Circular Flow Model, GDP, & National Income Accounting

Circular Flow Model, GDP & National Income Accounting

Definition of Gross Domestic Product (GDP)
Circular Flow Diagram
The Expenditures Approach to GDP Calculation
The Income Approach to GDP Calculation
Nominal and Real Values
Per Capita Measurements

National income accounting is a system of measurements which allows for comparisons of the sizes of different economies, as well as measurements of one economy's performance over time.

These are measurements of an economy's output and income on a macroeconomic level.

Given the wide variety of goods and services produced in a modern economy, the total output cannot be measured simply by adding together the number of units produced. Different goods and services have different values, so national income accounting requires measuring the value of production.

The most common measure: Gross Domestic Product, which is commonly shortened to GDP. The definition of GDP:


Gross Domestic Product (GDP):

The market value of all final goods and services produced in a year within a country's borders.

This definition necessarily excludes any production that is not traded on legal markets. For example, housework performed by a paid housekeeper would be counted, while the same work performed by household members for no pay would not be counted. If no measurable payment for services is included, it doesn't count. Transactions on the black market, such as illegal drug transactions, are not legally recognized or accurately measurable, and are therefore excluded. These exclusions mean that the official GDP calculations understate actual production.

Only final goods and services (those available to the ultimate consumer) are counted. This avoids double-counting, since the value of final goods and services incorporates the cost of intermediate goods. Intermediate goods are goods that are used in the production of other goods. GDP can be computed by counting each stage of production, but only if the value added at each stage is counted instead of the total value of the output at each stage.

Production is counted in GDP in the year it is produced, regardless of when it is sold. If a sale takes place in a later year, the later year's GDP will only reflect the income earned at the time of the sale - not the full value of the good being sold. The value of used goods is not included, since it does not represent new production.

The method used for including unsold production in GDP is to measure changes in inventories. Inventory is production that has not been sold. An increase in inventory would be an investment; a decrease in inventory would be consumption.

The circular flow model is used in economics courses to illustrate the relationships among production, expenditures, and income.

Shown here is a map of a complete circular flow model.

Circular Flow

The circular flow model shows that a national economy is a system. Income and output flow between segments of the economy. The total economy can be measured as income, and it also can be measured as output.

The orange lines in the above model represent flows of income; the blue lines represent flows of output, or non-cash flows within the model. The model shows that these flows (except for leakages and injections mentioned below) stay within the system: the arrows show the direction of the flows. For example, an employee of a firm will offer his services for pay. The employee represents the household sector. His services are not cash flows; they are labor. This is represented by the blue arrow going from households to firms, labeled resource services. The pay that he receives for this labor is income in the form of wages. This is a flow of money, and it is represented by the orange arrow going from firms to households.

The international sector is represented by lines instead of arrows; these flows move in both directions.

Financial intermediaries are not segments of the economy. They are shown to indicate that money that flows into them (called savings) is a leakage in the system. Money that flows out of them and back into the system (called investment) is an injection in the system. In equilibrium, leakages would equal injections.

The Expenditures Approach to GDP Calculation

The circular flow model shows the interrelationship between the four sectors of the economy: households, firms, government, and the international sector. Since GDP is a measure of production for the entire economy, it can be measured by adding together the expenditures for production of each of these four components, or sectors. Using this method to compute GDP is called the expenditures approach. The expenditures approach uses a formula that should become familiar to all students of macroeconomics:

GDP = C + I + G + NX

C = Consumption, or expenditures by the household sector
I = Gross Private Domestic Investment, or expenditures by firms (or the business sector)
G = Government purchases of goods and services, or expenditures by the government sector
NX = Net Exports, or expenditures by the international sector

Note that G does not include all government spending, but only spending on purchases of goods and services. In addition to government purchases which are counted in GDP, total government spending includes transfer payments. Transfer payments are expenditures for such things as unemployment compensation, welfare payments, and Social Security benefits. These transfer payments are not included in GDP because they do not represent current production in the economy. They only represent the transfer of money from one segment of the economy to another.

Net Exports (NX) equals total exports minus total imports. Exports are added into GDP because they represent goods and services that are produced within the economy but are not part of domestic expenditures. Imports are subtracted because they represent spending on goods and services that were not produced within the economy.

Expenditures approach to GDP calculation
Quick reference formula:

GDP=C + I + G +NX

C= Household Consumption
I= Gross Domestic Private Investment
G= Government Purchases of Goods and Services
NX= Net Exports (exports minus imports, or X minus M)

The Income Approach to GDP Calculation

What follows is a rather lengthy discussion of the calculations for GDP using the income approach. If you are only interested in the formula, here it is:

Income approach to GDP calculation
Quick reference formula:

GDP equals:

Wages (compensation of employees)
Plus interest
Plus rent
Plus profit (proprietors' income plus corporate profits)
Minus net factor Income from abroad
Plus capital consumption allowance (depreciation)
Plus indirect business taxes (sales tax plus excise tax)

As illustrated in the circular flow model, the flow of expenditures in the economy has a corresponding flow of income. Since these flows are equal in equilibrium, Gross Domestic Product, or GDP, can also be computed from the incomes received by the factors of production. This method of computing GDP is called the income approach.

