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Module 10
THE CIRCULAR FLOW MODEL AND GROSS DOMESTIC PRODUCT
For all countries there are three major
economic goals:
1. Promote Economic Growth
2. Limit Unemployment
3. Keep Prices Stable (Limit Inflation)
In this unit we will analyze how each
of these are measured.
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Homework Assignment: Due: Next class after test.
Go to the Freakonomics Radio podcast link and listen to the podcast. It’s approx. 20 minutes.
When you are done write a paragraph that answers the following questions.
1. What is the shadow economy and how does it impact GDP?
2. Give examples from the podcast to support your assertions.
3. Why should we care about a shadow economy?
http://freakonomics.com/2012/08/30/how-deep-is-the-shadow-economy-a-new-freakonomicsradio-podcast/
There are 4 keys to the Unit
1. Circular Flow Diagrams
◦(Module 10)
2. Gross Domestic Production (GDP)
◦ Module 10 & 11
3. Unemployment
◦(Module 12 & 13)
4. Inflation
◦(Module 14 & 15)
Warm Up
Make a list of all the things you
spent money on in the past week.
Be as specific as possible!
Economists collect statistics on production, income,
investment, and savings.
This is called national
income accounting.
The most important measure of growth is GDP.
Gross Domestic Product (GDP) = dollar value of all final goods and services
produced in a country in one year.
• Dollar value- GDP is measured in dollars.
• Final Goods-GDP does not include the value of intermediate goods.
Intermediate goods are goods used in the production of final goods and
services.
• One Year-GDP measures annual economic performance.
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Circular Flow Diagram: Inflow of money into each market or sector must
equal the outflow of money coming from that market or sector
Keys to the Circular Flow Chart
1. Chart has 4 sectors:
◦ Households: are the demand side of markets purchasing goods and services
◦ Firms: are on the supply side offering products to sale.
◦ Government: purchases goods and services and collects taxes to spend in the econonmy
◦ Rest of the world: Global trade and investments
All are connected by 3 types of markets
Factor; Market for Goods & Services; Financial Markets
Expanded Circular Flow Diagram: 4 sectors of economy {households; firms;
gov’t; rest of world} are all connected via 3 types of markets: {factor markets;
markets for goods and services; and financial markets}
Leakage and injections
In the five sector model of the economy there is leakage and injections
Leakage means withdrawal from the flow. When households and firms
save part of their incomes it constitutes leakage. Leakages may be in
form of savings, tax payments, and imports.
Summary of leakage and injections
LEAKAGES
INJECTION
Saving (S)
Investment (I)
Taxes (T)
Government Spending (G)
Imports (M) Exports (X)
Calculating GDP
Three Ways of calculating GDP:
1. Expenditure Approach (aka Aggregate Spending)
2. Income Approach (aka Sum of total factor income)
3. Total Value Approach of all final goods and
services
All ways generate the same amount since every
dollar spent is a dollar of income.
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1. Expenditures Approach-Add up all the
spending on final goods and services
produced in a given year.
GDP = C + I + G + Xn (exports-imports)
C IS CONSUMER SPENDING
I IS INVESTMENT SPENDING
G IS GOVERNMENT PURCHASES OF GOODS
AND SERVICES
X IS EXPORTS - IMPORTS
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2. Income Approach-Add up all the
income that resulted from selling all
final goods and services produced in a
given year.
In other words, add up all the income
earned by producers in the nation and that
must equal the value of the products that
they sold
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3. PRODUCT APPROACH (aka net product or value
added)
◦This is the sum of all the outputs of every enterprise in the nation
◦ 1. Estimate Gross Value of Domestic Output
◦ 2. Determine Intermediate Consumption (costs used to produce the final product
◦ 3. Deduct Intermediate Consumption from the Gross Value
GV= VALUE OF OUTPUT – VALUE OF INTERMEDIATE
GOODS
Expenditures Approach
Four components of GDP:
1. Consumer Spending (C)
Ex: $5 Spent on Pizza
2. Investments (I) -Businesses putting money
back into their own business.
3. Government Spending
Ex: Bombs or tanks, NOT social security
4. Net Exports -Exports (X) – Imports (M)
Ex: Value of 2 Ford Focuses minus 3 Hondas
Remember: GDP = C + I + G + Xn (exports–imports)
America’s trade balance (exports minus imports)
What is NOT included in GDP
1. Intermediate Goods
• No Multiple Counting, Only Final Goods
• EX: Price of finished car, not the radio,
tire, etc.
2. Nonproduction Transactions
•Financial Transactions (nothing produced)
•Ex: Stocks, bonds, Real estate, social
security
•Used Goods
•Ex: Old cars,
usedActivities
clothes
3. Non-Market
(Illegal)
•Ex: Illegal drugs, unpaid work
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Social security, welfare, and other transfer
payments are not included in government
expenditures. Recipients of transfer payments do
not provide any current goods or services in
exchanges for these payments. Hence, government
expenditures on transfer payments do not involve
the purchase of any new goods or services and are
therefore excluded from the calculation of
government expenditures.
