ECON 102 - Chapter 3

Learning Objectives

• Describe the circular flow of national income.

• Describe the components of GDP accounting.

• Understand some of the problems in determining official statistics.

• Measure economic growth and describe its sources, benefits, and costs.

LO1: Circular Flow of Income

Overview of the Circular Flow Model

• The circular flow model illustrates both the financial and the real flows among the three sectors of the economy:

  • Business

  • Household

  • Government

Simplified Circular Flow Model with Two Sectors

• In a simplified economy with two sectors:

  • Businesses

  • Households

• Flow of Goods and Factor Services:

  • Businesses sell goods and services to households.

  • Households provide factor services (labour, land, capital) to businesses.

• Financial Flows:

  • Households pay for goods and services (consumption spending).

  • Businesses pay for factor services (wages, rent, interest, profit).

Role of Households

• Households sell factor services to the business sector and earn income.

• With this income, households pay for the goods and services received from the business sector.

• Income is defined as:

  • The sum of all earnings from economic transactions.

  • Also described as the sum of all spending.

Components of the Circular Flow

• Product Market:

  • The market for consumer goods and services.

• Factor Market:

  • The market for factors of production.

Important Definitions

• Stock of Money: Quantity of money at a specific point in time.

• Flow of Income: Amount of income over a given period of time.

Explanation of Money Flow

• Each time money from the stock is spent, it adds to the flow of income.

• The velocity of money is defined as:
  $Velocity ext{ of Money} = \frac{total \ income \ (GDP)}{Money \ Supply}$

Leakages and Injections in the Circular Flow

• Leakages: Any flow of income that is diverted out of the circular flow and does not flow directly back.

  • Example: Saving is a leakage from the circular flow.

• Injections: Any spending flow that is not dependent on the current level of income.

  • Example: Investment is autonomous and represents an injection into the circular flow.

• Imports (leakage) vs. Exports (injection):

  • When goods and services are imported, payments leave the economy.

  • When exported, foreign payments are received.

Role of Government in the Circular Flow

• Governments collect taxes from households and businesses, which leaks out of the circular flow of income.

• Tax revenues may be used for spending programs, which are considered injections.

  • Net Tax Revenue is defined as:

  • Taxes less transfer payments.

• Transfer payments: Transactions where payments are made but no good or service flows back.

Summary of Circular Flow Mechanics

• In the Circular Flow model, there are three main leakages:

  • Savings

  • Imports

  • Taxes

• Corresponding three injections:

  • Investment

  • Exports

  • Government spending on goods and services

• If injections are greater than leakages, national income will rise; if leakages exceed injections, national income will decrease.

LO2: Measuring GDP

Expenditure Approach

• Aggregate Expenditures (AE) is calculated as: $AE = C + I + G + XN$

  • Where:

  • C = Consumption - spending by households

  • I = Gross Investment - spending by businesses

  • G = Government spending on goods and services

  • XN = Net exports (exports minus imports)

Data from 2021 for Expenditures

• Table 3.1 shows GDP by expenditures:

  • Consumption (C): $1328 billion (53%)

  • Consumer durables: 14 % of C

  • Semi-durable goods: 7 % of C

  • Non-durables: 25 % of C

  • Consumer services: 54 % of C

  • Investment (Ig): $538 billion (21%)

  • Machinery and equipment: 14%

  • Residential construction: 45%

  • Nonresidential construction: 24%

  • Government Spending (G): $645 billion (26%)

  • Net Exports (XN):

  • Exports: $776 billion

  • Imports: $777 billion

  • Total GDP: $2510 billion

Income Approach

• Alternatively, GDP can be measured using the income method, which adds up the incomes to the major sectors:

  • Wages and benefits

  • Corporate income

  • Other business income

  • Taxes on production (net of subsidies)

  • Taxes on products (net of subsidies)

Data from 2021 for Incomes

• Table 3.2 shows GDP by incomes:

  • Households: $1270 billion (51%)

  • Businesses:

  • Income of corporations: $725 billion

  • Income of other businesses: $296 billion

  • Government: $219 billion (9%)

  • Taxes on production (net of subsidies): $65 billion

  • Taxes on products (net of subsidies): $154 billion

  • Total Income: $2510 billion

From GDP to NNP

• Starting from GDP at market prices: $2510 billion

• Less depreciation: $333 billion

• Less taxes on products: $154 billion

• Net Domestic Product (NDP) = $2023 billion

• Net National Product (NNP) = $2013 billion after accounting for net foreign factor income of -$10 billion.

• National Income: Also referred to as NNP, can be denoted as:

  • Net National Income (NNI).

LO3: Problems in Measuring GDP

Exclusions from GDP Measurement

• Only productive activities included. Therefore, the following are excluded:

  • Intermediate Goods: to avoid double-counting, only the value added by each producer is included.

  • Transfer Transactions: Sales that merely transfer ownership and public/private transfer payments are excluded.

  • Secondhand Goods: Not measured in GDP.

Non-included Activities

• Certain productive activities are not included, such as:

  • Underground Activities: Illegal or unreported legal activities.

  • Nonmarket Activities: Services provided by homemakers, do-it-yourself production, and volunteer services.

LO4: Economic Growth

Definition of Economic Growth

• Economic Growth is:

  • An increase in real GDP per capita

  • OR an increase in an economy’s capacity to produce.

Types of GDP Measurement

• Nominal GDP: The value of GDP based on current market prices.

• Real GDP: The value of GDP adjusted for inflation, measured in terms of prices of a given base year.

• Example of Calculating GDP:

  • Year 1 & Year 2 Tables:

  • Year 1 values indicate GDP of $42,000 nominally based on quantities produced and their associated prices.

  • Year 2 shows nominal GDP of $49,200 when adjusted for current output prices against a base year.

Calculating GDP Growth

• Growth Rate Formula for GDP:
  $ext{Growth Rate of GDP} = \frac{GDP<em>{current} - GDP</em>{previous}}{GDP_{previous}} \times 100$

• Example Calculation:

  • Nominal Growth Rate in Year 2: 17.14%

  • Real Growth Rate in Year 2: 7.6%.

  • This translates to Real GDP growth of 7.6% in Year 2 based on the illustrated tables.

Real GDP per Capita

• Real GDP per capita measures averages relative to population:
  $RGDPpc = \frac{Real \ GDP}{Population}$

• Economic Growth Rate Calculation:
  $Economic \ Growth \ Rate = \frac{RGDPpc}{time} \times 100$

Understanding Sources of Economic Growth

• Factors affecting growth:

  • Labour Productivity: Measured as output produced per unit of labor input (per unit of time).

  • Other factors include quantity and quality of labor resources, amount of physical capital available, and rate of technological change.

Benefits and Concerns of Economic Growth

Benefits of Economic Growth

• Leads to a higher standard of living, improved health services, better education, and enhanced cultural support, among other benefits.

Concerns Regarding GDP Growth

• Higher GDP isn’t always better:

  • May include value of services previously excluded, ignores quality or desirability of goods, leisure’s value not considered, and social/environmental costs are often ignored.

  • GDP figures do not indicate income distribution fairness.

Chapter Summary

• Understanding the circular flow of national income and equilibrium concepts.

• Calculating various national accounting statistics and recognizing measurement problems.

• Understanding the measurement, significance, sources, and issues associated with economic growth.