Module The Circular Flow and Gross Domestic Product 10 KRUGMAN'S MACROECONOMICS for AP* Margaret Ray and David Anderson

What you will learn in this Module: How economists use aggregate measures to track the performance of the economy The circular flow diagram of the economy What gross domestic product, or GDP, is and the three ways of calculating it

The Simple Circular-Flow Diagram Note: One approach to teaching this model is to draw it once. Begin with the households who buy “stuff” from retailers of stuff. Dollars flow to the retailers, and stuff flows to the households. Once you have told a simple story and drawn a simple circular flow, you might have a prepared (and polished) visual ready to project for the students. Note: I suggest that the instructor spend more time on the Simple Circular Flow Model. Then show the Expanded Model side-by-side to show how the flow of money gets more complicated.   Stress to the students that this diagram is a simplified representation of the macroeconomy. It shows the flows of money, goods and services, and factors of production through the economy. The underlying principle is that the flow of money into each market or sector is equal to the flow of money coming out of that market or sector. The Simple Circular Flow Model There are two groups of decision-makers in private economy (no government or foreign sector yet): only households and businesses. Let’s begin with the product markets. A product market is where goods and services (cars, computers, and corn) are bought and sold. a. Households are on the demand side of these markets, purchasing goods and services. b. Businesses are on the supply side of these markets, offering products for sale. c. Interaction of this demand and supply determines the price of each product. d. Flow of consumer expenditures constitutes sales receipts for businesses. Let’s turn to the resource markets. A resource market is where resources (labor, capital, land) are offered for hire and employed. a. Households supply resources directly (workers) or indirectly (through ownership of corporations). b. Businesses demand resources in order to produce goods and services. c. Interaction of this supply and demand determines the price of each resource, which in turn is income for the owner of that resource. d. Flow of payments from businesses for resources constitutes business costs and resource owners’ incomes.

The Expanded Circular-Flow Diagram Note: If you are projecting the expanded model, the instructor can just point out a few of the interesting differences in the additions, and subtractions, of money from the macroeconomy compared to the earlier slide.

Gross Domestic Product Final goods and services Intermediate goods and services GDP Value of all goods and services produced (value added approach) Aggregate Spending (C + I + G + XN) Total Factor Income Gross Domestic Product Measuring GDP as the Value of Production of Final Goods and Services   Begin with the definition of GDP: The total market value of all final goods and services produced within a country in one year. Note: The instructor can explain GDP by looking at each important piece of the definition. Market Value: We must compute the value of production, not just the production GDP includes only final products and services; it avoids double or multiple counting, by eliminating any intermediate goods. Final goods are those that are ready for consumption. A bottle of ketchup at Kroger is counted. Intermediate goods are those that require further processing before they are counted as a final good. GDP is tabulated as the production done within the bounds of a given nation. If it was produced in America, it belongs in the GDP of America. It doesn’t matter where it is actually consumed, or where the actual company is headquartered. Ex. General Motors, an American company, has a factory producing trucks in South Africa. The value of these trucks is counted in South Africa’s GDP. Ex. A Honda Civic produced in Kentucky in 2009, but not sold until January 2010 is counted in 2009 production and 2009 GDP. GDP sums the dollar value of what has been produced in the economy over the year, not what was actually sold. Production This Year 2. Measuring GDP as Spending on Domestically Produced Final Goods and Services GDP is divided into the categories of buyers in the market; household consumers, businesses, government, and buyers from outside of the country. Personal Consumption Expenditures—(C)—includes durable goods, non-durable goods and services. Examples? A pedicure = service. A new washing machine = durable. A head of romaine lettuce = non-durable. An accounting firm buys a new fax machine. a. All final purchases of machinery, equipment, and tools by businesses. Domestic Investment—(I) A manufacturer buys a new stamping machine. Building a new apartment complex or a Lowe’s superstore. b. All construction (including residential). c. Changes in business inventory. ii. If businesses are able to sell more than they currently produce, this entry will be a negative number. Remember it’s about production in 2009, not consumption. i. If total output exceeds current sales, unsold inventories build up. b. Includes all direct purchases of resources (labor in particular). a. Includes spending by all levels of government (federal, state and local). Government Purchases (of consumption goods and capital goods)‚ (G) Employment of a nuclear physicist at Los Alamos. Purchase of a heavy duty van  from General Motors. Examples? b. Often goods purchased in the U.S. are produced elsewhere (Imports). a. All spending on goods produced in the U.S. must be included in GDP, whether the purchase is made here or abroad (Exports). Net Exports—(X - IM) c. Therefore, net exports, (X - IM) is the difference: (exports minus imports) and can be either a positive or negative number depending on which is the larger amount. Summary: GDP = C + Ig + G + Xn 3. Measuring GDP as Factor Income Earned from Firms in the Economy Demonstrates how the expenditures on final products are allocated to resource suppliers. The sum of the below entries equals national income: all income earned by American supplied resources, whether here or abroad. Compensation of employees: (includes wages, salaries, fringe benefits, salary and supplements, and payments made on behalf of workers like social security and other health and pension plans). Proprietors’ income: income of unincorporated businesses, sole proprietorships, partnerships, and cooperatives. Interest: payments from private business to suppliers of money capital. Rents: payments for supplying property resources (adjusted for depreciation it is net rent). Corporate profits: After corporate income taxes are paid to government, dividends are distributed to the shareholders, and the remainder is left as undistributed corporate profits. NI = Wages + Rents + Interest + Profits

The Components of GDP

What's Included Not Included Domestically produced final goods and services, including capital goods, new construction of structures, and changes to inventories Not Included Intermediate goods and services Inputs Used goods Stocks & Bonds Foreign produced goods & services In addition to the intermediate goods described above, the following are not counted in the GDP calculations. a. Second Hand Sales. GDP is designed to measure what is newly produced or created over the time period. Previously existing assets or property that is sold or transferred is excluded. This falls under the “do not double count” rule. If you buy a new Xbox in 2008 at Circuit City, it would count in the GDP for 2008. If you resell it on eBay in 2010, it is NOT counted again. Finals goods and services are only counted once, in the year in which they were produced.   b. Purely financial transactions are excluded. Public transfer payments, like social security or cash welfare benefits. Private transfer payments, like student allowances or alimony payments. The sale of stocks and bonds represent a transfer of existing assets. (However the brokers’ fee is included for current services rendered).