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Unit 2

2.1 Circular Flow and GDP

4 min readโ€ขnovember 18, 2020

Jeanne Stansak

Caroline Koffke


Unit 2: Economic Indicators and the Business Cycle


2.1: The Circular Flow and GDP

Circular Flow

The circular flow diagram is a graphical representation of how goods, services, and money flow through our economy between consumers and firms. There are two markets illustrated in the circular flow diagram: the factor (resource) market and the product market. The resource market is where factors of production (resources) are exchanged. The product market is where economic goods (products) and services are exchanged.

This diagram is based on the concept of voluntary exchange, the act of firms and consumers gathering freely in economic markets to achieve beneficial exchange in order to maximize their economic incentives. In the factor (resource) market, firms are demanding and consumers are supplying. In the product market, the consumers are demanding and firms are supplying.

Below is a drawing of the circular flow diagram:

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-jS15HamdYqo6.png?alt=media&token=d4b14801-fc03-4c9c-9978-b18ca489a99c

GDP (Gross Domestic Product)

GDP is the dollar value of all final goods and services produced within a country's borders in one year. We use GDP to compare ourselves to other countries, to see the impact of policy changes, and to compare our growth from year to year.

The two main methods of calculating GDP are the expenditures approach and the income approach. The expenditures approach is the sum of all aggregate spending on all final goods and services within a country's borders in one year.

Sample Problem:

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-zISekeJXFLsf.png?alt=media&token=93f66dd4-a461-428f-99a0-19b7498651a6

Using the data above and the expenditures approach we would calculate GDP by using the formula C + I + G + Xn. GDP equals $400 + $175 + $120 + ($80 - $110) which is $665.

The income approach is the sum of aggregate income earned on all inputs used in the product market to make goods and services in one year.

When using the expenditures approach, we calculate the money spent by a consumer on a particular good or service. For example, if a consumer walks into a Subway restaurant and purchases a sandwich for $5 then that $5 would be added to the overall GDP. When using the income approach, instead of adding what the consumer paid for the sandwich we would use the value of the pay the worker who made the sandwich receives.

The third way of calculating GDP is known as the value-added approach which involves calculating the value-added of any good or service by simply calculating the difference between the cost of inputs to production and the price of output at any particular stage in the overall production process.

Components of GDP

To calculate GDP, economists use four main components:

  • Consumer Spendingโ€”the value of any good or service purchased by a consumer. Ex: Little Caesar's pizza, haircut, car tune-up, etc.

  • Investment Spendingโ€”any spending done by businesses. Ex: money spent on tools and machinery. This is not an investment in the stock market or other investment vehicles.

  • Government Spendingโ€”any spending done by the government. Ex: construction projects, military equipment, etc. This DOES NOT include welfare payments or other government assistance programs (ie. social security).

  • Net Exports (Exports - Imports)โ€”the value of all goods and services exported from a country added together with the value of all goods the country imports subtracted from this sum. Ex: the value of three Ford Focuses exported minus the value of two Honda Civics imported.

What is Not Included in GDP?

There are several things that are not included in GDP: intermediate goods, non-production transactions (financial investments and used goods), and illegal or non-market activities.

Intermediate goods include goods that are used in the production of a good or service. For example, flour, cheese, and sauce purchased by a pizzeria is an intermediate good. We would only count the value of the final pizza in GDP and not the purchase of the intermediate goods used to make it.

Non-production transactions include financial transactions (i.e. personal investments) and used goods (those goods produced outside of the year we are calculating).

Illegal goods and services include anything not allowed by current laws and regulations (i.e. illegal drugs).

Non-market activities include types of services that are done but that do not receive payment. For example, a plumber who fixes his own leak at his own home would not be counted in GDP.

Calculating Nominal GDP

Nominal GDP is the total value of goods and services produced within a given time period, used to measure output at current prices.

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-GemNSlXJWCwJ.png?alt=media&token=713a1ac4-656f-4c52-96af-2731e8e07e92

In the table above, there is information on four different products produced by a particular country and the prices that they sell each unit of these products for. When you multiply the price of each product by the amount sold you get the total revenue earned.

When you add up the value of all the total revenues that gives us nominal GDP. The nominal GDP in this particular example is $380,000 ($45,000 + $120,000 + $175,000 + $40,000).

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