Circular Flow of Income Model
We start with a simple and closed economy -no foreign trade. In such an economy
there are only 2 sectors: Households and Firms
Households give the factors of production to firms and the firms use these factors
to produce. Then in turn, Firms give the output to households and households
spend the money.
In this very simple model there is no government. Further assumptions: No foreign
trade and finally…. Households don’t save. They spend all their income
Now let us make it more complicated.
Households do not spend all the income -they also save
When Households spend money, some is spent on foreign goods.
Also government takes some of the income in the form of taxes.
These are leakages… But then there are also injections.
In other words the additional complications can be summed up as follows
In such a system, we need to compare leakages to injections.
MEASURING ECONOMIC ACTIVITY
We use GDP as our chief measure
Gross Domestic Product…
and we have 3 methods to calculate GDP.
….
Remember
national Income = National Output…. because they measure the same thing
actually.
The 3rd method below is the classical method most often used in economic reports.
Again, all methods should produce the same result. But in theory there are
measurement errors and the 3 results will differ to some extent
GDP vs GNI
GDP is location based. As long as the economic activity occurs within the borders
of a country, it is counted. We do not consider who owns the factors of production.
GNI focuses on nationality…. GNI is the total income earned by a country’s factors
of production regardless of where they are located. We include COCA COLA Turkey
in USA’s GNI.
When comparing numbers over time we have to take into account real vs nominal.
To convert nominal GDP into Real GDP we use something called the PRICE
DEFLATOR.
And of course the really important figure is the PER CAPITA number
Do not write PER CAPITAL - that is wrong….
What is the purpose of these measurements?
BUT…. There are some shortcomings
THE BUSINESS CYCLE
Remember -the busimess cycle refers to the short term fluctuations
The through in the graph above is the recovery phase
Next comes the BOOM
Now lets turn our attention to the long term trend. The long term trend is
all about the Production Possibilities Curve… I.e. here what matters is the
LRAS
Do not confuse a fall in GDP growth rate with a fall in GDP