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MODULE 10: THE CIRCULAR FLOW MODEL AND GROSS

DOMESTIC PRODUCT

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.

Student learning objectives:

• 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:

• 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.

Common Student Difficulties:

• Students find it easy to derail the lesson by asking the infinite number of “what if?” questions. “What if the final product is assembled in China, but the components came from Canada and the corporation is headquartered in Germany?” Keep it simple and move forward before this line of discussion gets you bogged down for nearly the entire hour. In the above question, the final product was produced in China, therefore it is counted to China’s GDP.

Module 10: The Circular Flow Model and Gross Domestic Product 101

In-Class Presentation of Module and Sample Lecture

Suggested time: This module can be covered in one hour-long class. Because so little of the AP curriculum (and exam) is devoted to the finer points of national income accounting, spending more than one hour on this material probably leads to sacrificing material that will have a greater presence on the exam. A few years ago students were asked on the AP exam to draw a simple circular flow model, so it would be a good idea for the students to demonstrate that they can do this.

I. The National Accounts

A. The Circular - Flow Model

1. The Simple Circular Flow Model

2. The Expanded Circular-Flow Model

B. Gross Domestic Product

1. Measuring GDP as the Value of Production of Final Goods and Services

2. Measuring GDP as Spending on Domestically Produced Final Goods and Services

3. Measuring GDP as Factor Income Earned from Firms in the Economy

4. GDP: What’s in and What’s Out?

I. The National Accounts

Note: Stress to the students that you intend to cover simply the basics. There are entire buildings filled with people who do this for a living. The class just needs to know what is counted, and what is not counted, into a nation’s GDP.

• 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.

. The Circular Flow Model

Note: One approach to teaching this model is to draw it once. Begin with the households who buy “stuff” from retailers of stuff. Dollars flow to the retailers, and stuff flows to the households. Once you have told a simple story and drawn a simple circular flow, you might have a prepared (and polished) visual ready to project for the students.

Note: I suggest that the instructor spend more time on the Simple Circular Flow Model. Then show the Expanded Model side-by-side to show how the flow of money gets more complicated.

Stress to the students that this 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.

1. The Simple Circular Flow Model

There are two groups of decision-makers in private economy (no government or foreign sector yet): only households and businesses.

Let’s begin with the product markets. A product market is where goods and services (cars, computers, and corn) are bought and sold.

a. Households are on the demand side of these markets, purchasing goods and services.

b. Businesses are on the supply side of these markets, offering products for sale.

c. Interaction of this demand and supply determines the price of each product.

d. Flow of consumer expenditures constitutes sales receipts for businesses.

102 Section 3: Measurement of Economic Performance

Let’s turn to the resource 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.

2. The Expanded Circular-Flow Model

Note: If you are projecting the expanded model side-by-side with the simple model, the instructor can just point out a few of the interesting differences in the additions, and subtractions, of money from the macroeconomy.

B. Gross Domestic Product

Begin with the definition of GDP: The total market value of all final goods and services produced within a country in one year.

1. Measuring GDP as the Value of Production of Final Goods and Services

Note: The instructor can explain GDP by looking at each important piece of the definition.

• Market 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 | | |February | |

|# Cappuccinos |# Café lattes |# Scones |# Cappuccinos |# Café lattes |# Scones |

|25 |25 |50 |30 |30 |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 |Value of |

| | | |Production |

|Cappuccinos |25 |$3.00 |$75 |

|Café Lattes |25 |$2.50 |$62.50 |

|Scones |50 |$1.50 |$75 |

|Totals |100 | |$212.50 |

Module 10: The Circular Flow Model and Gross Domestic Product 103

|February |Quantity |Prices |Value of |

| | | |Production |

|Cappuccinos |30 |$3.00 |$90 |

|Café Lattes |30 |$2.50 |$75 |

|Scones |40 |$1.50 |$60 |

|Totals |100 | |$225 |

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.

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 |Cost |

|1 Lb. of tomatoes from Grower to Processor |$.50 |

|Bottle of ketchup from Processor to Kroger |$1.50 |

|Kroger sells ketchup to consumer |$3.00 |

|Total $ Spent |$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.

2. 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.

104 Section 3: Measurement of Economic Performance

Personal Consumption 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 Investment—(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.

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.

Government 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 Exports—(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 = C + Ig + G + Xn

3. 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). Interest: payments from private business to suppliers of money capital.

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.

Module 10: The Circular Flow Model and Gross Domestic Product 105

NI = Wages + Rents + Interest + Profits

Note: the instructor can again point out that, in the circular flow model, the top (spending) and bottom (income) parts of the model are equal.

4. 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).

106 Section 3: Measurement of Economic Performance

In-Class Activities and Demonstrations

It is suggested that the class perhaps look at one or two problems at the end of the chapter of the textbook, but no more than that.

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