The Circular Flow Robinson Crusoe engaged in two main economic activities on the island, production and consumption. All income generated from

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1 The Circular Flow Robinson Crusoe engaged in two main economic activities on the island, production and consumption. All income generated from production gets paid to households. Private Saving (PS): households don t spend 100% of what they earn but save some to use for consumption at a later point Financial Market: all the ways households might save o Adding to bank accounts o Buying financial assets Stocks Bonds The Private Savings that go into the Financial Market are available to be used for Investment. Investment (I): The purchase of machinery and other physical capital that is used to produce output (purchases of physical capital) Purchases of financial assets ( investing in the stock market ) are a form of Private Saving. Investment leads to a payment to capital-producing firms. Total income, which is generated from production, is denoted by Y. Y=C+I Y=C+PS C+I=C+PS I=PS Social Security benefits and unemployment compensation are government transfer payments. Net taxes (T): taxes minus transfers The net flow of payments between government and households is an arrow from households to the government. G, which points from the Government to the outside border of the Circular Flow represents government purchases of goods and services. In recent years in the US, G has been much larger than T, as the US government has run a budget deficit. The government pays for the excess of spending over net receipts by issuing government bonds, a form of borrowing from the Financial Market. Savers lend the government money in exchange for bonds. When the bonds come due, the government pays back the money that it borrowed from savers. A government deficit is an arrow from the financial market to the government. The government budget was actually in surplus as recently as When the government has positive savings, we draw this as an arrow from the government to the financial market. When there is a government, firms produce goods and services for three sectors in the economy (consumers (C), firms (I), government (G)).

2 Y=C+I+G Y+C+PS+T C+I+G=C+PS+T I=PS+T-G Government Savings (GS) is net tax receipts minus spending for government purchases (T-G). GS can be positive (surplus) or negative (deficit). I=PS+GS If there is a deficit (GS<0), then Investment will be smaller than Private Saving, because some of the Private Saving is taking the form of households purchasing government bonds. The sum of Private Saving and Government Saving is called National Saving (S). I=PS+GS=S A closed economy doesn t trade with the rest of the world. Rest of the World (ROW) interacts with the circular flow in three ways: o Some of the goods and services that Consumers (C), Firms (I), and the Government (G) buy are imported goods. Imports are a leakage of dollars out of the domestic circular flow Y=C+I+G-Imports o Some of the goods and services that domestic firms produce will be sold to the rest of the world as exports which lead to payments to domestic firms, and to income from domestic households. Exports are an arrom from ROW to the flow of payments to domestic firms Y=C+I+G+Exports-Imports o When a country runs a trade deficit, the contry gets goods that are worth more than the value of what the country gives up via exports. Imports>exports (X<0) ROW accepts US dollars as a kind of IOU When the US runs a trade deficit, ROW is lending to the US ROW holders of dollars will want to earn some return on those holdings A way to do this is to purchase dollar-denominated financial assets, which brings funding to the US financial market Net Exports (X): the balance of trade as exports When X is positive (exports>imports) there is a trade surplus. When X is negative (exports<imports) there is a trade deficit. When a country runs a trade deficit (X is negative: the green X arrow points towards ROW), the blue arrow points towards the Financial Market. Under a US trade surplus, the blue arrow would point towards ROW, while the green arrow would point towards the US. o The US would be financing ROW s trade deficit. Y=C+I+G+X

3 GDP Y=C+S+T C+I+G+X=C+S+T I+G+X=S+T I+X=PS+GS=S If GS<0 then Investment will be smaller than Private Saving because some Private Saving will take the form of purchases of government bonds, leaving less available for lending to firms. If X<0 then lending from abroad can help finance the government budget deficit, leaving more funding available for Investment. Y=GDP C=Consumption I=Investment G=Government Purchases X=Net exports=exports-imports PS=Private Savings T=Net Taxes GS=Government Spending You can be certain that Investments are greater than Private Savings if the government budget (GS>0) is in surplus and there is a trade deficit (X<0). The Private Savings that go into the Financial Market are available to be used for Investment. There are no redeeming features in a trade deficit. Imports are not a deduction from GDP NIPAs=National Income and Product Accounts o A set of economic accounts that provide information on the value and composition of output produced in the US during a given period and on the types and uses of the income generated by that production. BEA=Bureau of Economic Analysis GDP=Gross Domestic Product o Measures the value of the goods and services produced by the US economy in a given time period. The featured measure of output in the NIPAs is GDP. GDP measures the market value of the goods, services and structures produced by the nations economy in a particular period. GDP includes market production and some nonmarket production. Whenever possible, GDP is valued at market prices. The NIPAs value market goods and services using prices set by the market. This approach provides a common unit of measurement (dollars) that facilitates comparisons of the various goods and services that make up economic activity. Imputations measure the value of goods and services that are not fully reflected in market prices. o Examples include meals provided by employers

