The Circular-Flow Diagram

The equality of income and

expenditure can be illustrated
with the circular-flow diagram.
 The Circular-Flow Diagram
 The circular flow of income and
spending shows connections between
different sectors of an economy

• It shows flows of goods and services and

factors of production between firms and
households

• The circular flow shows how national

income or Gross Domestic Product is
calculated
 The Circular-Flow Diagram
 Leakages (withdrawals) from the circular flow
 Not all income will flow from households to
businesses directly. The circular flow shows that
some part of household income will be:
• 1.Put aside for future spending, i.e. savings (S) in banks
accounts and other types of deposit

• 2.Paid to the government in taxation (T) e.g. income tax

and national insurance

• 3.Spent on foreign-made goods and services, i.e. imports

(M) which flow into the economy
 The Circular-Flow Diagram
 Withdrawals are increases in savings, taxes or imports so
reducing the circular flow of income and leading to a
multiplied contraction of production (output)
 Injections into the circular flow are additions to
investment, government spending or exports so boosting
the circular flow of income leading to a multiplied
expansion of output.
 Capital spending by firms, i.e. investment expenditure (I) e.g. on
new technology
 The government, i.e. government expenditure (G) e.g. on the NHS
or defence
 Overseas consumers buying UK goods and service, i.e. UK export
expenditure (X)
 An economy is in equilibrium when the 
rate of injections = the rate of withdrawals 
from the circular flow.
 Gross Domestic Product

 Gross domestic product (GDP) is

the total market value of newly
produced, final goods and
services within a country in a
given period of time (which is
generally one year).
 GDP Calculation: An economy produces three
products A, I and S

Pa Qa Pi Qi Ps Qs

10 10 12 10 08 10

How can we calculate the total market value?

Total market value = Pa.Qa + Pi.Qi + Ps.Qs

= 10*10 + 12*10 + 08*10
= 100 + 120 + 80
= 300
GDP Calculation: In reality, A, I and S is the output of
Agriculture sector, Industrial sector and Services sector

How can we calculate the share of a particular

sector in total GDP?

• Share of Agriculture sector = Value of Agricultural output/GDP*100

• Share of Industrial sector = Value of Industrial output/GDP*100
• Share of Services sector = Value of Services sector output/GDP*100

For real data and chart, see ES-2011-12,

Chapter 1, P11 Fig 1.4 and P16 Table 1.1.
 Which of these activities should be recorded in GDP?

 A person purchases a locally produced, brand new BMW 316i  in

Rs. 3,800,000.
 2 months later, he sells the BMW 316i  in Rs. 3,400,000.
 James works in a Car Washing center. He washes a client’s car.
 James washes his father’s car at home.
 Mr. Naveed (A real estate agent) sells a New Bungalow worth Rs.
35 million to a client and charges Rs. 1 million as commission.
 03 months later, he re-sale the same Bungalow in Rs. 40 million
to another party and receives Rs. 1.2 million as commission.
 The Measurement of GDP
There are three approaches to measuring GDP:
the expenditure approach (final sales),
the production approach (value added), and
the income approach (incomes of the factors of production).

Expenditure approach: We add the expenditures of final consumers on

products and services.
Value added approach: It measures the contribution to output made by
each producer.
Income/Cost approach: In this approach, consideration is given to the costs
incurred by the producer within his own operation.

Reference for Real methodology

Pbs.gov.pk….Sections…National accounts….Methodology…P2
Intermediate Vs Final goods and “Value added”

Value addition
A farmer produces wheat which are
sold to a miller at Rs100.
Farmer’s Rs. 100
The miller processes the wheat into Miller’s Rs. 80
flour, which he then sells to a baker
for Rs.180.
Baker’s Rs. 70
Shopkeeper’s Rs. 50
The baker uses the flour to bake bread Total Rs. 300
which is then sold to shops for
Rs.250.
Any step in the production
The shopkeeper then sell the bread to process that improves the
final consumers for Rs.300. product for the customer
and results in a higher net
worth.
 Calculate GDP in an economy, having two producers only…

Farmer (Oranges) Juice seller

Transactions of Mr. A Transactions of Mr. B

Wages paid (Rs.200) Oranges purchased (Rs.500)

