Circular Flow & GDP Summary

Circular Flow Basics

  • Circular flow diagram: simplified economic model showing money (outer loop) and real resources (inner loop)
  • Money is a stock; national income is a flow
  • In a closed 2-sector model (Households & Firms):
    • \text{National\ Output} = \text{National\ Income} when all income is spent on consumption

Two-Sector Model

  • Households supply factors ⇒ receive income Y (wages, profits, interest, rent)
  • Firms sell goods/services ⇒ receive consumption spending C
  • Fundamental identities:
    • Y = C + S (savings S is withdrawal)
    • Y = C + I + \Delta R (investment I and inventory change \Delta R are injections)
    • Setting equal ⇒ S = I + \Delta R
  • Equilibrium when \Delta R = 0 and S = I

Injections & Withdrawals (J & W)

  • Injections J: I,\;G,\;X → increase economic activity
  • Withdrawals W: S,\;T,\;M → reduce economic activity
  • Equilibrium national income when J = W

Savings, Investment & Adjustment

  • I is exogenous; S is induced (rises with Y)
  • If I > S ⇒ inventories fall, output & income rise toward equilibrium
  • If I < S ⇒ inventories rise, output & income fall toward equilibrium
  • Key investment drivers: lower interest rate r, higher business confidence, replacement of depreciated capital

Multi-Sector Models

  • 3-sector (Households, Firms, Government):
    • I + \Delta R + G = S + T
  • 4-sector (adds Overseas):
    • I + \Delta R + G + (X - M) = S + T
  • Imports M are withdrawals; exports X are injections

Aggregate Demand (AD)

  • AD = GDP = C + I + G + X - M
  • National-accounts terminology:
    • C: Final consumption expenditure (private)
    • I: Gross fixed capital formation
    • G: Central-government final consumption
    • X,M: Exports & imports of goods/services

GDP Measurement Methods

  1. Expenditure: sum of final C + I + G + X - M
  2. Income: wages + operating surplus + net taxes + depreciation
  3. Production (Value-Added): sum of value added at each stage
  • All three give identical GDP in theory

Nominal vs Real GDP & Price Indices

  • Nominal values: current prices; Real values: constant prices (inflation-adjusted)
  • \text{Real\ GDP} = \dfrac{\text{Nominal\ GDP} \times 1000}{CPI}
  • Price index: average price level relative to base period
    • Simple index = \dfrac{\text{Expenditure}{\text{current}}}{\text{Expenditure}{\text{base}}} \times 1000
    • Weighted index (e.g., CPI) assigns budget shares as weights
  • Other indices: PPI (inputs/outputs), CEPI, Terms of Trade

Business Cycle

  • Boom: rising Y,\;C,\;I, employment, confidence
  • Recession: falling economic indicators
  • Upturn: investment-led recovery
  • Downturn: investment slows; only replacement I; output & jobs fall

Limitations of Circular Flow & GDP

  • Omits firm/government savings & borrowing, price-level changes
  • GDP excludes: non-market/illegal activity, unpaid work, transfer payments, second-hand sales
  • Real GDP preferred for welfare & growth analysis