Circular Flow and Gross Domestic Product
Circular Flow and Gross Domestic Product
The National Accounts
Gross Domestic Product (GDP) is defined by the formula:
GDP = \text{private consumption} + \text{gross investment} + \text{government investment} + \text{government spending} + (\text{exports} - \text{imports})
The United States calculates this via the National Income and Product Account (NIPA), reported by the Bureau of Economic Analysis (BEA), which is part of the U.S. Department of Commerce.
NIPA tracks various economic factors:
Spending by consumers
Sales of products
Business investment spending
Government purchases
Other financial flows
The Circular Flow Diagram
Definitions:
Household: A person or group sharing income.
Firm: An organization producing goods and services for sale.
Product Markets: Venues for buying and selling goods and services.
Factor Markets: Venues for buying and selling resources, especially labor and capital.
Consumer Spending: Household expenditure on goods and services.
The Expanded Circular-Flow Diagram
This shows only the flow of money in the economy.
The underlying principle is that the inflow of money in each market must equal the outflow:
This connects four economic sectors: households, firms, governments, and the rest of the world.
Total Flow of Funds Calculation:
\text{Total Flow} = \text{Consumer Spending} + \text{Investment Spending} + \text{Government Purchases} + \text{Exports} - \text{Imports}
Key Terms
Shareholder: Individual owning a part of a company.
Transfer Payments: Payments the government makes to individuals without expecting goods or services in return.
Disposable Income (YD): YD = Y + Tr - T
Where:
Y = Income
Tr = Transfers
T = Taxes
Investments: Long-term loans in the form of IOUs that pay interest.
Government Purchases: Total expenditures by government at all levels.
Exports: Goods/services sold to foreign countries.
Imports: Goods/services purchased from foreign countries.
Tariff: A tax on imports or exports.
Inventories: Stocks of goods/raw materials for business operations.
Gross Domestic Product (GDP)
Final Goods and Services: Goods/services sold to the end user.
Example: Buying a new vehicle from a dealership.
Intermediate Goods and Services: Goods/services used as inputs in the production of final goods/services.
Example: Manufacturer's purchase of steel/glass for car production.
Calculation of GDP:
Defined as the total value of all final goods and services produced in the economy during a specific year.
In 2018, the U.S. GDP was 20,500,600 million USD, or approximately 62,500 per person.
Approaches to GDP Calculation
Value-Added Approach:
This method surveys firms and sums their contributions to the value of final goods/services while excluding intermediate goods.
Value-Added: The difference between the value of sales and the cost of inputs.
Labor is classified as a factor of production, not as an intermediate good.
Expenditure Approach:
Measures aggregate spending on domestically produced final goods/services:
\text{Expenditure Approach} = \text{Aggregate Spending on domestic goods/services}
Avoids double counting by considering only sales to final buyers.
Includes capital goods purchases as part of final spending.
Categories of Spending:
C: Consumer Spending
I: Investment Goods
G: Government Purchases
X: Exports
IM: Imports
The GDP equation can be summarized:
GDP = C + I + G + X - IM
Net Exports = X - IM
Income Approach:
Sums total income earned by households from firms, including:
Wages
Interest
Rent
Profit (dividends)
Inclusion and Exclusion in GDP Calculation
Included:
Domestically produced final goods/services.
Capital goods, new structures, changes in inventories.
Excluded:
Intermediate goods/services
Used goods
Household production activities
Transfer payments
Underground economic activities
Financial assets (stocks, bonds)
Foreign-produced goods/services
Check for Understanding
Write out the GDP formula:
GDP = C + I + G + X - IM
Define each variable:
C: Consumer spending
I: Investments
G: Government purchases
X: Exports
IM: Imports
Examples in GDP Calculation
Transactions and their GDP implications:
Coca-Cola builds a new bottling plant in the U.S.
Included: Yes, as a new structure.
Delta Airlines sells an existing airplane to Korean Airline.
Excluded: No, as it’s a used good.
An individual buys an existing share of Disney Stock.
Excluded: No, as it’s a transfer of ownership.
A California winery sells Chardonnay to a customer in Montreal.
Included: Yes, as an export.
An American buys French perfume in Tulsa.
Excluded: No, as it’s an import.
A book publisher adds surplus inventory of unsold books.
Included: Yes, seen as investment.
Nominal GDP vs Real GDP
Nominal GDP: Value measured at current prices without inflation adjustment.
Real GDP: Value adjusted for inflation, measured by a constant price level from a base year.
It reflects true economic growth, not merely price increases.
Real GDP Measurement
Aggregate Output: Total quantity of final goods/services produced in the economy.
GDP must be discounted by the GDP deflator to compare performance over time rather than just changes in price.
Example Calculation:
Year 1 Sales:
Apples: 2000 ext{ billion} \times 0.25
Oranges: 1000 ext{ billion} \times 0.50
Total: 1000 ext{ billion}
Year 2 Sales:
Apples: 2200 ext{ billion} \times 0.30
Oranges: 1200 ext{ billion} \times 0.70
Total: 1500 ext{ billion} (inflation accounted).
Calculating Real GDP Example
Year 1 Prices Actions:
Apply Year 1 prices to Year 2 production:
Result:
\text{Output at Year 1 prices} = 2200 \times 0.25 + 1200 \times 0.50 = 1500\text{ billion}
Original Year 1 Output:
1000 billion
Real GDP Growth Calculation:
Increased to 1150 billion when measured at Year 1 prices.
Final Definitions
Real GDP: Total value of final goods/services in a steady price framework (base year).
Nominal GDP: The value of final goods/services at current prices during the output production year.
GDP Per Capita
GDP Per Capita Formula:
\text{GDP per capita} = \frac{GDP}{\text{Population}}
Differentiates economic output size from population size.
Effective for comparing GDP between nations once adjusted for purchasing power parity.