Circular flow model

RESOUR
CE
MARKET

HOUSEHOL
BUSINESS DS
FIRMS

PRODUCT
MARKET

Dr. Aminul I Akanda Source: books and web materials

Dr. Aminul I Akanda Source: books and web materials
 Circular flow For an Open and
closed economy
 Follow class lecture………..

Dr. Aminul I Akanda Source: books and web materials

 National accounting
Gross domestic product (GDP) is the total market value
of all final goods and services produced within a
country in a given period of time.

“GDP is the Market Value . . .”

Output is valued at market prices.
“. . . Of All Final . . .”
Records only the value of final goods, not intermediate
goods (as value is counted only once).
“. . . Goods and Services . . . “
Includes both tangible goods (food, clothing, cars) and
intangible services (haircuts, housecleaning, doctor visits).

Dr. Aminul I Akanda Source: books and web materials

  “. . . Produced . . .”
– Includes goods and services currently produced, not
transactions involving goods produced in past.
– However, GDP is not the market value of total sales
during a period—it is the market value of total
production
 “ . . . Within a Country . . .”
– Measures the value of production within the
geographic confines of a country.
 “. . . In a Given Period of Time.”
– Measures the value of production that takes place
within a specific interval of time, usually a year or a
quarter (three months).

Dr. Aminul I Akanda Source: books and web materials

 IS GDP A COMPLETE MEASURE ?

 GDP includes all items produced in the

economy and sold legally in markets.
 What Is Not Counted in GDP?
– GDP excludes most items that are produced
and consumed at home and that never enter
the marketplace.
– It excludes items produced and sold illicitly,
such as illegal drugs.

Dr. Aminul I Akanda Source: books and web materials

 Economy’s income and expenditure

 For an economy as a whole, income must

equal expenditure because:
– Every transaction has a buyer and a seller.
– Every dollar of spending by some buyer is a
dollar of income for some seller.
– The equality of income and expenditure can be
illustrated with the circular-flow diagram.

Dr. Aminul I Akanda Source: books and web materials

 Approaches of GDP Measurement
(GDP = W + R + I + P)
Income (wages, rent, interest (I), profits)
Income Value of what is
Approach earned

Firms Same As Households

Expenditures Value of what is

Approach spent

Expenditures by Consumers, Investors, Government, and Traders

(GDP = C + I + G + Xn )
Dr. Aminul I Akanda Source: books and web materials
 Y
Y == CC ++ II ++ G
G ++ NX
NX
Totaldemand
Total demand Investment
fordomestic
domestic Investment
for spendingby
spending by
output(GDP)
output (GDP) businessesand
and
businesses
households
households Netexports
Net exports
ornet
or netforeign
foreign
Consumption Government demand
demand
Consumption Government
spendingby
spending by purchasesof
purchases ofgoods
goods
households
households andservices
and services

Dr. Aminul I Akanda Source: books and web materials

 COMPONENTS OF GDP
 Consumption (C):
– Spending by households exception of purchases of new house.
– Durable goods: Goods that last a relatively long time, such as
cars and appliances.
– Nondurable goods: Goods that are used up fairly quickly, such
as food and clothing.
– Services: Things that do not involve the production of physical
things, such as legal services, medical services, and education
 Investment (I):
– Nonresidential investment includes expenditures by firms for
machines, tools, plants, and so on.
– Residential investment includes expenditures by households
and firms on new houses and apartment buildings.
– Change in inventories computes the amount by which firms’
inventories change during a given period.

Dr. Aminul I Akanda Source: books and web materials

  Government Purchases (G):
– The spending on goods and services by local, state,
and federal governments.
– Does not include transfer payments because they are
not made in exchange for currently produced goods
or services.
 Net Exports (NX):
– Exports minus imports.

