Chapter 3

• Circular Flow of Income 

  • The circular flow model illustrates both financial and the real flows among the three sectors of the economy which are business, household and government 

• Circular Flow of Income Example with two sectors - businesses and households 

  • Businesses sell to the households, households provide service factors to the business 

  • Households pay for goods and services (consumption spending) and sell factor services to the business sector and earn income. Using this income they can pay for the goods and services received from the business sector 

  • Income is the sum of all earnings from economic transactions or the sun of all spending 

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

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Look carefully at test diagrams as they may be flipped around  

Product Market 

• The market for consumer goods and services. Consumption 

Factor Market 

• The Market for factors of production. Business and being paid for providing services 

Stock of Money 

• Quantity of money at a specific point in time. Amount of money supply 

Flow of Income 

• Amount of income over a given period of time 

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  Stock of money is $10, total income is $30, total spending is $30, total production is $30. Only the end product is measured in GDP 

   

• Velocity of Money 

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

  • The number of times the stock of money is spent in a year on a final goods is called the velocity of money 

  • Velocity of Money = total income (GDP) / money supply 

• Savings 

  • The portion of income (Y) that is not spent on consumption (C) 

  • Important source of loanable funds for financial institutions to loan to businesses 

  • Amount depends primarily on the level of incomes. Higher income, higher saving 

  • S = Y - C (savings equals income minus consumption) 

    • Formula 2  

• Leakage 

  • Any flow of income that is diverted out of the circular flow and does not flow directly back. It may come back in at some point by the bank, choosing when to invest the savings into the business sector (not income dependent) 

  • Saving is a leakage from the circular flow 

• Injection 

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

  • Investment means spending on new capital goods and represents an injection into the circular flow 

  • Investment is autonomous and is not determined by income. Investment will always occur by banks that is based on risk and current portfolios 

• Imports are a leakage 

  • When goods and services are imported, Canadian payments leave Canada and flow to another country 

  • Buying something off Amazon from China is a leakage as it is flowing out of the Canadian economy 

• Exports are an injection 

  • When goods and services are exported, foreign payments are received by the Canadian economy 

  • Sending goods and getting money back, flowing into Canadian economy 

• Collection of Taxes is a leakage, Government spending tax revenues are injections 

• Net Tax Revenue = Taxes less Transfer Payments 

• Transfer payments are a one-way transaction where payment is made but no goods or services flow back 

• Net Tax Revenue is a Leakage 

• Tax revenues used for government spending programs are Injections 

   

• Learn the names of each arrow 

  • Consumption is households to business 

• Summary of Circular Flow Model 

  • Three leakages: savings, imports, and taxes 

  • Three injections: investments, exports and government spending on goods and services 

  • If injections are greater than leakages national income will rise, and if leakages exceed injections national income will fall 

Measuring GDP: The Expenditure Method 

• Aggregate expenditures (AE) = C + Ig + G + Xn 

  • Consumption (C) - spending by households 

  • Gross Investment (Ig) - spending by businesses 

  • Government Spending (G) - spending on goods and services 

  • Net Exports (Xn = X - IM) - spending by foreigners 

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• C = Consumption 

• I = Investment 

• G = Government spending 

• S = Saving 

• IM = Imports 

• T = Taxes 

• X = Exports 

• N = Not applicable 

Test your Understanding: Identify the elements of the following 

• A student gets a haircut from a self-employed hairdresser = C (consumption) 

• The hairdresser buys scissors from a local store = I (investment) 

• Hairdresser saves $5 from each day = S (saving) 

• The hairdresser buys a GM share = NA (not applicable) 

  • Buying a share in stock market is a change in ownership not a type of consumption because the market share has set value and does not increase 

• New issues of shares by GM would be an investment 

• GM expands its computer systems in office = I (investment) 

• American tourist go skiing in Canada = X (exports) 

  • Canada gets the money from other country 

• Canadians go tour in Tokyo = IM (imports) 

  • Money leaves Canadian economy and goes to Tokyo 

• Russia buys beef from Alberta cattle ranchers = X (exports) 

