Question

1. Describe the different components of GDP by using the Circular Flow Model. In your description be sure to note how the different components interact in the Product, Resource, and Financial Markets.
2. Why do we get the same number when we count the total output and when we count total income?
3. What would cause one of these components of GDP to decrease?
4. Why would a decrease in one of these components typically lead to a decrease in other components?
5. Why did traditional economics believe that the business cycle would automatically correct for a decrease in one of the components of GDP?
6. Why did Keynes believe that the business cycle would not automatically correct itself?
7. What could government do to correct the business cycle according to Keynes?

Answer 1

Answer 1. Circular flow model

It is the flow of money income or the flow of of goods and services across different sectors of an economy in a circular firm.

Different sectors in a circular flow

Household sector

Household provide factor services to firms, Government and foreign sector. In return it receives factor payments. Households also receive transfer payments from the government and the foreign sector. Household spend their income on payment for goods and services purchased firms, tax payment to government, payment for imports.

Firms

Producers receive revenue from households, Government and the foreign sector for sale of their goods and services. Producers also receive subsidies from the government. Producers make payment for factor services to households, taxes to the government, imports to the foreign sector.

Government

Government receives revenue producers, households and the foreign sector for sale of goods and services, Taxes, fees etc.

Government make factor payment to households and also spend money on transfer payments and subsidies.

Foreign sector

Foreign sector receives revenue producers, households and government for export of goods and services. It makes payment for import of goods and services from producers and the government. It also make payment for the factor services to the households.

The savings of households, producers and government get accumulated in the financial market.

Financial market invest money by lending out money to households, producers and the government. The influence of money in the financial market are equal to outflows of money. It means the circular flow of income is completed continous.

The circular flow can be categorised in three phases

Phase of production in the circular flow means the process of value addition by the producing sector. The producer hire factor services from the household sector. Using other non factor inputs goods and services are produced.

For providing their factor services to the producers, the household get factor payments or factor income. In this phase of circular flow there is generation or distribution of income as an outcome of production of goods and services. Value addition on value of production is converted into factor income after monetary value of goods and services is distributed among factors of production.

Income is spent on purchase of final goods and services when households purchase the final goods there is consumption expenditure. when producer purchase the final goods there is investment expenditure. does In this phase there is disposition of income as an outcome of generation of income.

Components of GDP

Private final consumption expenditure

It refers to expenditure incurred by households and private non profit institutions serving households on all type of consumer goods.

Government final consumption expenditure

It refers to the expenditure incurred by general government on various administrative Services like defence law and order education so on. Government produces goods and services with the aim of social welfare without any intention of earning profit.

Gross domestic capital formation or gross investment.

It refers to the addition to existing stock of capital. it represent expenditure incurred on acquiring goods for investment by the production units located within the domestic territory

Net exports

it refers to the difference between export and import of a country during a period of one year. Exports refers to expenditure by foreigners on purchase of domestic product. Imports is the expenditure by residents on foreign products. Instead of creating exports and imports separately the difference between the two is taken and is termed as net exports.

Answer 2. Why do we get the same number when we count the total output and when we count total income.

Total production is equal to total income.

In a circular flow model, the national product in terms of money value of goods and services produced is distributed among the productive factors. It means total money value of output is given to factors of production in the form of rent, wages, interest and profit for their factor services. So National Product or the money value of goods and services produced is exactly equal to Income generated or national income.

Answer 3. Causes of decrease in GDP

Savings, taxation and imports result in decrease in GDP.

These variables have a negative impact on the process of production of the process of income generation and are considered as Leakages. The resulting withdrawals from the circular flow of income. These variables cost reduction in the flow of income of production as well as reduced demand of goods and services.

Answer 4. Decrease in one of these component leads to decrease in the other component of GDP.

when household and firms save a part of their income, it leads to a leakage from the circular flow of income. Such income does not pass through the circular flow. As a result it is not available for spending on currently produced goods and services. This will further lower the demand for goods and services that are produced in the economy. So less expenditure by households means low income generation.

When income generation will be low investment in the economy will also be low.

In case of imports when we buy goods and services from foreign countries, there is outflow of of money to some other country. this results in contraction of money supply in the economy. As a result income generation is low. Further demand for goods and services due to decrease money supply falls.

Answer 5. Traditional economist believe that business cycle would automatically correct for a decrease in one of the components of gdp

Economists like Adam Smith, James mill, Marshall and so on advocated for a free economy. It is an economy in which the government does not interfere in the areas of production, consumption and investment. Decisions regarding what to produce, how to produce and for whom to produce a determined by the market forces of demand and supply. Profit maximization is the main motive of the producers. they believe that in a free economy resources are fully and optimally utilised. Full employment equilibrium is a normal feature of this economy. If at all, there is is disequilibrium, it will be short lived and will be corrected by the market forces through the automatic mechanism.

Answer 6. Keynes believe that the business cycle would not automatically correct itself.

This school of thought is advocated by Keynes. After the great depression of 1929 there was a worldwide depression. It was a condition of Persistent fall in prices, profits , level of investment and employment. He observed that classical belief was not working. Unemployment continued to persist. accordingly he suggested that government must interfere to correct disequilibrium. In his book the general theory of employment, interest and money, he suggested the need of the government intervention to control economy in the situation of disequilibrium. key stress that government intervention is required in the areas of production and investment to correct underemployment equilibrium by creating new job opportunities.

Answer 7. What could government do to control the business cycle according to Keynes.

According to keynesian, when the economy is not at full employment equilibrium, there would be situations of excess demand and deficient demand. Keynes believe that government intervention is required to correct disequilibrium in case of either inflation or deflation. He suggested that government should attend to those functions which fall outside the private sphere and those decisions which are made by no one in the state does not make them.

According to him the equilibrium level of employment may or may not be the full employment level. It means equilibrium level may exceed or fall short of full employment level. If equilibrium level exceeds the full employment level then there is excess demand in the economy that may result in inflation. In that case government should increase taxes, and reduce its expenditure in order to bring back the economy to equilibrium position. This will reduce the money supply in the economy. The purchasing power will decrease and the excess demand will be corrected.

If equilibrium level falls short of full employment level then it is a situation of deficient demand and results in deflationary gap in the economy in order to correct the situation of deflationary gap government should incur expenditure on infrastructural and administrative activities. It should increase expenditure on public works like construction of roads flyovers buildings and so on. With a view to provide additional income to people. Also government should reduce the rate of taxes and even abolishes some of the taxes. It raises the purchasing power of people. due to increasing disposable income people are able to spend more. It raises the level of aggregate demand and help to control the situation of deflationary gap.

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