The Circular Flow and Grow Domestic Product - Section 3, Module 10

national income and product accounts (or just national accounts) - keep track of the spending of consumers, sales of producers, business investment spending, government purchases, and a variety of other flows of money among different sectors of the economy

Circular Flow diagram - simplified representation of macroeconomy showing the flows of money, goods and services, and factors of production

simplified circular flow diagram:

• shows that economy contains only two groups - households and firms

  • Households → consists of either and individual or group of people who share their income

  • Firms → an organization that produces goods and services for sale and that employs members of households

• two kinds of markets

  • product markets - where households buy the products they want from firms

    • consumer spending - household payments for goods and services

    • flow of goods and services to households and money to firms

  • factor markets - firms buy the factors of production (resources)

    • households own/receive income from selling the factors of production

      • income from labor, rent, interest, profit, wages

expanded circular flow diagram:

• same as before, but flows to and from government is also added

  • government injects funds through government spending and takes out funds through taxes

    • government spending - the total of purchases made by federal, state, and local government

    • Taxes - payments that firms and households are required to make to the government

      • tax revenue - funds the government receives from taxes

  • disposable income - the total amount of household income available to spend on consumption (left after taxes)

  • government transfers - payments that the government makes to households or firms without expecting a good or service in return

circular flow diagram with financial markets

• private savings - when households do not spend all of their money on consumption or taxes and there are leftover savings that are not spent, they leak out of the circular flow

  • frequently held by financial institutions (such as banks) that inject it back into the circular flow through loans

  • financial markets - channel private savings into government borrowing (borrowed by the government) and investment spending (borrowed by firms)

    • investment spending includes spending on new productive capital

    • inventories - goods and raw materials held by firms to facilitate their operations → included in investment spending because they influence the ability of a firm to make future sales (just like investing in new machines, etc)

    • investment spending also includes construction

Circular Flow with the rest of the world

• exports - goods and services sold to other countries

  • payments for exports lead to an injection of funds from the rest of the world into the US’s circular flow

• imports - goods and services purchased from other countries

  • lead to a leakage of funds out of the US’s circular flow

• Foreign Lending - lending by foreigners to US borrowers generates a flow of funds into the US

  • foreign borrowing = opposite

Gross Domestic Product (GDP) - total value of FINAL goods and services produced in an economy in a given period

3 approaches to calculate GDP:

1. expenditure approach - adds up aggregate spending (total spending on domestically produced final goods and services in the economy → sum of consumer spending, investment spending, government purchases of goods and services, and exports minus imports)

2. income approach - adds up total factor income earned by households from firms in the economy (rent, wages, interest, and profit)

3. Value-added approach - surveys firms and adds their individual contributions to the value of each final good and service

Expenditure Approach

• most common way to calculate GDP

• to prevent double counting, final goods (goods and services sold to the end user) are counted and intermediate goods (goods and services that are inputs into the production of final goods and services) are excluded

• To calculate:

  • net exports - exports minus imports (x-m)

Income Approach

• add up all the income earned by factors of production

Value Added Approach

• counts only the value added - the value of a producer’s sales minus the value of the inputs purchased from other businesses

  • input costs are subtracted at each stage