Circular Flow of Income Model
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Households and Firms Interactions-
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Households provide factors of production (labor, land, capital) to firms in exchange for income (wages, rent, etc.).
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Example: A factory (firm) hires workers (households) and pays them wages, which they then spend on goods and services.
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Firms Produce Goods and Services for Households-
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Firms use the factors of production to create goods/services for sale to households.
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Example: A local bakery sells bread to consumers.
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Government Role-
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Collects Taxes: Governments collect taxes from both households (income tax) and firms (corporate tax).
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Provides Public Goods and Services: Governments provide public goods (infrastructure, education, healthcare) funded by taxes.
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Example: Schools and hospitals are funded by tax revenue.
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Circular Flow of Income Model
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Injections: Additions to the economy, which include:
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Investment (I): Spending on capital goods (e.g., machinery).
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Government Spending (G): Expenditure on public services (e.g., infrastructure projects).
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Exports (X): Sale of goods/services to other countries.
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Leakages: Withdrawals from the economy, which include:
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Savings (S): Income not spent on consumption.
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Taxes (T): Income paid to the government.
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Imports (M): Purchase of goods/services from other countries.
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Diagram for Circular Flow of Income Model
National Income Accounting
Methods of Measurement:
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Output Method: Measures total value of goods and services produced in an economy.Example: A country’s total output of cars, textiles, and software is calculated to find GDP.
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Income Method: Measures total income earned by factors of production (wages, rents, interests, and profits).Example: Salaries paid to workers, dividends to shareholders contribute to national income.
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Expenditure Method: Total spending on goods and services, calculated using the formula:GDP = C + I + G + (X - M) where:
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C: Consumption by households
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I: Investment by businesses
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G: Government spending
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(X - M): Net exports (exports minus imports)
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Main Concepts
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GDP (Gross Domestic Product):
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Measures the economic performance of a country.
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Example: The United States had a GDP of approximately $21 trillion in 2021.
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GNI (Gross National Income):
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GDP plus net income from abroad (e.g., remittances).
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Example: If a country’s GDP is $500 billion and it receives $50 billion from citizens working abroad, GNI would be $550 billion.
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Nominal vs. Real GDP:
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Nominal is measured at current prices; real is adjusted for inflation.
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Example: If nominal GDP is $1 trillion and inflation is 2%, real GDP is approximately $980 billion.
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GDP per capita:
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GDP divided by population, indicating average economic output per person.
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Example: A country with a GDP of $1 trillion and a population of 100 million has a GDP per capita of $10,000.
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Green GDP
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Concept:
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Green GDP adjusts GDP for environmental costs of production, such as pollution and depletion of natural resources.
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Example: If a country has a nominal GDP of $2 trillion but incurs $300 billion in environmental costs, its Green GDP would be $1.7 trillion.
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Importance:
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Highlights sustainability and environmental impact of economic activities.
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Encourages policies that account for ecological damage and promotes sustainable development.
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Example: Countries like China are increasingly adopting Green GDP measures to balance economic growth with environmental protection.
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The Business Cycle Diagram
Key Concepts
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Expansion:
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Economic activity rises; unemployment decreases; consumer spending increases.
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Example: Post-2008 financial crisis recovery, where GDP growth resumed.
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Peak:
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The economy reaches its maximum output before decline; inflation may rise.
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Example: The U.S. experienced a peak in the economy in early 2020 before the COVID-19 pandemic.
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Contraction:
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Economic activity slows; GDP declines; unemployment rises.
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Example: The 2020 recession caused by the COVID-19 pandemic led to significant economic contraction globally.
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Trough:
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Lowest point of economic activity before recovery.
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Example: The 2008 financial crisis had a trough in economic activity in 2009 before recovery began.
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Long-term Growth:
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Shows the overall trend of increasing GDP over time, despite short-term fluctuations.
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Example: The U.S. economy has shown long-term growth despite experiencing multiple recessions.
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The Use of National Income Data
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Uses:
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Government: National income data informs policy-making, budget allocations, and economic planning. Example: A government may use GDP data to decide on infrastructure investments.
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Businesses: Companies analyse national income data for market trends, investment opportunities, and consumer behaviour. Example: A tech company might invest more in a country with rising GDP growth and increasing disposable income.
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Economists: Researchers use national income data to study economic performance and forecast future trends.Example: Economists analyse GDP growth rates to predict economic conditions for the upcoming year.
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Limitations of National Income Data
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Comparisons: Differences in data collection methods, exchange rates can distort comparisons. Example: GDP figures may not be directly comparable between countries with different measurement techniques.
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Non-market Activities: GDP excludes unpaid work and informal sector contributions. Example: Volunteer Work and household chores, which contribute to societal well-being, are not included in the GDP.
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Quality of Life: GDP does not account for happiness, health, or environmental quality. Example: Countries with high GDP may still struggle with issues like pollution and inequality.
Other Measures of Economic Activity
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Human Development Index (HDI):
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A composite measure that evaluates health (life expectancy), education (mean years of schooling), and standard of living (GNI per capita).
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Example: Norway consistently ranks high on the HDI due to its strong healthcare and education systems.
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Genuine Progress Indicator (GPI):
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Measures economic progress by factoring in environmental and social costs.
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Example: GPI adjusts GDP by considering costs of crime, pollution, and family work
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Happy Planet Index (HPI):
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Measures well-being and environmental impact, reflecting the efficiency with which countries deliver long, happy lives.
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Example: Countries like Costa Rica often score high on the HPI due to their focus on happiness and sustainability.
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Income Distrubution
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Measurement:
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Lorenz Curve:
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Graph representing income distribution; the further the curve from the diagonal line of equality, the greater the inequality.
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Example: A Lorenz Curve for a country with significant wealth disparity would be more bowed outward.
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Gini Coefficient:
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A numerical measure of income inequality ranging from 0 (perfect equality) to 1 (perfect inequality).
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Example: A Gini coefficient of 0.25 indicates relatively equal income distribution, while a coefficient of 0.55 suggests high inequality (e.g., South Africa).
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Lorenz curve and Gini coefficient diagram
Lorenz Curve
Gini coefficient
Evaluating Economic Measures
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GDP
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Strength: A widely used indicator of economic performance.
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Weakness: Does not reflect income distribution or well-being.
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Example: Countries like the U.S. may have high GDP but significant wealth gaps.
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Green GDP
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Strength: Incorporates environmental costs.
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Weakness: Difficult to measure and calculate accurately.
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Example: China’s efforts to implement Green GDP face challenges in data collection.
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HDI
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Strength: Provides a broader measure of development than GDP alone.
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Weakness: Still limited in scope as it doesn't capture all aspects of well-being.
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Example: A country may have high HDI but low social equity.
Importance
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Understanding these measures helps in making informed economic policies.
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Recognizes the need for multiple indicators to get a complete picture of economic well-being.
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Example: Policymakers may prioritize economic growth while also considering social and environmental factors.