Recall - from the Basics of Economics page of this site - that the income received by the factors of production is as follows:

Labor earns wages (sometimes called compensation of employees)
Capital earns interest
Land earns rent
Also, firms earn profits, which remain within the circular flow. Sometimes, economists consider entrepreneurship to be a separate factor of production (rather than a special category of labor), and profit would be listed as the income received by entrepreneurs. Profit as an income category is in turn divided into two categories: proprietors' income (sole proprietorships and partnerships) and corporate profits (corporations).

Total income received by the segments of the economy, then, would be:

Wages + Interest + Rent + Profits

This sum of income received by the segments of the economy does not add up to GDP, however. It will not match the GDP amount as calculated using the expenditures approach. Due to accounting differences, some adjustments need to be made in order to get from this number to GDP. While the sum of income received by segments of the economy is not equal to GDP, this sum does have a name: National Income, or NI. It follows that the formula for national income is:

NI = Wages + Interest + Rent + Proprietors' Income + Corporate Profits

From national income, three more adjustments are needed in order to get to GDP.

First, you may notice that government receipts are not part of this equation. That is because income tax receipts include money that is part of the incomes of the other segments of the economy. They are already being counted elsewhere. However, some taxes are collected from consumers by businesses, which have to turn this money over to the government. These taxes include state and local sales taxes, and excise taxes. Together, they are called indirect business taxes. In order to balance income and expenditures, this amount needs to be added to NI. This yields a number called net national product, or NNP.

NNP = NI + Indirect Business Taxes

This number (NNP) still does not equal GDP. GDP using the expenditures approach includes an item called “gross private domestic investment”. A portion of this amount is received as income. Some of it is used to replace worn-out or accidentally destroyed equipment. This replacement value is called capital consumption allowance. The routine replacement of worn-out equipment is called depreciation, and is computed and allocated over the lifetime of the equipment using an accounting procedure at each individual firm. Since depreciation makes up the vast majority of the capital consumption allowance, often this allowance is simply referred to as depreciation. In order to balance income and expenditures, this amount needs to be added to income. Adding the capital consumption allowance (or depreciation) to NNP will yield a number that is called Gross National Product, or GNP.

GNP = NNP + Capital Consumption Allowance (or Depreciation)

Notice the distinction in terms here: GNP, NNP. The difference is gross vs net. Gross refers to gross investment and net refers to net investment, which is total investment net of the allowance for depreciation: Gross investment minus depreciation equals net investment.

Okay, we are almost there, but not quite. We are looking for GDP, and we now have GNP. GNP includes income received by citizens, regardless of whether the income was earned on production within the country or not. It excludes income earned within the country's borders by non-citizens. GDP is a measure of production that occurs within a nation's borders, regardless of the nationality of whoever produces it. An adjustment needs to be made to GNP to account for this difference. This adjustment is called net factor income from abroad, or net foreign factor income. It is found by taking income received by citizens outside the nation's borders, and subtracting income received by foreigners within the nation's borders. Subtracting net factor income from abroad will yield GDP. Finally!!

GDP = GNP - Net Factor Income from Abroad

This GDP amount, found using the income approach, should be equal to GDP using the expenditures approach. Since compilation of figures in the real world is imperfect, there may be a difference for routine error and rounding.

NI = Wages plus Interest plus Proprietors' Income plus Corporate Profits
NNP = NI plus Indirect Business Taxes
GNP = NNP plus Capital Consumption Allowance (or Depreciation)
GDP = GNP minus Net Factor Income from Abroad

Nominal and Real Values

One of the uses of national income accounts, such as GDP, is for the comparison of an economy's performance over time. National income accounts measure economic growth. However, just looking at the value of GDP from one period of time compared to the value of GDP from another period of time will not give an accurate measure of economic growth. This is because a change in the value of GDP has two components: a change in total output, and a change in prices (or the overall price level). To measure growth, you would need to isolate these two components, take out the price level component, and only look at the total output component.

In order to do this, economists adjust the GDP numbers by a price index to reflect the change in the overall price levels over the relevant time frame.

The actual raw numbers for GDP are called nominal values. The numbers for GDP after the adjustment for the change in the price level are called real values. The price index used for adjusting for the price level change relating to GDP is called a GDP deflator, or GDP price index (GDPPI). The calculation is as follows:

Real GDP = Nominal GDP divided by GDPPI

Per Capita Measurements

Comparisons of the different economies of the world - as well as comparisons of the economy of one nation over different time frames - gain additional meaning if the national income measurements are reported on a per capita basis. Per capita means per person, and is determined by dividing the national income measurement by the total number of people in the population.

What is the "best" measurement of the macroeconomy?

GDP is the one that is most widely used. It counts the total production within the economy, so it probably is a better measurement for many kinds of comparisons than most of the other measurements. But NDP is a better measurement to reflect growth: it doesn't count replacement of capital as "new" production. GDP is more widely used than NDP because it is easier to calculate, and easier to make comparisons between countries which use different accounting methods. The best measurement for determining the standard of living would be real GDP per capita, but even that is not a perfect measurement of the standard of living. It can tell you the changes in wealth for an "average" person in the economy, but it will not tell you if the changes in wealth are distributed equitably. If all of the gains go to a very small segment of the economy - a tiny fraction of the population - then a per capita measurement can be very misleading. Also, it doesn't account for the fact that many people view a "standard of living" as including things that cannot be measured in monetary terms.