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Note 2: for non-honors students. The material and the order of the material may vary somewhat from that presented in the regular sequence.

CHAPTER 1: CIRCULAR FLOW AND GDP

The Circular Flow Model

Our next economic model represents the main participants in the economy and how they interact. The two main sectors of an economy are the households and the producers. Producers make the goods and services and sell them to households, but in order to make the goods and services they first need inputs or the factors of production. There are four factors of production and each receives payment for its participation in production: labor is paid wages, capital is paid interest, land is paid rent and entrepreneurship is paid profit. There are always two directions to the flows in the economy – the money to purchase something is moving in one direction, the good or service being purchased is moving in the opposite direction.

Households sell the four inputs to the production sector and receive payment back. Households then spend most of their income buying the goods and services produced by the production sector; what the households don’t spend they save. The production sector and government access those savings by borrowing in order to finance purchases. In addition both the production sector and government spend part of their income buying goods and services. Foreign businesses, governments and consumers not only inject funds into this economy when they buy from us, but also divert funds from this economy when they sell to us. Money keeps flowing from one sector to another forming the basis of income, spending, production and sales. The circular flow chart on the next page shows the basic sectors of the economy and traces the movement of money – for simplicity’s sake we have left off the goods and services being produced.

The overall demand for a nation’s output, Aggregate Demand, comes from the purchasing behavior of the four sectors – the household sector, the production sector itself, the public sector (or government) and the foreign sector. Aggregate demand is the sum of these four components:

C stands for consumption – it is the consumer spending on or demand for goods and services by the household sector. Consumption is by far the largest component of aggregate demand in the US, making up about 2/3 of the spending on American goods and services. Example, GM sells cars to household consumers.

I stands for investment – it is the business spending on or demand for goods and services by the production sector. (The bulk of the net savings of American households is borrowed by the business sector for these purposes and that is the representation on the chart on the next page). Businesses keep some of their own output and buy some of the output of other companies making up part of the demand for American goods and services. . Example, GM sells cars to other businesses and/or keeps some for itself.

G stands for government purchases – it is the government spending on or demand for goods and services by any level of the public sector. This only includes the government buying goods and services; it does not include the government transfers - giving money away without a purchase as in Social Security checks. (Government does borrow from the net savings of households but for simplicity we have left that off the chart). Example, GM sells cars to a government agency.

Financial Markets

Sn Foreign Sector I M X

C Xn

Household Sector G Production Sector

Transfers Taxes

Public Sector

Xn stands for net exports – it is the net spending on or demand for goods and services by the foreign sector. It is a net calculation because the foreign sector pumps money into the domestic economy when they buy our goods (exports) but pumps money out of the domestic economy when they sell goods to us (imports). Part of the C, I and G was spent on foreign goods or services not domestic. Example, GM sells cars to foreign buyers, but some components of the cars GM sold to households, businesses or government were bought from foreign producers which diverted money away from American producers. Net exports equals exports minus imports and can be negative, zero or positive. Each has a different effect on aggregate demand.

X > M Exports are greater than imports, what is known as a trade surplus. This will make net exports a positive number which raises aggregate demand. For example, the US exports $800 billion and imports $500 billion. The foreign sector has pumped $800 billion in purchasing power into the American economy and pumped $500 billion out for a gain of $300 billion. The net exports of $300 billion increases the aggregate demand for American goods and services by $300 billion. X = M Exports are equal to imports, what is known as balanced trade. This will make net exports zero which has no effect on aggregate demand. For example, the US exports $800 billion and imports $800 billion. The foreign sector has pumped $800 in purchasing power into the American economy and pumped $800 billion out for no change to the overall demand for American goods and services.

X < M Exports are less than imports, what is known as a trade deficit. This will make net exports a negative number which lowers aggregate demand. For example, the US exports $800 billion and imports $950 billion. The foreign sector has pumped $800 billion in purchasing power into the American economy and pumped $950 billion out for a loss of $150 billion. The net exports of negative $150 billion decrease the aggregate demand for American goods and services by $150 billion.

Gross Domestic Product

Not only is C+I+G+ Xn equal to aggregate demand it is also equal to the value of national output or gross domestic product. The economic value of something is measured by what people pay for it – what it sells for. If you buy a new car for $16,000, then the value of that new car is $16,000. To measure the value produced by the production sector we can count the value of the goods and services as they sold: how much consumers paid for the goods they bought, how much business paid for the goods they bought, how much government paid for what they bought and how much the foreign sector paid, net, for the goods they bought – which is aggregate demand.

