Economists have some simple key models to understand our complex economies. One such model is the circular flow model. This model comes handy when we understand why GDP from income method and expenditure method should equal.
There are two main ways of calculating nominal GDP and will discuss these in detail later in this article. These methods are known as the expenditure method and the income method.
But first, we should understand the relationship between the income method and expenditure method of calculating GDP in a circular flow model. The circular flow model shows the linkages between two groups of economic decision makers, households and businesses. It also tells us that there are two types of economic markets, the resource or factor market, and the product market for goods and services. Once we understand this simple circular flow model, it will be useful to understand the complex economy and the GDP computation. In order to learn more about what GDP is, please click here.
The model begins by assuming a simple economy with two markets:
- Factor or resource market: a market for factors of production that the firms demand.
- Product market: a market for goods and services that the households demand.
By household, we mean people living in a house. Businesses are privately owned entities producing goods and services to sell in exchange for money. It is important to understand that the households and businesses are both buyers and sellers.
Households are sellers in the factor market. They sell land (including any natural resource like trees), labor, capital, and entrepreneurial ability in exchange for money. Households are buyers in the market for goods and services. Households give money to businesses for goods and services.
Businesses are sellers in the market for goods and services. Businesses sell goods and services in exchange for money, which they call revenue. At the same time, businesses are buyers in the market for resources. Businesses exchange the revenue earned in the market for goods and services to buy factors of production i.e., land, labor, capital and entrepreneurial ability in the resource market. Here, the money they spend is called the cost of production.
Let’s understand it better with a simple example.
When you go to your local pizzeria to eat your favorite pizza, you give your money to the owner for the pizza you buy from him. When you pay your bill, you are buying goods and services. But the money doesn’t remain with the pizzeria owner for long. The pizzeria owner uses part of this money to buy resources such as wheat flour from a farmer. He also pays wage/salary to the server who took your order and also might spend money to purchase a new equipment for his pizzeria. For the pizzeria owner, all these expenditures are costs of production. After he pays his costs of production, the remaining income is his profit. This is the money he earns as being an entrepreneur owning and operating his business with his skills. Now let’s say your money went to the farmer and that for her, is her income. But that money won’t remain with her for long as well. She will spend it too on other things she wants to buy, and the entire cycle will start again.
Thus, this circular flow keeps going on and on. Here’s an animation explaining the model, you can see the circular flow between the product market and factor market. You will also see the flow of money between the two. Money flows in one direction while goods and services and resources flow in the other direction. Through this model, we can see the relationship between households and businesses and how these different decision-makers fit together in our big economy.
In reality, our economy is more complex and has more elements, like, government, foreign trade etc. and we can expand the model to include all these players. But the basic idea won’t change.
I hope this made sense. Let’s go back to the two ways of calculating GDP and we can see why these two methods will yield similar results.
Expenditure method: Since GDP is the market value of all final goods and services produced in a country at a given period, if we add the total spending done by all the people in a country, we can get a number close to nominal GDP. We usually categorize these total expenditures done by these four sectors:
- Household spending includes any new good or service we buy, big or small. So, we will add all our expenditures be it on buying an apple or a new house, in a given period, to get the private consumption component of GDP. We can denote it with C.
- Spending by firms/businesses on capital and inventory, which we call investment or I. Investment here refers to investment by a firm in machinery, research& development, inventory, etc. We only include investments done by businesses in real assets in the calculation of GDP. We don’t include any financial investments, like buying a company’s stock or bond or a financial asset.
- Government, like us, spends money on various things. These include big expenditures on building infrastructure, public parks, public-funded education, hospital, nuclear energy, defense, salaries paid to government officials and small expenditures on office supplies, and many more. All of those will be part of the G component of GDP. But we won’t include government spending on any transfer payments, such as pensions to retired people or on welfare programs and subsidies. Those payments are not counted in GDP because no good is produced or service is exchanged against these payments.
- Spending by the rest of the world (Exports – Imports or net exports). We denote it with NX. Sometimes, a country produces some goods more efficiently than other countries and can sell them to other countries for profit. Those are called Exports. Similarly, the things a country has a comparative disadvantage in making, it can buy from other countries, which can make it relatively cheap.Since GDP, includes only goods produced “within the boundaries of a country.” we will include foreign people’s expenditure on things made in our country or our exports. At the same time, we won’t include us buying any foreign-made goods or our imports.
- So, GDP = C + I + G+ NX
Let’s look at the second approach of calculating the GDP.
- Income method: Here we add the total income earned by all the people living within the boundaries of a country. Economists classify income earners into four broad categories. Labor, land, capital, and entrepreneurship. These are called factors of production- the inputs used in the production of goods and services. Thus, we sum up all the income earned in a given year by these four factors of production using this formula.
Wages/salary (earned by labor) + Profits (earned by an entrepreneur) + Rent (earned by landowners) + Interest income (earned on capital equipment).
There is another method, which is less frequently used and is called the value-added method.
- Value-added Method: In this method, we add up all the value-added at various stages of production. For example, to make a dress, we will calculate the value of the raw material that a fabric company sells to the dress manufacturer ($10), which he combines with his skill and capital ($40) to make a dress worth $50.
So, these were all the ways of calculating the nominal GDP. To learn more about US GDP, please click here.