Taxes (Rs.150) Wages (Rs.150)

Oranges sold to Mr. B Rs.500 Taxes (Rs.100)

Oranges sold to public Rs.500 Juice sold to public Rs.1000

 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.
 Other Measures of Income

 Gross National Product (GNP)

 Net National Product (NNP)
 National Income
 Personal Income
 Disposable Personal Income
 Gross National Product

 Gross national product (GNP) is the total

income earned by a nation’s permanent
residents (called nationals).
 It differs from GDP by including income
that our citizens earn abroad and
excluding income that foreigners earn
here.
 Net National Product
(National Income at market price)

 Net National Product (NNP) is the total

income of the nation’s residents (GNP)
minus losses from depreciation.
 Depreciation is the wear and tear on
the economy’s stock of equipment and
structures.
 National Income (at factor cost)

 National Income is the total income earned by a

nation’s residents in the production of goods and
services.

 It differs from NNP by excluding indirect business taxes

(such as sales taxes) and including business subsidies.

 ES 2011-12, chapter 1, p-16, table 1.1

 Personal Income
 Personal income is the income that
households and noncorporate businesses
receive.
 Unlike national income, it excludes retained
earnings, which is income that corporations
have earned but have not paid out to their
owners.
 In addition, it includes household’s interest
income and government transfers.
 Disposable Personal Income

 Disposable personal income is the income

that household and noncorporate
businesses have left after satisfying all
their obligations to the government.
 It equals personal income minus personal
taxes and certain nontax payments.
 The Components of GDP

GDP (Y ) is the sum of the following:

 Consumption (C )
 Investment (I )
 Government Purchases (G )
 Net Exports (NX )

Y = C + I + G + NX
 The Components of GDP

 Consumption (C):
 The spending by households on goods and
services, with the exception of purchases of
new housing.
 Investment (I):
 The spending on capital equipment,
inventories, and structures, including
new housing.
 The Components of GDP

 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.
 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.
 Real versus Nominal GDP

An accurate view of the economy

requires adjusting nominal to real
GDP by using the GDP deflator.
 GDP Deflator

 The GDP deflator measures the current

level of prices relative to the level of
prices in the base year.
 It tells us the rise in nominal GDP that is
attributable to a rise in prices rather than
a rise in the quantities produced.
 GDP Deflator

The GDP deflator is calculated as follows:

Nominal GDP
GDP deflator =  100
Real GDP
 Converting Nominal GDP to Real
GDP

Nominal GDP is converted to real

GDP as follows:
(Nominal GDP20xx )
Real GDP20xx = X 100
(GDP deflator20xx )
 GDP and Economic
Well-Being
 GDP is the best single measure of the
economic well-being of a society.

 GDP per person tells us the income and

expenditure of the average person in the
economy.
 GDP and Economic
Well-Being

 Higher GDP per person indicates a

higher standard of living.

 GDP is not a perfect measure of the

happiness or quality of life, however.
GDP, Life Expectancy, and Literacy
Country Real GDP per Life Adult
Person (1997) Expectancy Literacy
United States $29,010 77 years 99%
Japan 24,070 80 99
Germany 21,260 77 99
Mexico 8,370 72 90
Brazil 6,480 67 84
Russia 4,370 67 99
Indonesia 3,490 65 85
China 3,130 70 83
India 1,670 63 53
Pakistan 1,560 64 41
Bangladesh 1,050 58 39
Nigeria 920 50 59
 Summary

 Because every transaction has a buyer and

a seller, the total expenditure in the
economy must equal the total income in
the economy.
 Gross Domestic Product (GDP) measures
an economy’s total expenditure on newly
produced goods and services and the total
income earned from the production of
these goods and services.
 Summary

 GDP is the market value of all final goods

and services produced within a country
in a given period of time.
 GDP is divided among four components
of expenditure: consumption, investment,
government purchases, and net exports.
 Summary

 Nominal GDP uses current prices to

value the economy’s production. Real
GDP uses constant base-year prices to
value the economy’s production of goods
and services.
 The GDP deflator--calculated from the
ratio of nominal to real GDP--measures
the level of prices in the economy.