The Simple Circular Flow
Slide 8-1
The Simple Circular Flow
Slide 8-2
The Simple Circular Flow
Slide 8-3
The Simple Circular Flow
Slide 8-4
The Simple Circular Flow
Figure 8.1
Slide 8-5
The Simple Circular Flow
 Two observations
– In every economic exchange, the seller
receives exactly the same amount that
the buyer spends.
– Goods and services flow in one direction
and money payments flow in the other.
Slide 8-6
The Simple Circular Flow
 Profits explained
– Question
• Why is profit a cost of production?
– Answer
• Profits are the return entrepreneurs receive
for the risk they incur when organizing
productive activities
Slide 8-7
The Simple Circular Flow
 Product Markets
– Transactions in which
households buy goods
Slide 8-8
The Simple Circular Flow
 Final Goods and
Services
– Goods and services
that are at their final
stage of production
and will not be
transformed into yet
other goods or services
Slide 8-9
The Simple Circular Flow
 Factor Markets
– Transactions in
which businesses
buy resources
Slide 8-10
The Simple Circular Flow
 Total Income
– The yearly amount
earned by the
nation’s factors of
production
Slide 8-11
The Simple Circular Flow
 Question
– Why must total income
be identical to the dollar
value of total output?
 Answer
– Every transaction
simultaneously involves
an expenditure and a
receipt
Slide 8-12
National Income Accounting
 Gross Domestic Product (GDP)
– The total market value of all final goods
and services produced by factors of
production located within a nation’s
borders
Slide 8-13
National Income Accounting
 Observations
– GDP measures the dollar value
of final output
– GDP measures the dollar value of final
goods and services produced per year
by factors of production located within
a nation’s borders
Slide 8-14
Two Main Methods
of Measuring GDP
 Expenditure Approach
– A way of computing national income
by adding up the dollar value at current
market prices of all final goods and
services
Slide 8-15
Two Main Methods
of Measuring GDP
Expenditure Approach
Slide 8-16
Two Main Methods
of Measuring GDP
 Income Approach
– A way of measuring national income
by adding up income received by all
factors of production
Slide 8-17
Two Main Methods
of Measuring GDP
Income Approach
Slide 8-18
Two Main Methods
of Measuring GDP
 Deriving GDP by the expenditure
approach
– Consumption Expenditure (C)
• Durables
– Life span of more than three years
• Nondurables
– Life span of less than three years
• Services
– Intangible commodities
Slide 8-19
Two Main Methods
of Measuring GDP
 Deriving GDP by the expenditure
approach
– Gross Private Domestic Investment (I)
• The creation of capital goods, such as
factories and machines, that can yield
production and hence consumption in
the future
Slide 8-20
Two Main Methods
of Measuring GDP
 Deriving GDP by the expenditure
approach
– Gross Private Domestic Investment (I)
• Fixed investment
• Inventory investment
• New residential structures
Slide 8-21
Two Main Methods
of Measuring GDP
 Deriving GDP by the expenditure
approach
– Government Expenditures (G)
• State, local, and federal
• Valued at cost
Slide 8-22
Two Main Methods
of Measuring GDP
 Deriving GDP by the expenditure
approach
– Net Exports (Foreign Expenditures)
Net exports (X) = total exports - total imports
Slide 8-23
Two Main Methods
of Measuring GDP
 Mathematical representation
using the expenditure approach
GDP = C + I + G + X
Slide 8-24
GDP and Its Components
Figure 8-3
Slide 8-25
Two Main Methods
of Measuring GDP
 Deriving GDP by the income approach
Slide 8-26
Deriving GDP
by the Income Approach
 Gross Domestic Income (GDI)
– The sum of all income—wages, interest,
rent, and profits—paid to the four factors
of production
Slide 8-27
Two Main Methods
of Measuring GDP
 Gross Domestic Income (GDI)
– Wages
– Interest
– Rent
– Profits
Slide 8-28
Gross Domestic Product
and Gross Domestic Income, 2000
(in billions of 2000 dollars per year)
Figure 8-4
Source: U.S. Department of Commerce. First quarter preliminary data annualized.
