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 $= \dfrac{\text{Expenditure}<em>{\text{current}}}{\text{Expenditure}</em>{\text{base}}} \times 1000$
  • 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