MAcro CHAPTER 2.1:

CHAPTER SUMMARY

The circular flow model shows how everything in an economy works together and is constantly moving. Below is a simple version of this model, showing the two groups in the model: households (people) and businesses (firms). Notice that money always moves in one direction, and the things given in exchange for that money always moves in the opposite direction.

As we can see, households give businesses the factors of production (land, labor, capital, and enterprise) they need to produce, and receive personal income in exchange. All exchanges like this make up the factor market.

Households also buy goods & services from businesses, and in exchange they give the businesses money (expenditures). All exchange like this make up the product market.

These two markets can be seen in the more complex version of the Circular Flow Model below. Note that it shows the exact same thing - just with more detail.

This model can be applied to all economies, but in order to measure how much economic activity is happening in a country, we use a measure called Gross Domestic Product (GDP). GDP is made up of four parts:

• C - Consumer spending: all the money that households spend.

• I - Investment spending: all the money that businesses spend on capital - things to help them produce better, like machines.

• G - Government Spending: all the money that the government spends.

• Nx - Net Exports: The value of all the stuff we sell to other countries (exports) minus the value of all the stuff we buy from other countries (imports). The formula for this is [exports - imports], sometimes shown as [X - M].

The overall formula is GDP = C + I + G + Nx or GDP = C + I + G + X - M. This is called the expenditure approach, and measures the total value of all the things produced in our economy in a given time period.

There are also some things that are not included in GDP:

• Intermediate goods: Parts & goods that are not finished yet. This is because we don't want to "double count" things. If we count the value of an engine, and then also the total value of the car, we have counted the engine two times.

• Non-production transactions: These are buying & selling of things that don't involve making something. This might include buying a stock or buying used goods.

• Illegal/non-market activities: This might include things like the illegal sale of drugs, or cooking a meal at home.

There is another way to calculate GDP called the income approach, which is done by adding up the total national income (TNI), sales taxes (T), depreciation (D), and net foreign factor income (F), but this is much less common and much harder to do, and the AP exam only requires you to know that this approach exists, so we won't focus our efforts here.

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