2.1 — Circular Flow Model and Gross Domestic Product (GDP)

Circular Flow Model

The circular flow model shows how money, resources, and goods/services move between households and businesses in the economy:

1. Households provide resources (labor) to businesses in exchange for income.
2. Businesses use resources to produce goods/services and sell them to households.
3. Government interacts by collecting taxes and redistributing income through public services.

Gross Domestic Product (GDP)

GDP is the dollar value of all final goods and services produced within a country’s borders in a year.

• Dollar Value: GDP is measured in dollars.
• Final Goods: Does not include intermediate goods (goods used in production of final goods).
• One Year: Measures annual economic performance.

It has its own limitations.

Why is GDP Important?

GDP measures how well a country is doing financially. It helps us:

1. Compare to previous years (growth).
2. Evaluate policy changes (effectiveness).
3. Compare to other countries (relative performance).

Measuring Growth

The year-to-year change in GDP is calculated as:

$$\text{Change in GDP}=\frac{\text{Year 2 - Year 1}}{\text{Year 1}}$$

Calculating GDP

Two methods of calculating GDP:

1. Expenditures Approach: Add all spending on final goods/services.
2. Income Approach: Add all income from selling final goods/services.
   • Both methods yield the same value, as every dollar spent is income to someone else.

There are also two types of GDP, both real and nominal. This is further described in 2.6 — Real vs. Nominal GDP.

Expenditures Approach

The expenditure approach accounts for all consumption within the economy. It consists of:

1. Consumer Spending ($C$): Spending on goods and services.
   • Example: $5 pizza.
2. Investment ($I$): Spending by businesses on tools/machinery.
   • Example: Buying new equipment.
3. Government Spending ($G$): Spending on goods/services (not transfer payments like Social Security).
   • Example: Military spending.
4. Net Exports ($X_n$): Exports (X) - Imports (M).
   • Example: Value of 3 Ford cars minus 2 Honda imports.

$$GDP=C+I+G+X_n$$

This expenditure approach is also used to calculate aggregate demand in future units.

Income Approach

The income approach calculates the GDP by accounting for all income within the economy. It consists of:

1. Wages ($W$): All money that people earn from their jobs
2. Interest Income ($I$): Money earned from bank deposits
3. Rent ($R$): Money earned from renting properties
4. Profits ($\text{Revenue}-\text{Costs}$): Amount made by businesses

$$GDP=W+I+R+P$$