Gross domestic product, or GDP, is the value of the final goods and services produced in a country during a given year. There are several important parts to this definition. Final goods and final services are used in order to avoid multicounting, - counting production more than once. A final good is one that is being sold to the ultimate user in our economy. We do not want to count production whose value is already part of something else we are counting. Primary goods are freshly extracted from nature while intermediate goods are still in the processing phase. Both of these will be part of the value of the final good.

Example: A landowner sells raw timber to Kimberly Clark $10,000 adds $10,000
Kimberly-Clark sells lumber to Home Depot $18,000 adds $ 8,000
Home Depot sells lumber to contractor $32,000 adds $14,000
Contractor sells decks to 20 customers $50,000 adds $18,000

If we counted each of these transactions in GDP we would count the same components more than once – the value of the timber is part of the value of the lumber, the value of the lumber is part of the value of the decks. We could count how much extra value each producer added to the value they started with – so the landowner produced $10,000 and Kimberly Clark added $8000 more value to the $10,000 they started with, etc. This way we have eliminated the duplication of previous steps and will come up with a contribution to GDP of $50,000. That $50,000 is also the value of the final good, the decks to the consumers – we can avoid the duplication by simply taking the value of the final good.

The sale of used goods is omitted from GDP for the same reason – we do not want to count things more than once. Since goods are counted in the year they are produced, we have already included used goods in the GDP of previous years; we do not want to count them again as current production. Any new production associated with the sale would be counted – for example, if we bought new tires or had the air conditioning fixed on our old car before we sold it, that new production would be in this years GDP.

The same concept holds for situations where the good is produced in one year but sold in another – we do not want to count the good more than once. Production is more relevant than purchasing from the point of view of measuring economic performance and looking at the effect on employment and consumer income. We therefore, use the year of production. How do we find out about the good if it has produced but not yet sold? Firms have to take inventory at the end of each calendar year for tax purposes; they report the approximate market value of the inventory at that time. The government then “closes the books” on GDP for that year by using this estimated retail value – while some of these units will eventually sell at a higher price, others will have to be sold at a discount to get rid of them – the error is probably not very large since these two events partially cancel each other out.

Finally, GDP is a measure of production, therefore, we do not consider purely financial transactions to be part of GDP. If you take $1000 out of your bank account and buy a corporate bond with it (essentially lending the company $1000), we do not count this $1000 as part of GDP – it is purely a transfer of money from one party to another and does not reflect $1000 of production. Somewhere someone will use that $1000 to buy something and that is when it will show up in GDP. The company takes the $1000 you lent it and buys a computer then we add $1000 to GDP. What about the $50 commission your broker charged for buying the bond for you? That represents the current production of a service and, therefore, would be in GDP.

Expenditures vs. Cost/Income Approach

C+I+G+ Xn tracked the value of production by the money received for it, the money flowing into businesses as it is spent -. this is known as the expenditures approach because it measures the spending or expenditures on GDP. The other way to calculate GDP is to follow the money as it is dispersed by businesses – the money flowing out. This is known as the cost/income approach because the dispersal represents a cost to the businesses and income to the recipients.
The firms receiving the money represented by C+I+G+ Xn will send that money somewhere; much of it will be paid to those who provide the four factors of production.

Wages compensation for labor
Net interest compensation for financial capital
Rent compensation for land
Profit compensation for entrepreneurship
Indirect Taxes payment to government as part of the cost of production
Depreciation payment to replace the capital stock used in production process

Unless there is measurement or entry error the two GDP calculation methods will give the same answer – there is always measurement and entry error. The two numbers, however, are consistently very close in the US.

The value of aggregate spending must equal the value of aggregate income.

GDP adjustments

Raw GDP numbers can be very misleading when we seek to analyze them over time or space. For example, if we want to interpret how the US economy is doing compared to other countries, we will run into a problem with population. Saying the US has a GDP about 5 times that of France does not mean that we are 5 times richer than the French, we also have almost 5 times as many people to support with that GDP. In order to make such a comparison it is important to adjust the data for population – we want average GDP or GDP per person – this is known as GDP per capita.

GDP per capita = *

NOTE: (US GDP is in billions while population is in millions)

If we took the value of national output and divided it equally between every man, woman and child, each person would receive the GDP per capita. The US consistently has one of the highest GDP per capita numbers in the world and it is often the largest when certain corrections are made.