Calculating GDP using all 3 methods brings the same result
Current Events
http://www.bbc.co.uk/news/business-24821383
http://www.google.com/search?q=gdp&rls=com.microsoft:en-us&ie=UTF-8&oe=UTF8&startIndex=&startPage=1&safe=active
What's Included
Not Included
Intermediate goods and services
Inputs
Domestically produced final
Used goods
goods and services, including
Stocks & Bonds
capital goods, new construction
of structures, and changes to
Foreign produced goods & services
inventories
1. Economists keep track of the flows of money between sectors with the national
income and product accounts, or national accounts.
2. Households earn income via the factor markets from wages.
3. Disposable income is allocated to consumer spending (C) and private savings.
4. Via the financial markets, private savings and foreign lending are channeled to
investment spending (I), government borrowing, and foreign borrowing.
5. Government purchases of goods and services (G) are paid for by tax revenues and
any government borrowing.
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6. Exports (X) generate an inflow of funds into the country from the rest of the world,
but imports (IM) lead to an outflow of funds to the rest of the world.
7. Gross domestic product, or GDP, measures the value of all final goods and services
produced in the economy.
8. GDP can be calculated in three ways:
a. add up the value added by all producers;
b. add up all spending on domestically produced final goods and services (GDP = C + I + G +
X − IM); or
c. add up all the income paid by domestic firms to factors of production. These three
methods are equivalent.
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For each situation, identify if it is included in GDP
1. $10.00 for movie tickets
2. $5M Increase in defense expenditures
3. $45 for used economics textbook
4. Ford makes new $2M factory
5. $20K Toyota made in Mexico
6. $10K Profit from selling stocks
7. $15K car made in US, sold in Canada
8. $10K Tuition to attend college
9. $120 Social Security payment to Bob
10.Farmer purchases new $100K tractor
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GDP=$7,125,010
1. $10.00 for movie tickets
2. $5M Increase in defense expenditures
X $45 for used economics textbook
4. Ford makes new $2M factory
X $20K Toyota made in Mexico
X $10K Profit from selling stocks
7. $15K car made in US, sold in Canada
8. $10K Tuition to attend college
X $120 Social Security payment to Bob
10.Farmer purchases new $100K tractor
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Partner check
With your partner complete the circular flow handout.
Draw your own circular flow model that illustrates the Factor and Product markets and the flow
of goods and services from each component.
http://www.ted.com/talks/tim_jackson_s_econ
omic_reality_check.html
Making our world equitable
Real vs. Nominal GDP (Module 11)
Nominal GDP is GDP measured in current prices. It does
not account for inflation from year to year.
Real GDP adjusts for inflation and is the BEST MEASURE OF
ECONOMIC GROWTH
Per Capita GDP measures a country’s GDP by the
size of its population.
Divide the GDP for a year by the number of people
in the nation to obtain the best measurement of a
nations growth and productivity.
How can you measure growth from year to
year?
Chain-Linking: Use a base year and a later year
% Change
in GDP
=
Year 2 – Year 1
Year 1
X 100
Real vs. Nominal GDP Example
2008
10 cars at $15,000 each = $150,000
10 trucks at $20,000 each = $200,000
The GDP for year 2008 shows the dollar
value of all final goods produced.
Nominal GDP = $350,000
2009
10 cars at $16,000 each = $160,000
10 trucks at $21,000 each= $210,000
Nominal GDP = $370,000
2009
10 cars at $15,000 each = $150,000
10 trucks at $20,000 each= $200,000
REAL GDP = $350,000
The nominal GDP in year 2009 is higher
which suggests that the economy is
improving. But how much is the REAL GDP?
How do you get it?
Use 2008 Prices.
The Real GDP for 2009 is the same as
2008 after we adjust for inflation.
------------------------------------------Year 2-Year1
Year 1
x 100
World GDP Distribution
2010 Nominal GDP
The top 10 most populated countries 2011
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Top 10 Nations GDP Per Capita
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What is the most popular movie of all time?
What is the problem with this method?
Nominal Box Office Receipts
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Real Box Office Receipts (adjusted for inflation)
Real GDP “deflates” nominal GDP by adjusting for
inflation in terms of a base year prices.
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% change GDP = yr2-yr1 x100
yr1
so real GDP
yr2 (P1xQ2) – yr1 (P1xQ1)
year 1(P1xQ1)
x 100
Show how full GDP arrived at for both years and then show how arrive at % change.
Nominal versus Real GDP in 2001, 2005, and 2009 demonstrates how our
GDP actually went up much less during President Bush’s administration than
actually believed as compared to when he began his presidential term.
Does GDP accurately measure standard of
living?
Standard of living (or quality of life) can be measured, in
part, by how well the economy is doing…but it does not
measure a nation’s happiness just output