The Circular Flow and GDP

Circular Flow of Income and Expenditures

Households

• Provide: Labor and other resources to firms

• Receive: Income in the form of wages, rent, interest, and profits

• Spend: Income on goods and services produced by firms

Firms

• Produce: Goods and services using resources provided by households

• Sell: These goods and services to households

• Pay: Households for their resources, completing the income cycle

Expenditures and Income

• The total money spent on goods and services is the same as the total money households earn

• This is an important idea for understanding how a country's income is measured

Parsing GDP

• Gross domestic product (GDP): the market value of all final goods and services produced within a country in a given period

  • market value: the total dollar value assigned to goods and services that reflects the economy’s output and helps gauge its overall growth/decline

  • “all” does not refer to illegal activities and goods/services that are produced and consumed within the household

More on Final and Intermediate GDP Contributions

• intermediate GDP = the value of goods and services that are used as inputs in the production of other goods and services

  • these are not counted in GDP to avoid double-counting

• final GDP = the value of goods and services that are purchased for final use, not for further production

  • only final goods are included in GDP to give an accurate measure of economic output

Investment and Consumption

• Investment: refers to spending by businesses on capital goods that will be used for future production, such as machinery and buildings

• Consumption: the spending by households on goods and services for their own use, which constitutes a significant portion of GDP

Income and Expenditure Views of GDP

Both approaches should theoretically yield the same GDP figure, as they are two sides of the same economic coin.

Income Approach to GDP

how much is earned as income on resources used to make stuff

• Wages: Payments to workers

• Rent: Income from land or property

• Interest: Earnings from capital investments

• Profits: Returns to business owners

• Y = w + i + r + p

The sum of these incomes equals the total value of goods and services produced, as every dollar earned is a dollar spent in the economy

Expenditure Approach to GDP

how much is spent on stuff

• Consumption (C): Household spending on goods and services

• Investment (I): Spending on business capital, residential construction, and inventories

• Government Spending (G): Government expenditures on goods and services

• Net Exports (NX): Exports minus imports.

The formula is: GDP = C + I + G + (X - M)

Value Added Approach to Calculating GDP

• no matter how much u measure gdp, u should get to the same value

• value added should get u to the same value as the market value of the final goods and services produced in a given time period

Components of GDP

• Y is GDP

• Y = firms + households + govt + (foreign purchases (exports) - foreign products (imports))

• Y = I + C + G + NX

• I represents investment, C denotes consumer spending, G is government expenditure, NX refers to net exports