AP Macroeconomics The Circular Flow & GDP

Gains from Exchange

What are they? A set of numbers that every country calculates In the US, the Bureau of Economic Analysis calculates these numbers They keep track of consumer spending, sales of producers, business investment spending, government purchases, among other things National Income & Product Accounts (aka National Accounts)

Remember that diagram? What does it represent? That the flow of money into each market or sector is equal to the flow of money coming out of that market or sector. It helps us to understand the underlying principles of national accounts. It shows the flows of money, goods and services, and factors of production through the economy.

The “Simple” Circular Flow Diagram

2 “inhabitants” in a simple economy Households: either an individual or a group of people who share their income Firms: organizations that produce goods or services for sale— and that employs members of households

2 “markets” in a simple economy Product Market: in which households buy goods and services they want from firms. Factor Markets: in which firms buy resources they need to produce goods & services (i.e. labor from households)

The “Expanded” Circular Flow Diagram It is “expanded” to include extra elements ignored in the simple diagram in order to keep it “simple” or easy to understand The underlying principle (that the in-flow of money into each market or sector must equal the outflow of money coming from that market or sector still applies)

EXPANDED CIRCULAR FLOW DIAGRAM

In product markets… People engage in consumer spending, or buying goods & services from domestic firms and from firms all over the world

In Factor Markets… Households also own factors of production – land, labor, and capital. They sell these factors to firms in return for rent, wages, and interest payments.

A little deeper… For the most part, households spend most of their income received from factors of production on goods and services However, not all of it is spent on goods & services – some of it must necessarily go to the government in the form of taxes (income, and sales) What is the NC sales tax? Another portion of that money is set aside in the form of savings (in financial markets and private savings) And the government makes payments to some households without expecting payment in return. Can we think of an example?

What’s left? Wow. So after paying taxes and receiving government transfers (i.e. payments from the government), we can all whatever it is that is leftover “disposable income”

The government giveth and taketh away While the government takes from households in the form of taxes, it also gives it back (as previously mentioned) in the form of government transfers The government also partakes in purchases of goods and services (think military, A.C. Reynolds HS, and that sidewalk that you [would never] spit on outside your house)

The rest of the world in eins, zwei, und drei… The rest of the world also participates in the US economy, and it does so in three ways: 1) Exports – flow of funds into the US 2) Imports – flow of funds out of the US 3) Participation in US financial markets by foreigners

GROSS DOMESTIC PRODUCT …aka GDP…

What is GDP? GDP is the total value of all final goods and services produced in an economy during a given period, usually one year.

Calculating GDP in eins, zwei, und drei There are three ways to calculate GDP: 1) Survey firms and add up the total value of their production of final goods and services (add up the value of all goods & services produced in the economy, excluding intermediate goods & services)

Method zwei 2) Add up aggregate spending on domestically produced final goods & services in the economy (GDP measured by flow of funds into firms. This method avoids double-counting, that is we wouldn’t count both the consumer’s spending on a burger and the butcher’s spending on the cow) GDP = C+I+G+X-IM C= Consumer spending I= Investment spending G= government purchases of goods & services X=sales to foreigners (exports) IM=spending on imports X-IM = (difference between the value of exports and the value of imports in aka net exports

Method drei (not as emphasized as the first two) 3) Sum the total factor income earned by households from firms in the economy (add up all the income earned by factors of production [Note: the wages earned by labor; the interest earned by those who lend their savings to firms & the government; the rent earned by those who lease their land or structures to firms; and the profit earned by shareholders}

What’s Included in GDP? Domestically produced final goods & services This includes the following: Capital goods New construction of structures Changes to inventories (stocks of goods and raw materials that firms hold to facilitate their operations)

What’s excluded in GDP? Intermediate goods & services Inputs Used goods Financial assets such as stocks [i.e. shares in ownership of a company] and bonds [i.e. loans to firms in the form of an IOU that pays interest] Foreign-produced goods & services

And Now… Homework: Morton WB, Activity 12 > Macroeconomics

Works Cited The Economics of Seinfeld. “Gains from Exchange.” Krugman, Paul, and Robin Wells. Krugman’s Economics for AP. New York, Worth Publishers. Reffonomics.