Question

Write a short essay on the concept of the circular flow and the measurement of Gross Domestic Product (GDP). As part of your answer, make sure that you outline and explain key details of both the expenditure approach and the income approach to the measurement of GDP.

Answer 1

The circular flow of income is a continuous flow of production, income and expenditure. It is categorised circular because it has neither any beginning nor an end. It is based on two basic assumptions:

1. In any exchange process, the producer or seller receives what the consumer or buyer spends.

2. Goods and services flow in one direction and money payment flow in the opposite direction that results to a circular flow.

Expenditures Approach: The expenditures approach computes as GDP = C + I + G + (X-M) where C is the level of consumption of goods and services, I is gross investment, G is government purchases, X is exports, and M is imports.

Income Approach: The income approach computes as GDP = National Income (NY) + Capital Consumption Allowance and Depreciation (CCA) + Indirect Business Taxes (IBT) + Net Factor Payments to the rest of the world (NFP)

The circular flow diagram displays the three aggregate markets namely goods markets, factor markets, and financial markets. It also reflects the transactions among four economic agents namely, households, governments, firms, and the rest of the world

The firm hires factors of production from households. In the enclosed diagram the blue flow, Y, indicates the total income paid by firms to households. Households purchases consumer goods and services. The red flow, C, displays consumption expenditures. Households save, S, and pay taxes, T. Firms borrow few of what households save for financing the investment. Firms purchase the capital goods from other firms. The red flow I indicates the investment expenditure by firms. Governments buy goods and services, G, and either borrow or repay debt if spending is more or is less than taxes. The rest of the world buys goods and services from the nation, X, and sells us goods and services, M; and the net exports are X - M. The green flows indicate the borrowing and lending. The blue and red flow displays the circular flow of expenditure and income; and the sum of the red flows equals the blue flow.