4 GDP is a measure of current production, not sales. GDP is equal to the value of goods and services for final users. o GDP considers: Goods consumed and not used in a later stage of production Goods sold, given away or transferred to foreign residents Goods used to produce other goods and that last more than a year Goods that are inventoried for future consumption GDP can be measured in three different ways: o Expenditure approach: GDP can be measured as the sum of expenditures, or purchases, by final users GDP=Consumption+Investment+Government Spending+Exports-Imports o Income approach: GDP can be measured as the sum of these changes o Value-added approach: GDP can be measured either as total sales less the value of intermediate inputs or as the sum of the value-added at each stage of the production process GDP captures output produced in the US GDP includes the output of US offices or establishments of foreign companies located in the US and excludes the output of foreign offices or establishments of US companies located outside the US. GDP is a gross measure. Economic depreciation, or the consumption of fixed capital (CFC), is a measure of the amount that would need to be set aside to cover the physical deterioration, normal obsolesce, and accidental damage of existing fixed assets. Subtracting CFC from GDP leaves net domestic product, which is a measure of current production that excludes the investment that is necessary to replace existing fixed assets as they wear out or become obsolete. Net domestic product is a measure that indicates how much of the Nation s output is available for consumption or for adding to the Nation s wealth. In addition to GDP, which is measured using the final expenditures approach, the NIPAs also present gross domestic income (GDI), which is GDP measured using the income approach. Income is equal to product (GDI is equal to GDP). Gross national income (GNI) is the most comprehensive measure of a nation s income, calculated as GDI plus income receipts from the rest of the world less income payments to the rest of the world. Personal income is the income received by persons from participation in production and from transfers from government and businesses. The income measures in NIPAs do not include gains or losses resulting from changes in the prices of assets (that is, capital gain or losses), because a change in the price of an asset does not represent income from production.

5 GDP is based on the number and quality of housing units in service and will not change if a house switches from being rented by a landlord to being lived in by its owner. GDP from slides GDP is the market value of all final goods and services newly produced in a country during some period of time. Final goods: that the item went to its final use (in the country) during the year. Intermediate goods: used up in the production of final goods. o Not counted in GDP because their value is included in the value of the final goods that they are used in. Capital goods can be continually used to produce final goods o Ex: manufacturing equipment that is used to make cars. A good must be produced during year X for it to be counted in the GDP of year X. A good must be produced in the geographic borders of country X to count toward country X s GDP, even if it is being produced by non residents. If a good is used for personal production it is a final good. Shortcomings of the GDP concept: o Per capita GDP is a flawed measure of standard of living GDP doesn t account for value of increased leisure over time GDP doesn t account for other important quality-of-life variables Many things that are bad for standard of living cause GDP to rise or accompany a rise in GDP Natural disasters (rebuilding) Pollution (industrial production) Illegal drugs, prostitution counted as production in SNA (US has not adopted this practice yet) o Official GDP is a flawed measure of output Many countries have poor data collection and/or large informal sectors. Budget for NIPA in US is 100 million Home production is not counted Quality Improvements Free goods aren t counted Not the Full Shilling On July 12 th, 2016, Ireland s GDP growth went from 7.8% to When a company executes a tax inversion it and its intellectual property are now added to the country s capital stock and the returns are included in GDP. Ireland s capital stock grew by one-third in This growth will make it easy for Ireland to satisfy the euro zone s demand that countries keep their budge deficits below 3% of GDP but it may allow politicians to return to bad habits.