Economics Online Tutor




Circular Flow Model, GDP & National
Income Accounting
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) is 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, and
not 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 the
current year's 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.
Economics classes and textbooks always seem to begin the discussion of national income accounting with
a detailed look at the circular flow model.  They generally start with a basic model with unrealistic
assumptions of a closed economy with no government, in order to highlight the relationships between
households and firms, and then gradually add in the other segments.  I don't necessarily agree with this
approach.  I understand why it is done this way: an understanding of the relationships is important for an
understanding of what national income accounting measures.  I just find that this approach is confusing
for many students, and other methods could be used to highlight the interrelationships involved.  My
approach here: sort of a compromise.  I have included a diagram of a circular flow model (above), but only
the final, complete version, not the intermediary ones that gradually add in segments of the economy.  And
I will not include a detailed explanation of it: students can get that directly from their textbooks or other
class materials, if required.  I will just give a brief description of the important points to be learned from
this model.

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

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.  But 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 that are not arrows.  This is done for simplicity purposes.  
The model could show one set of arrows to represent exports and another set of arrows to represent
imports.  To keep from having the model filled with too many arrows, these are simply shown as lined to
represent net exports.  Since net exports can be either positive or negative, the model doesn't show
arrows to indicate a direction of flow.

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.

That is all that I intend to include about the circular flow model.  I only want to highlight the relationships
that you need for an understanding of the discussion to follow.

The discussion of GDP and national income accounting continues with a discussion of GDP calculations
using the expenditures approach.  To continue to that section,
click here.
More details and definitions of national income
accounting are in the remaining pages of this
section.  For now, the discussion turns to the
circular flow model.  

Shown here is a map of a complete circular flow
model.  It is included as a reference for the
discussion that immediately follows:
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