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The Circular Flow model and GDP The simplest form of circular flow $ Consumption Goods and Services Producers Households Factors of production Incomes $ rent wages interest profit Circular Flow model and GDP - Producers make goods and services - Consumers buy this output - There are no leakages, so payments for goods and services by households is equal to the value of all goods and services produced in the economy (GDP). This is called consumption spending in the circular flow model. - Introduction of the Financial Sector I (Investment) d Financial Institutions Ca(Payments for goods and services) S (savings) c Producers Households GDP = C+I+(x-m) b Y (Income) An Open Economy Financial Institutions Overseas Sector I (Investment) d X (Export receipts) f M (Import g payments) aC (consumption) S (Savings) c Producers Households b Y (Income) Calculating GDP Three methods Income Approach Expenditure approach Calculating the value of goods and services by measuring the amount households have spent on goods and services. Value Added approach We will only be looking at expenditure approach • Think back to the circular flow diagram. Which flow do you think represents the expenditure on all goods and services? • Consumption spending!! Expenditure Approach Measures the value of all purchases of all final good and services produced in the economy. For households all consumption (C) is accounted for For the firms we calculate investment (I) Spending by government (G) Spending by overseas countries on good and services produced in NZ (X) Less the spending by NZ on goods and services produced overseas (M) Role of the Government Financial Institutions Overseas Sector I (Investment) d X (Export receipts) f M (Import g payments) aC (consumption) S (Savings) c c G (Government Spending) Producers Households Government tr a (transfers) b Y (Income) T b (taxes) Find GDP for the following data using the expenditure approache. Values of output at each stage of Bread production Grower Miller Baker 30 45 75 Intermedi ate goods Sales 30 price 30 75 75 150 Wages Wheat Grower Miller Baker Wages 30 45 75 Intermediate goods - 30 75 Sales price 30 75 150 • The expenditure approach= value of the final product = $150 million The Circular Flow Model Withdrawals Injections Savings Investment Import Export Taxes Payments Receipts Transfers Growth and Circular Flow Any injections into the circular flow increase economic growth because they increase the money supply. They cause profits, revenue, income and employment to increase so spending increases This then causes business confidence to increase so spending on capital(Investment) will also increase This results in an increase in output so GDP increases, causing economic growth Introduction of the Financial Sector Financial Institutions I (Investment) d Ca(Payments for goods and services) 1. S (savings) c Producers Households b Y (Income) 1.Explain how economic activity can be measured by the flow of payments for goods and services 2.Describe the difference between savings and investment 3. Explain how increased investment will lead to economic growth 4. Identify ONE limitation of the four sector circular flow model as a tool for illustrating growth Answers 1. The circular flow model has no leakages thus to then measure the value of payments for goods and services is just equal to incomes of consumers (all income earned is spent) 2. Savings is a withdrawal as it is income not spent. Investment is an injection into the circular flow model and is simply creating capital resources. 3. Increased investment means increased capital resources. These are used to produce other G&S. Therefore increased investment results in increased output and thus increased growth. 4. The model only shows a few flows in an economy. Thus there are only a limited number of interactions between the sectors