Slide 8-29
Gross Domestic Product
and Gross Domestic Income, 2000
(in billions of 2000 dollars per year)
Expenditure Point of View—Product Flow
Expenditures by Different Sectors:
Household sector
Personal consumption expenses
$6,661.5
Government sector
Purchase of goods and services
1,734.6
Business sector
Gross private domestic investment
(including depreciation)
1,727.0
Foreign sector
Net exports of goods and services
-273.6
Gross Domestic Product
$9,849.5
Slide 8-30
Gross Domestic Product
and Gross Domestic Income, 2000
(in billions of 2000 dollars per year)
Income Point of View—Cost Flow
Domestic Income (at factor cost):
Wages
All wages, salaries, and supplemental
employee compensation
$5,678.4
Rent
All rental income of individuals plus
implicit rent on owner-occupied dwellings
155.4
Interest
Net interest paid by business
490.2
Profit
Proprietorial income
Corporate profits before taxes deducted
701.3
952.0
Non-income expense items
Indirect business taxes and other adjustments
Depreciation
Statistical discrepancy
Gross Domestic Income
762.1
1,215.4
-105.3
$9,849.5
Slide 8-31
Other Components
of National Income Accounting
 National Income (NI)
– The total of all factor payments
to resource owners
 Personal Income (PI)
– The amount of income that households
actually receive before they pay personal
income taxes
Slide 8-32
Other Components
of National Income Accounting
 Disposable Personal Income (DPI)
– Personal income after personal income
taxes have been paid
Slide 8-33
Going from GDP
to Disposable Income, 2000
Billions of Dollars
Gross domestic product (GDP)
Minus depreciation
9,849.5
-1,215.4
Net domestic product (NDP)
Minus indirect business taxes
and other adjustments
National Income (NI)
Minus corporate taxes, Social Security
contributions, corporate retained earnings
Plus government and business transfer payments
-1,236.5
+1,606.8
Personal Income (PI)
Minus personal income tax and non-tax payments
8,242.3
-1,253.2
Disposable personal income (DPI)
Source: U.S. Department of Commerce
8,634.1
-762.1
7,872.0
6,989.1
Slide 8-34
Distinguishing Between Nominal
and Real Values
 Nominal Values
– Measurements in terms of the actual
market prices at which goods are sold;
expressed in current dollars
Slide 8-35
Distinguishing Between Nominal
and Real Values
 Real Values
– Measurements after adjustments have
been made for changes in the average
of prices between years; expressed in
constant dollars
Slide 8-36
Distinguishing Between Nominal
and Real Values
 Correcting GDP for price index changes
– Nominal (current) dollars GDP
– Real (constant) dollars GDP
nominal GDP
= 100
Real GDP =
price level*
*Price level: measured by the GDP deflator
Slide 8-37
Correcting GDP for Price Changes
(1)
(2)
(3)
Year
Nominal GDP
(billions of
dollars
per year)
Price Level Index
(base year 1992 = 100)
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
5,803.2
5,986.2
6,318.9
6,642.3
7,054.3
7,400.5
7,813.2
8,300.9
8,759.9
9,254.6
9,849.5
86.8
89.8
91.7
94.2
96.1
98.2
100.0
101.7
102.9
104.4
106.4
Source: U.S. Department of Commerce, Bureau of Economic Analysis
(4) = [(2)/(3)]
x 100
Real GDP
(billions of dollars
per year
in constant 1992 dollars)
6,683.5
6,669.2
6,891.1
7,054.1
7,337.8
7,537.1
7,813.2
8,165.1
8,516.3
8,867.0
9,256.2
Slide 8-38
Distinguishing Between Nominal
and Real Values
 Example
– Base Year = 1992
– Price Index = 100
Slide 8-39
Distinguishing Between Nominal
and Real Values
nominal GDP
= 100
Real 1992 GDP =
price index
$6,020.2
= 100 = $6,020.2 billion
Real 1992 GDP =
100
Real GDP = nominal GDP
in the base year
Slide 8-40
Distinguishing Between Nominal
and Real Values
 1993
– Price Index = 102.2
$6,343.3
= 100 = $6,206.8 billion
Real 1993 GDP =
102.2
Slide 8-41
Distinguishing Between Nominal
and Real Values
 1987
– Price Index = 82.7
$4,539.9
= 100 = $5,489.6 billion
Real 1993 GDP =
82.7
Slide 8-42
Nominal and Real GDP
Figure 8-5
Source: U.S. Department of Commerce
Slide 8-43
Distinguishing Between Nominal
and Real Values
 Per capita GDP
– Adjusting for population growth
real GDP
Per capita real GDP =
population
Slide 8-44
Distinguishing Between Nominal
and Real Values
 Question
– Is real per capita GDP a good indicator
of social well-being?
Slide 8-45
Distinguishing Between Nominal
and Real Values
 Some issues
– The distribution of output
– Changes in leisure time
– Increased traffic congestion
– Air pollution
– Crime
– Housework
Slide 8-46
Issues and Applications:
How Well Do Economists Predict GDP?
 Forecasting economists have done
a relatively good job predicting
long-run trends in real GDP.
 They have not done as well
predicting recessions.
Slide 8-47
Economic Forecasts:
Missing the Mark
Start of Recession
Date of Forecast
Forecasted Growth
over the Next Year (%)
December 1969
December 1969
1.5
-.6
November 1973
December 1973
1.5
-1.8
January 1980
December 1979
-.7
-.3
July 1990
December 1989
2.1
-.1
July 1991
December 1990
2.2
.7
Source: Business Week, September 30, 1992, p. 92
Actual Growth
in Real GDP (%)
Slide 8-48
How Well Do Economists
Predict GDP?
 Difficulties in predicting downturns
– Trying to develop computer models
for a changing multi-trillion dollar economy
– Globalization
– Data sources and methodology
Slide 8-49