Circular Flow & GDP

How the U.S. Economy works

Branches of Economics• Microeconomics --studies economic behavior &

decision making of small units: individuals, families, businesses

• Macroeconomics --studies economic behavior &

decision making of entire economies

Analyzing Sony’s $100 price cut for PS3

Analyzing how a federal income tax cut has affected unemployment

Key Concept: Circular Flow

• Describes how goods, services and money flow through a free market economy

Circular FlowPRODUCERS CONSUMERS

Factor Market

Product Market

Circular FlowPRODUCERS CONSUMERS

Factor Market (Factors of Production)--land, labor, capital, education/skills are

exchanged

Product MarketWhere goods & services sold

The U.S. Free Market EconomyThe U.S. Free Market Economy

labor

Wages/paycheck

Make productsPay for products

Boeing cuts 1000 jobs

Income tax rebate $700Interest rates go up

Price of oil goes down

Measuring the Circular Flow: GDP

• The total dollar value of economic output of the circular flow is called Gross Domestic Product (GDP)

• Dollar Value of all FINAL new goods & services produced in USA over one year

GDP = C + I + G + (X-M)

How to Calculate GDP

GDP is a very IMPERFECT measure—it does NOT

Measure:

Leisure time v. hours worked

What is produced—shoes, guns, toys count the same

How happy or content people are

GDP Growth Rate

• Instead we use the percentage growth rate (measured quarterly and annually)– Example: GDP grew last year at a +2.2% rate last quarter

GDP #s are hard for our minds to grapple with:GDP increased from $13.2 trillion to $13.5 trillion; DOES NOT COMPUTE!

GDP growth: Speed Limits

• Too fast: If GDP grows above 5.0%, the economy may experience inflation– Prices rise

• Too slow: If GDP grows below 2%, not enough jobs are created– Unemployment rate increases

Gross Domestic Product (GDP) Growth Rate

• Slowest ever -13.0% (1932)

• Fastest ever +18.5% (1942)

• Historical average: +2.5%-3.0%

Recent GDP Growth Rates: 1Q 2008: +0.9%2Q 2008 +2.8% 3Q 2008 -0.5%4Q 2008 -6.5%

1Q 2009: -6.4%

2Q 2008 -0.7%3Q 2008 +2.2%