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

2. 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

3. 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

4. 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

5. 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

6. 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

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

8. 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

9. 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

10. 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

11. 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

12. 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

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

14. 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

15. 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

16. 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

17. 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

18. 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.

19. 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

20. 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)

21. 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

22. 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.

23. 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.

24. 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.

25. 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.

26. 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.

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

28. 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.

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

30. Table 2 Real and Nominal GDP

31. Table 2 Real and Nominal GDP

32. Table 2 Real and Nominal GDP

33. 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.

34. The GDP Deflator
The GDP deflator is calculated as follows:

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

36. Table 2 Real and Nominal GDP

37. 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

38. 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.

39. 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.

40. Table 3 GDP and the Quality of Life

41. 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.

42. 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.

43. 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.

44. 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.