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Lesson summary: The circular flow and GDP

In this lesson summary review and remind yourself of the key terms and calculations used in describing the output of an economy. Key topics include the expenditures approach, income approach, and value added approach to calculating GDP and why imports are subtracted from GDP.

Lesson Overview

Just how much stuff did the nation of Gerbilalia produce last year? We can use one of our key macroeconomic measures, gross domestic product (GDP), to figure this out.
GDP can be measured in three different ways: the value added approach, the income approach (how much is earned as income on resources used to make stuff), and the expenditures approach (how much is spent on stuff). However, you will likely run into the expenditures approach the most as you progress through this course.
A model called the circular flow diagram illustrates how the expenditures approach and the income approach must equal each other, with goods and services flowing in one direction and income flowing in the opposite direction, in a closed loop.

Key Terms

gross domestic product (GDP)the market value of the final production of goods and services within the geographic borders of a country in a given period; for example, if the GDP of India is $2.264 trillion in 2016, this means that this is the value of all new goods and services that were produced inside the border of India, excluding intermediate goods, during 2016.
expenditures approach to GDPone of the three approaches to calculating GDP that involves adding up all spending on final goods and services in an economy; the expenditures approach categories this spending into five categories: consumption, investment, government spending, exports, and imports: Y=C+I+G+XM.
income approach to GDPan approach to calculating GDP that involves adding up all of the income earned within the borders of a country in a given year; the income approach adds up wages, rents, interest, and profits.
value-added approach to GDPan approach to calculating GDP that involved adding up all of the value added at various stages of production; for example, in the production of a cake that sells for $12, the value-added approach counts the value of the raw ingredients that a farmer sells to the baker ($4), which a baker then combines with her capital to create a cake, which adds $8 in value.
final goods and servicesthe goods and services that are purchased by consumers, businesses, the government, or other countries in their final form for their intended final use; for example, a car purchased by a household, a haircut, or a laptop bought by a student.
intermediate goodsgoods that are used in the production of a final product; for example, tires are final goods when Katherine buys them at the tire store. But when Acme Motor Company buys tires to build a car that they plan on selling, those tires would be considered intermediate goods.
consumption (C)when using the expenditures approach, “C” is the category of GDP that is spending by households on final goods and services in a given year but excludes spending on new housing
investment (I)when using the expenditures approach, “I” is the category of GDP that is spending businesses do in order to produce goods and services (such as buy computers for accountants to use or build factories to build cars); investment includes spending on capital goods (tools, equipment) and inventory.
government spending (G)when using the expenditures approach, “G” is the spending by government entities, whether local or national governments, on goods and services such as building roads and national defense; note that transfer payments are not included in “government spending” in GDP even though it is something that is part of the money that a government might spend each year.
transfer paymentany payment by a government to a household that is not in exchange for a good or service; for example, if the government hires a contractor they are buying a service that is included in GDP, but if they send a retired person a pension check they are not buying a good or service and it is not counted in GDP.
exports (X)goods that are produced in one country and then sold within another country; for example, if a producer in the United States makes 400 Katnest Evergreen bobblehead dolls and sells them to a store in Japan, these dolls would be counted as Exports for the United States.
imports (M)goods that are produced in a different country than where they were purchased; for example, those bobblehead dolls made in the U.S. are purchased by Japanese consumers, so they would get counted initially as consumption (“C”) for Japan. Since they do not reflect something that was produced in Japan, they are subtracted from Japan’s GDP as an import (“M”).
net exports X-Mspending on exports minus spending on imports’ “exports” is the value of goods that go out of a country, “imports” is the value of the goods that come into a country. There is a trade deficit when imports are higher than exports and there is a trade surplus and when exports are higher than imports.

Key Takeaways

Gross Domestic Product (GDP)

Gross domestic product (GDP) is a measure of the final output of a nation’s economy. GDP measures the total value of all new goods and services produced in an economy in a given year.
For example, in 2016 GDP in Japan was $4.939 trillion. This means that during 2016, Japan produced goods and services within its geographic borders that were sold for $4.939 trillion. GDP can be measured using 1) the expenditures approach, 2) the income approach, or 3) the value added approach. The three approaches are equivalent—regardless of which approach you use you should end up with the same value.

The circular flow diagram

GDP can be represented by the circular flow diagram as a flow of income going in one direction and expenditures on goods, services, and resources going in the opposite direction. In this diagram, households buy goods and services from businesses and businesses buy resources from households.

Key Graphical Model: The circular flow diagram

The circular flow diagram has a box representing households and another box representing firms. An arrow pointing from households to firms represents the flow of resources. An arrow pointing from firms to households represents the flow of goods and services. Collectively these two arrows represent the flow of goods, services, and resources in a clockwise way. An arrow pointing from households to firms represents spending by households on goods and firms revenues. An arrow pointing from firms to households represents payments made by firms to households. Collectively, these two arrows represent the flow of income in a counterclockwise way.
Figure 1: The circular flow diagram
The circular flow diagram illustrates the equivalence of the income approach and expenditures approach to calculating national income. In this diagram, goods, services, and resources move clockwise, and money (income from the sale of the goods, services, and resources) moves counterclockwise.
Individuals purchase goods and services from businesses, and their expenditures (the money they spend) go to businesses. Firms purchases resources, such as labor from households, and the money they pay for these resources go to households.

Key Mathematical Model: Two approaches to measuring GDP

The expenditures approach

GDP can be calculated using the expenditures approach using the following equation:
Each component is described in the table below:
Cconsumption: spending by households
Iinvestment: spending by businesses on capital and inventory
Ggovernment spending: spending by all government entities on goods and services (but not transfer payments)
Xexports: goods and services produced within a country that are purchased in other countries
Mimports: goods and services that are produced in other countries but are purchased in your country.

The income approach

GDP can be calculated using the income approach using the following equation:
Where each category refers to the income received from supplying one of the four economic resources:
wwages earned from labor
iinterest earned on capital
rrent earned on land
pprofits earned on entrepreneurial talent

Common misperceptions

  • When people casually use the word “investments” in everyday language, they are typically referring to financial assets such as stocks and bonds. However, in the context of GDP, “investment” means real assets—the spending on physical equipment, research and development, and inventory.
For example, if a company buys a computer, that is physical equipment. If a company restocks its warehouse, that is building inventory. Both the equipment and inventory are counted in the investment category of GDP. A share of stock of a company is not considered an “investment” because it is an ownership claim rather than a real asset. When reading or writing about anything involving investment, make sure to specify whether you mean a real asset or a financial asset.
  • Not all government spending is counted in GDP; only what a government spends on goods and services is counted. In many countries, governments also have social welfare programs that do things like provide pensions for retired people or allocate money to people with lower incomes. These payments, called “transfer payments,” neither reflect actual production of a good by the person receiving the money nor a service provided by the person receiving the money. Therefore, they should not be counted in GDP. Nobody is “buying” grandma when she gets a pension check!

Discussion Questions

  • Why are imported goods deducted from the calculation of GDP?
  • Give three examples of goods that your household purchased last year that would not be counted in GDP.
  • What does the circular flow diagram say about the relationship between the expenditures approach and the income approach to calculating GDP?

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