Circular Flow of the Economy: Scope and Diagrams

Macroeconomics

• Macroeconomics studies the overall performance and behavior of an entire economy.
• It focuses on aggregate variables such as national income, employment, inflation, and economic growth.
• It examines the interactions between households, businesses, government, and international trade.

Circular Flow Diagrams

• The circular flow model illustrates how money, goods, and services move between different sectors in an economy.
• Households provide factors of production (labor, land, and capital) to firms through the markets for factors of production.
• Firms use these factors to produce goods and services, which are sold in the markets for goods and services.
• Households purchase goods and services from firms through the same market for goods and services.
• Firms pay wages, rent, and profit to households for their supply of factors of production.
• Households use this income to spend on goods and services supplied by firms.

National Income

• Gross Domestic Product (GDP): The market value of all final goods and services produced within a country's borders during a specific period.
• Gross National Product (GNP): The total income earned by a country's residents (including those abroad) from all economic activities.
• Methods of calculating GDP:
  • Expenditures Approach: Adds up spending on final goods and services (consumption, investment, government spending, exports, and imports).
  • Income Approach: Adds up all income earned within the country (wages, rents, interest, profits).
  • Value-Added Approach: Sums up value added at various production stages.
• Nominal GDP: Measures GDP using current prices.
• Real GDP: Adjusts nominal GDP for inflation, providing a more accurate picture of economic growth.

Inflation

• Inflation: The sustained increase in the general price level of goods and services over time.
• It erodes purchasing power and affects the cost of living.
• Causes:
  • Demand-pull inflation (excessive demand).
  • Cost-push inflation (rising production costs).
  • Built-in inflation (expectations of future price increases).
• Effects:
  • Redistributes income and wealth.
  • Impacts savings, investments, and financial planning.