  • Money flows into the economy so export  

• Government builds a new highway = G (government spending) 

• Measuring GDP: The Income Method 

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• Adding up the incomes to the three major sectors: households, businesses and government income 

• Stats Canada’s income GDP includes (memorize five category's) 

  • Wages and benefits - 10 

  • Income of corporations - 10 

  • Income of other businesses - 10 

  • Taxes on production (net of subsidies) - 10 

  • Taxes on products (net of subsidies) - 10 

  • What is the value of the GDP? = 50 

• Gross Domestic Product (GDP) is the same as Gross Domestic Income (GDI) 

• Net Domestic Product (NDP) is the same as Net Domestic Income (NDI) 

• Net National Product (NNP/NP) is the same as Net National Income (NNI) and National Income 

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• Depreciation 

  • The value of existing capital goods decreasing over time 

  • Net investment = Gross investment - depreciation 

• Indirect Taxes 

  • Sales taxes that businesses collect for the government 

• Net National Product (NNP) 

  • NDP +/- net foreign factor income 

  • If a foreign corporation operates in Canada some of the profit may be transferred out of the country 

  • Also, foreigners may be working in Canada and some Canadians may be working abroad 

• Calculate National Income 

  • GDP - Depreciation - Taxes ± net foreign factor income = NNP 

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• Earned Income vs. Unearned Income 

  • National income is earned 

  • To find disposable income, add income that is not earned (transfer payments) and deduct income earned but not paid out (undistributed profit, corporate and personal income taxes) 

  • National income + government transfer payments - undistributed corporate profits - corporate profit taxes - other income not paid out = Personal Income 

• Personal Income 

  • Personal income is the peoples gross pay, this is income before payroll deductions 

  • It is received income before tax, whereas National Income can be earned income 

  • Personal income less personal income taxes equals disposable income 

• Disposable Income 

  • The net income that people take home after income tax and payroll deductions 

  • It is split into savings and consumption 

• Problems in Measuring GDP 

  • Only productive activities are included, these are examples of non-productive activities: intermediate goods, (to avoid double-counting, add value when sold to final consumer/customer, not when sold at the seller but when sold to the customer), secondhand goods, sales the merely transfer ownership (stocks/bonds), public transfer payments, secondhand goods 

  • Underground activity’s (illegal activities and unreported activity’s ) and nonmarket activity’s (homemakers services, volunteer services) are also not included in the GDP even though they are technically productive 

  • Nonmarket activities (productive but not included in the GDP) - Servies of homemakers, volunteers, do-it yourself work 

• Economic Growth 

  • An increase in real GDP per capita (per person) OR an increase in an economy’s capacity to produce 

• Nominal GDP 

  • The value of GDP in terms of prices prevailing at the time of measurement 

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• Real GDP 

  • The value of GDP measured in terms of prices prevailing in a given base year 

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GDP per Capita 

• Accounting for the sharing of GDP among the population 

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• Economic Growth Rate 

  • The best measure of a change in standard of living. 

  • RGDPpc is real GDP per capita 

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• Labor Productivity 

• A measure of the amount of output produced per unit of labor 

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• Human Capital 

• accumulated skills and knowledge of humans 

• Sources of Economic Growth 

  • Quantity and quality of labor resources 

  • Amount of physical capital 

  • Rate of technological change 

  • Amount and quality of natural resources 

  • Benefits of Economic Growth - examples 

  • Higher living standards 

  • Improved health services 

  • Improve education quality 

  • Better transport, support for the arts, culture and environmental protection 

  • Higher protection of human rights 

• Higher GDP is not Always Better 

  • quality and/or desirability of the goods produced is overlooks 

  • Increased leisure, this limits growth 

  • GDP figures do not indicate how fairly a country’s income is distributed 

  • The social and environmental costs of higher GDP are ignored 

• Need to Know 

  • Circular flow of national income 

  • Why national income falls and rises 

  • How to calculated national accounting stats and some issues when doing to 

  • Measurement, importance, sources and problems of economic growth