and capital. Businesses pay households for these resources.

Product Market

Where businesses sell and households buy goods and services. Household spending becomes revenue for businesses.

Physical Flow in Circular Flow

Represented by red arrows; includes goods, services, and resources moving between sectors.

Monetary Flow in Circular Flow

Represented by green arrows; includes wages, payments, and spending moving between sectors.

Firms Responsibility

Responsible for producing goods and services, requiring factors of production from households (labor, land, capital, entrepreneurship).

Households Dual Role

Consume goods and services and provide factors of production to firms, receiving payments (wages, rent, interest, profits) in return.

Government Role in Circular Flow

Collects taxes from households and firms, spends on public goods and services (roads, education, healthcare), and provides transfer payments (pensions, benefits).

Banks and the Financial System Role in Circular Flow

Households and firms save income in banks, which lend these savings to households and businesses for consumption or investment.

International Sector Role in Circular Flow

Involves exports (income into the economy) and imports (money spent abroad), showing open economies' interaction with the world.

Factor Payments

Firms paying households for factors of production (wages, rent, interest, profit).

Consumption (C)

Households using their income to buy goods and services produced by firms.

Savings (S)

Money households save in banks instead of spending; a leakage from the circular flow.

Taxes (T)

Money paid to the government; a leakage from the circular flow.

Imports (M)

Money spent on goods and services from abroad; a leakage from the circular flow.

Investment (I)

Money banks lend to firms for investment; an injection into the circular flow.

Government Expenditure (G)

Government spending on goods and services; an injection into the circular flow.

Exports (X)

Income from selling goods abroad; an injection into the circular flow.

Withdrawals (Leakages)

Parts of national income not returned directly to firms through domestic spending (Savings, Taxes, Imports).

Savings (S) Definition

The portion of household income not spent on consumption; deposited into banks or financial institutions.

Net Taxes (T) Definition

The difference between taxes paid and benefits received (transfer payments like pensions or unemployment benefits).

Imports (M) Definition

Goods and services purchased from abroad by households, firms, or governments.

Investment (I) Definition

Spending by firms on capital goods (machinery, buildings, technology) to produce future output.

Government Expenditure (G) Definition

Spending by the government on public goods and services (infrastructure, education, healthcare, defense).

Exports (X) Definition

Goods and services produced domestically but sold to foreign households, firms, or governments.

Aggregate Demand (AD)

The total demand for goods and services in an economy at a given time, calculated as AD = C + I + G + (X – M).

Household Spending (Consumption - C)

Expenditures by households on goods and services (food, clothing, transportation, healthcare, entertainment).

Disposable Income

Income remaining after taxes and transfers (benefits), influencing the amount available for consumption.

Consumption Smoothing

Households aim to maintain a stable standard of living over time, borrowing during low-income periods and saving during high-income periods.

Government Spending (G) Definition

Purchase of goods and services by the public sector (infrastructure, education, healthcare, and defense), excluding transfer payments.

Investment (I) Definition

Spending on capital goods (equipment, machinery, buildings, infrastructure) used to produce future output.

Imports (M) Definition

Purchase of goods and services produced abroad by households, businesses, or the government.

Exports (X) Definition

Sale of domestically produced goods and services to foreign consumers, firms, or governments, injecting income from abroad.

Net Exports (X – M)

The difference between exports and imports. A trade surplus (X > M) adds to aggregate demand, while a trade deficit (X < M) subtracts from it.. It is crucial for exchange rate and current account of the balance of payments.

Equilibrium Condition in the Short Run

Total output (GDP) that firms are willing to produce is determined by aggregate demand — the total planned spending in the economy

Equilibrium (Withdrawals = Injections)

Occurs when total planned spending equals total planned output (S + T + M = I + G + X).

Multiplier Effect

An initial change in an injection (I, G, X) or withdrawal (S, T, M) causes a chain reaction of spending throughout the economy.

Marginal Propensity to Withdraw (MPW)

The sum of the marginal propensity to save (MPS), tax (MPT), and import (MPM); determines the size of the multiplier. MPW = MPS + MPT + MPM

Gross Domestic Product (GDP)

Total market value of all final goods and services produced within a country’s borders over a specific period.

Final Goods and Services

Goods purchased by their end user, included in GDP to avoid double counting. Intermediate goods are excluded.

Nominal GDP

Total value of goods and services produced within a country valued at current market prices, not adjusted for inflation or deflation.

Real GDP

The measure of the value of goods and services produced in an economy, adjusted for changes in the price level (inflation or deflation). It reflects a more accurate economic growth

GDP Deflator

An index used to adjust Nominal GDP to Real GDP, calculated by dividing Nominal GDP by Real GDP and multiplying by 100.

GDP (Gross Domestic Product)

Measures the total value of goods and services produced within a country’s borders, regardless of who owns the resources used.

GNP (Gross National Product)

Total value of goods and services produced by the residents of a country, both within the country and abroad.

Expenditure Approach to Measure GDP

Calculates GDP by measuring the total expenditure on goods and services produced within a country. (GDP = C + I + G + (X−M))

Income Approach to Measure GDP

Determines GDP by looking at the income generated from the production of goods and services, distributed to the factors of production (labor, capital, and land).

GDP per capita

Used to measure standard of living. Calculated as GDP / population

Household Production

Unpaid housework, volunteer work and subsistence farming are not transacted in the market an not included in GDP

Underground economic activity

Economic activities that are intentionally concealed from official authorities and are not included in GDP.

United Nations’ Human Development Index (HDI)

HDI combines health, knowledge, and standard of living to provide comprehensive measure of human development than income alone