Dr. Aminul I Akanda Source: books and web materials

 GDP calculation
 Value added method —GDP is also the
total value added of all firms in the
economy. The value added of a firm equals
the value of the firm’s output minus the
value of the intermediate goods that the
firm purchases

12
 Value added method
– The market value of a firm’s product or service
minus the cost of inputs purchased from other
firms
– The summing of the value added by all firms in
the economy yields the total value of final goods
and services

13
 Value added method (Table)
 Value Added in Bread Production

 Each stage of production adds value

 But if we add up the total sales made at all stages of production we will
double count intermediate inputs
 Value of final sales = the total value added at all stages of production
 GDP sums up value added at each stage of production.

14
 GDP AND ECONOMIC WELL-BEING
 GDP is not a perfect measure of the happiness
or quality of life, however it is the best single
measure of the economic well-being of a society.
 Per Capita GDP (measured by dividing real GDP by
population) calculations may be a better measure
of the standard of living.
• For comparing standards of living between citizens of
a country and citizens of different countries.
• Higher per capita GDP indicates a higher standard of
living.
• However, the measurement of per capita GDP suffers
from fallacious composition of income.

Dr. Aminul I Akanda Source: books and web materials

 GDP AND ECONOMIC WELL-BEING

 Some things that contribute to well-being

are not included in GDP.
– The value of leisure.
– The value of a clean environment.
– The value of almost all activity that takes place
outside of markets, such as the value of the
time parents spend with their children and the
value of volunteer work.
 Shortcomings of the GDP to be a perfect
measure the economic well-being.
1. Non-market Transactions: All productive activities do
not pass through markets. Thus, GDP understates
productive activity in the economy.
2. Leisure time is not considered by GDP, but additional
leisure can easily be argued to increase well being.
3. Improved product quality does not directly enter GDP.
Only quality enhancements that result in higher prices
get into GDP.
4. Voluntary and social works do not enter in GDP. The
value of the time parents spend with their children and
the value of volunteer work takes place outside of
markets and not included in GDP.

Dr. Aminul I Akanda Source: books and web materials

 REAL VERSUS NOMINAL GDP

 Nominal GDP values the production of

goods and services at current prices.
 Real GDP values the production of goods
and services at constant prices.

Dr. Aminul I Akanda Source: books and web materials

 Table: Real and Nominal GDP

Dr. Aminul I Akanda Source: books and web materials

 The GDP Deflator
The GDP deflator is
calculated from the ratio of
N o m in a l G D P
nominal GDP to real GDP
for same year times 100 —
G D P d e f la to r = 100
measures the level of
R eal G D P
prices in the economy.

 The GDP deflator tells us

the rise in nominal GDP N o m in a l G D P 2 0 X X
that is attributable to a rise
R e a l G D P20X X  100
in prices rather than a rise
G D P d e fla to r 2 0 X X
in the quantities produced.

Dr. Aminul I Akanda Source: books and web materials

 GDP Deflator from Real and Nominal GDP

How do you interpret the result of GDP deflator?

What is the use of it?

Dr. Aminul I Akanda Source: books and web materials

 GDP VERSUS GNP
Gross national product (GNP) add receipts of factor income (wages,
profit, and rent) from the rest of the world and subtract payments of
factor income to the rest of the world from GDP (remittance adjusted).

GNP =
GDP + Factor Payments from Abroad - Factor Payments to Abroad

Whereas GDP measures the total income produced domestically,

GNP measures the total income earned by nationals (residents of a
nation).

Dr. Aminul I Akanda Source: books and web materials

 Exercise
Given the following items produced in your economy for different years.

2000 2001 2002 2003 2004

Price Quantity Price Quantity Price Quantity Price Quantity Price Quantity

Food 9 950 10 1000 12 1100 13 1200 15 1250

Energy 45 20 50 20 60 30 65 35 75 40
Shelter 450 2 500 2 600 2 700 3 750 3
Clothing 50 50 50 55 40 60 50 65 55 70

Find out the following

a) Nominal GDP for each year,
b) Real GDP for each year taking 2002 as base year,
c) GDP deflator for 2000 and 2003,
d) Growth rates of real GDP for 2003 and 2004, and
e) interpret your results.

Dr. Aminul I Akanda Source: books and web materials