Name _____________________________
Section 3
Module 10: The Circular Flow and Gross Domestic Product
Lecture Notes
Pump Primer
Draw a diagram of the Simple Circular Flow Model.
Learning objectives:
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
How economists use aggregate measures to track the performance of the economy.
The circular flow model of the economy.
What gross domestic product, or GDP, is and the three ways of calculating it.
Key Economic Concepts for This Module:
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
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The national income and product accounts, often referred to simply as the national accounts,
keep track of the spending of consumers, sales of producers, business investment spending,
government purchases, and a variety of other flows of money between different sectors of the
economy.
The circular - flow 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. This demonstrates how we can use three equivalent
ways to calculate GDP.
Gross domestic product, or GDP, is the total value of all final goods and services produced in
an economy during a given period, usually a year.
There are three ways to calculate GDP. (1) Add up the total value of their production of final
goods and services. (2) Add up aggregate spending on domestically produced final goods and
services in the economy—GDP = C+ I + G + (X-IM). (3) Sum the total factor income earned by
households from firms in the economy.
Introduction
The purpose of this module is to introduce macroeconomics and one of the most widely used
measurements of the strength of the economy, gross domestic product. The simple circular flow model is
used to show the flow of income and output and this is useful in describing how we measure gross
domestic product. The model can also be used to represent recession when the flow of income is slower
and recovery when the flow of income is faster.
The National Accounts
(Note: We are only going to cover the basics. You only need to know what is counted and what is not
counted, into a nation’s GDP.)
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
National income accounting is a method of measuring the flows of income and expenditures in
the economy over a period of time.
National income accounts serve the same purpose for the economy as a whole as does the income
statement of a business firm.
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The Simple Circular Flow Model

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.

There are two groups of decision-makers in private
economy (no government or foreign sector yet): only
households and businesses.
o __________________ markets. A product
market is where goods and services (cars,
computers, and corn) are bought and sold.
a. Households are on the _______________ side of these markets, purchasing goods and
services.
b. Businesses are on the _______________ side of these markets, offering products for
sale.
c. Interaction of this demand and supply determines the ________ of each product.
d. Flow of consumer expenditures constitutes sales receipts for businesses.
o
_________________ markets (or, factor 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 Model

A more detailed model than the simple
model.
Gross Domestic Product

Definition of GDP: The total market value
of all ___________ goods and services
produced within a country in _______ year.
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Measuring GDP as the Value of Production of Final Goods and Services

________________ Value: We must compute the value of production, not just the
production. Suppose you need to track the monthly production of a small coffee shop. A first
attempt might be to sum up all of the cappuccinos, café lattes and scones that were purchased.
The table below represents the output in two recent months. At first glance, the two months
produced the same amount (100) of goods, but clearly the mix of goods at the coffee shop is
different.
Simply Adding Production
January
# Café
# Cappuccinos
lattes
25
February
#
# Café
Cappuccinos
lattes
#
Scones
25
50
30
30
#
Scones
40
Adding the Value of Production
To paint a more accurate picture of what that production was worth, we need to incorporate the
value of these items.
January
Quantity
Prices
Cappuccinos
Café Lattes
Scones
Totals
25
25
50
100
$3.00
$2.50
$1.50
Value of
Production
February
Quantity
Prices
$75
$62.50
$75
$212.50
Cappuccinos
Café Lattes
Scones
Totals
30
30
40
100
$3.00
$2.50
$1.50
Value of
Production
$90
$75
$60
$225.50
While both months had 100 units of production, we can see that February was a more impressive
month because the total value of the production was higher. This difference would certainly have
been noticed, and appreciated, by the owners of the coffee shop.
Final Goods
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 the
grocery store is counted.

Intermediate goods are those that require further processing before they are counted
as a final good.
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Example. A raw material like a tomato may be bought and sold several times before it appears as
a final product. If we were to count the dollars at every stage of this process, we would be double
counting, and this is to be avoided.
Transaction
1 Lb. of tomatoes from Grower to
Processor
Bottle of ketchup from Processor to Kroger
Kroger sells ketchup to consumer
Total $ Spent
Cost
$0.50
$1.50
$3.00
$5.00
At each stage, value is added to the final product, the bottle of ketchup. The total price of ketchup
includes all of these values, so we only count the final transaction price of $3.
If we added all of these transactions, we come up with $5, which overstates the value of the good
in its final use. GDP only adds the final transaction as the value of the final good produced and
consumed.
Within a Nation
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.
Production This Year
GDP sums the dollar value of what has been produced in the economy over the year, not what
was actually sold.
Example A Honda Civic produced in Kentucky in 2009, but not sold until January 2010
is counted in 2009 production and 2009 GDP.
The Components of GDP
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 ______________________ Expenditures—(C)—includes durable goods,
non-durable goods and services.
Examples:
A head of romaine lettuce = non-durable.
A new washing machine = durable.
A pedicure = service.

Domestic ____________________—(I)
a. All final purchases of machinery, equipment, and tools by businesses. An
accounting firm buys a new fax machine. A manufacturer buys a new stamping
machine.
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b. All construction (including residential). Building a new apartment complex or a
Lowe’s superstore.
c. Changes in business inventory.
i. If total output exceeds current sales, unsold inventories build up.
Remember it’s about production in 2009, not consumption. ii. If businesses are able
to sell more than they currently produce, this entry will be a negative number.

_____________________ Purchases (of consumption goods and capital goods)‚ (G)
a. Includes spending by all levels of government (federal, state and local).
b. Includes all direct purchases of resources (labor in particular).
Examples:
Purchase of a heavy duty van from General Motors.
Employment of a nuclear physicist at Los Alamos.

Net _____________—(X - IM)
a. All spending on goods produced in the U.S. must be included in GDP, whether the
purchase is made here or abroad (Exports).
b. Often goods purchased in the U.S. are produced elsewhere (Imports).
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 = ___ + ___ + ___ + ____
Measuring GDP as Factor Income Earned from Firms in the Economy
 The sum of the below entries equals national income: all income earned by American
supplied resources, whether here or abroad.

Demonstrates how the expenditures on final products are allocated to resource
suppliers.

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).

Rents: payments for supplying property resources (adjusted for depreciation it is net
rent).
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Interest: payments from private business to suppliers of money capital.
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Proprietors’ income: income of unincorporated businesses, sole proprietorships,
partnerships, and cooperatives.

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.
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
NI = Wages + Rents + Interest + Profits
(Note: In the circular flow model, the top (spending) and bottom (income) parts of the
model are equal.)
GDP: What’s In, What’s Out?

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)
Common Student Difficulties:

“What if the final product is assembled in China, but the components came from Canada and the
corporation is headquartered in Germany?” The final product was produced in China, therefore it
is counted to China’s GDP.
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