Raw GDP numbers, even GDP per capita, can be very misleading when we make comparisons over time. For example, if we want to interpret how the US economy is doing compared to the past – measure how GDP is changing, we will run into a problem with the price level. Saying that the US in 1970 had a GDP of $1,039.7 billion while in 2000 the US had a GDP of $9,872.9 billion does not mean we became over 9 times richer during the 30 years. A dollar in 1970 is worth more than a dollar in 2000 because the price level has increased significantly over that generation. Much of the increase in GDP is NOT an increase in production but an increase in prices - we need to correct for inflation. We need to distinguish between nominal and real variables.

Nominal variables reflect face value. They are measured in the dollars of that time (called current dollars) and have not been adjusted for inflation. Real variables reflect purchasing power value. They are measure in the dollars of an arbitrarily selected base year (called constant dollars) and have therefore been adjusted for inflation. In general, economists have little use for nominal data except as a way to get to real data. There are a couple of ways to adjust for inflation and convert nominal measures to real ones. With overall GDP we traditionally use an approach that takes current production and measures that production at base year prices.

If society is currently producing 1000 tons of steel at $50 a ton, 50,000 pounds of wheat at 40¢ a pound and 4000 gallons of gas at $1.40 a gallon then nominal GDP is $75,600. In order to find real GDP we first select a base year – 1980 for example. If steel was $40 a ton, wheat 25¢ a pound and gas $1.40 a gallon in 1980 then today’s real GDP – today’s output in base year prices – was $58,100. The ratio of nominal to real GDP is known as the GDP deflator (this number is typically multiplied by 100 to make the deflator easier to interpret as a percent).

GDP deflator = *

The GDP deflator in this case is approximately 130.12; in other words, prices today are 130.12% of prices in the base year of 1980 or 30.12% higher. This is not the inflation rate which measures the rate of price change on an annual basis.

The nominal GDP of the US in 1970 was $1,039.7 billion but the real GDP was $3,578 billion using 1996 as the base year. The GDP deflator was therefore 29.06 – prices in 1970 were about 29% of prices in 1996 – there has been a lot of inflation over that time. The nominal GDP of the US in 2000 was $9872.9billion, but the real GDP was $9224 billion using 1996 as the base year. Therefore, the GDP deflator was 107.04 – since 2000 is only 4 years away from the base year, prices had not changed significantly, only about 7% during that period.

The bottom line is that we can now compare the increase in production that has occurred from 1970 to 2000 by comparing the real GDPs. The US economy went from $3,578 billion to $9224 billion less than a threefold increase. Our nominal data showed the US economy having expanded by more than a factor of nine; the real data showed the US economy only expanded by a bit less than a factor of three. This was a significant difference.

If we then adjust the real GDP data for population, we see that the per capita real GDP in the US has grown from about $17,626 in 1970 to about $32,779 in 2000. Here we see that the output per person has less than doubled during this time period – a far cry from the increase we saw with nominal GDP uncorrected for population. People on average are close to but not quite twice as well off as they were the previous generation…or are they?

Limits of GDP as a Measure of Economic Well being

The most common interpretation of GDP data is as a measure of economic performance – of the strength of an economy and the well being of the members of that economy. We talk about how the economy has grown, how standards of living have increased. The problem is that GDP data does not reflect all the characteristics we would need to accurately make that assessment. The GDP concept has limits.

A. Does not include non-monetary, non-official transactions

The government can only include the value production that it knows about and can put a dollar amount on. Goods and services that are not sold in the marketplace, whose sales are hidden or that are not sold for money, are difficult even to estimate in value.

1. Home produced, home consumed: these goods and services are both made and used in the home – since they are not bought and sold in the marketplace, the government has no record of their having been produced. The presence of these goods means that GDP is missing some of the actual value produced in the economy – it causes us to underestimate the true material standard of living. As long as every GDP number is off by the same percent, our pattern of changes – how fast GDP is increasing or decreasing – will be accurate. If the degree of home production/home consumption changes over time, this also biases our estimates of economic growth. We will underestimate economic growth if home production, home consumption becomes a larger proportion of actual production over time. We will overestimate economic growth if home production, home consumption becomes a smaller proportion of actual production over time

2. Underground economy: there is a whole network of production and exchange that is non-official, deliberately hidden from view. This includes illegal goods and services, as well as production that is hidden for tax purposes or to avoid regulation. Since the government misses this production, we will underestimate the actual level of goods and services produced in the economy as well as the income of American households. Again, as long as every GDP number is off by the same percent, our pattern of changes – how fast GDP is increasing or decreasing – will be accurate. If the degree of underground production changes over time, this also biases our estimates of economic growth – we will underestimate economic growth if more production is moving into the underground economy and we will overestimate economic growth if more production is moving out of the underground economy.