The Circular Flow and GDP Module 10 The Circular Flow and GDP © 2007 Thomson South-Western

THE ECONOMY’S INCOME AND EXPENDITURE When judging whether the economy is doing well or poorly, it is natural to look at the total income that everyone in the economy is earning

What is Standard of Living? The configuration of arrows shown on the first day of class represents our standard of living Standard of living is an economy’s level of prosperity; best measured by the value of goods & services (products) produced on average per person

What is Standard of Living? A nation’s standard of living is the level of consumption of goods and services (products) that the country’s people enjoy, measured by average income per person. It is the quantities and quality of goods & services (products) consumed that determine how well off people are

THE ECONOMY’S INCOME AND EXPENDITURE For products to be consumed they must be produced Today, nearly ALL of the world’s nations employ some form of the market system

THE ECONOMY’S INCOME AND EXPENDITURE For an economy as a whole, income must equal expenditure because: Every transaction has a buyer and a seller. Every dollar of spending by some buyer is a dollar of income for some seller. Income=Expenditure

Figure 1 The Circular-Flow Diagram Revenue Spending Labor, land, and capital Wages, rent, and profit = Flow of inputs and outputs = Flow of dollars

THE ECONOMY’S INCOME AND EXPENDITURE Critical to understand the key decision makers and the main markets present in this system, which is governed by supply and demand In the free-enterprise system, resources, products and money payments are exchanged among the three interconnected decision makers in the economy

THE ECONOMY’S INCOME AND EXPENDITURE There are 3 types of decision makers in the economy: Households Businesses (Firms) Government The fourth would be the rest of the world --In a power point soon

Figure 1 The Circular-Flow Diagram Firms sell Households buy MARKETS FOR GOODS AND SERVICES Revenue Spending Goods and services sold Goods and services bought FIRMS Produce and sell goods and services Hire and use factors of production Buy and consume goods and services Own and sell factors of production HOUSEHOLDS Households sell Firms buy MARKETS FOR FACTORS OF PRODUCTION Factors of production Labor, land, and capital Wages, rent, and profit Income = Flow of inputs and outputs = Flow of dollars

Our First Model: The Circular-Flow Diagram Firms Produce and sell goods and services Hire and use factors of production On the supply side of the markets Households Buy and consume goods and services Own and sell factors of production On the demand side of the markets 7

Our First Model: The Circular-Flow Diagram Markets for Goods and Services Firms sell Households buy Markets for Factors of Production Households sell Firms buy 7

Our First Model: The Circular-Flow Diagram Factors of Production Inputs used to produce goods and services Land, labor, and capital 7

Our First Model: The Circular-Flow Diagram Interaction of this demand and supply determines the price of each product Flow of consumers expenditures constitutes sales receipts for businesses 7

CIRCULAR FLOW QUESTIONS-1 What is household? CONSUMERS/RESOURCE OWNERS CONSUMERS play a leading role in the economy demand the products produced Resource owner Supply the resources used to produce the products

CIRCULAR FLOW QUESTIONS-2 What is business/firm? play a leading role in the economy demands the resources that households supply Utilize these resources to supply the products that households purchase

CIRCULAR FLOW QUESTIONS-2 What is government? play a leading role in the economy demands the resources that households supply Utilize these resources to supply the products that households use

CIRCULAR FLOW QUESTIONS-1 What is a product market? is the place where goods and services (G/S) are exchanged. An example would be a retail clothing store.

CIRCULAR FLOW QUESTIONS-2 Give two examples of transactions that you made in the product market within the last week. Food at Wegmans Gas at Raceway

CIRCULAR FLOW QUESTIONS-3 What is the factor market? the place where resources are used to produce products that are exchanged. The three components of the factor market are land, labor and capital, (and entrepreneur)

CIRCULAR FLOW QUESTIONS-4 Give examples of the factor markets. Land purchased by a firm to build a new factory Labor purchased by a firm to build products Purchase machines to produce the product

CIRCULAR FLOW QUESTIONS-5 Explain how the circular flow model reflects interdependence. the arrows represent how all components of the economy rely on each other. IF one component falters, it has a ripple effect on the economy.

CIRCULAR FLOW QUESTIONS-6 Where do households get the money to buy goods in the product market? Households get the money to buy goods in the product market by providing labor in the input markets.

CIRCULAR FLOW QUESTIONS-7 Where do firms get the money to buy raw materials in the factor markets? Firms get the money to buy raw materials in the factors markets by providing G/S for sale in the product markets for households to purchase. A commercial bank acts as an intermediary, linking savers and borrowers so that borrowers can acquire the funds to get the needed resources.

CIRCULAR FLOW QUESTIONS-8 What determines the price that consumers will pay for a good in the product market? The price is set by the demand for a good as determined by the marketplace.

CIRCULAR FLOW QUESTIONS-9 What determines the price that firms will pay for labor in the factor market? The price is set by the demand for labor as determined by the marketplace.

GDP and Its Components (2004) (expanded in the next ppt) Government Purchases 15% Net Exports -5 % Investment 16% Consumption 70%

REAL VERSUS NOMINAL GDP Nominal GDP values the production of goods and services at current prices. Real GDP values the production of goods and services at constant prices.

REAL VERSUS NOMINAL GDP An accurate view of the economy requires adjusting nominal to real GDP by using the GDP deflator.

Table 2 Real and Nominal GDP

Table 2 Real and Nominal GDP

Table 2 Real and Nominal GDP

The GDP Deflator The GDP deflator is a measure of the price level calculated as the ratio of nominal GDP to real GDP times 100. It tells us what portion of the rise in nominal GDP that is attributable to a rise in prices rather than a rise in the quantities produced.

The GDP Deflator The GDP deflator is calculated as follows:

The GDP Deflator Nominal GDP is converted to real GDP as follows:

Table 2 Real and Nominal GDP

Figure 2 Real GDP in the United States Billions of 2000 Dollars $10,000 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1970 1975 1980 1985 1990 1995 2000 2005

IS GDP A GOOD MEASURE OF ECONOMIC WELL-BEING? GDP is the best single measure of the economic well-being of a society. GDP per person tells us the income and expenditure of the average person in the economy. Higher GDP per person indicates a higher standard of living. GDP is not a perfect measure of the happiness or quality of life, however.

GDP AND ECONOMIC WELL-BEING Some things that contribute to well-being are not included in GDP. The value of leisure. The value of a clean environment. The value of almost all activity that takes place outside of markets, such as the value of the time parents spend with their children and the value of volunteer work.

Table 3 GDP and the Quality of Life

Because every transaction has a buyer and a seller, the total expenditure in the economy must equal the total income in the economy. Gross domestic product (GDP) measures an economy’s total expenditure on newly produced goods and services and the total income earned from the production of these goods and services.

GDP is the market value of all final goods and services produced within a country in a given period of time. GDP is divided among four components of expenditure: consumption, investment, government purchases, and net exports.

Nominal GDP uses current prices to value the economy’s production Nominal GDP uses current prices to value the economy’s production. Real GDP uses constant base-year prices to value the economy’s production of goods and services. The GDP deflator—calculated from the ratio of nominal to real GDP—measures the level of prices in the economy.

GDP is a good measure of economic well-being because people prefer higher to lower incomes. It is not a perfect measure of well-being because some things, such as leisure time and a clean environment, are not measured by GDP.