The Circular Flow Diagram

The Circular Flow and Measurement of GDP

The circular flow diagram (shown below) is used to illustrate the flow of spending and money in the economy Opens in new window.

GDP Opens in new window can be represented by the circular flow diagram as a flow of income going in one direction and expenditures on goods, services, and resources going in the opposite direction.

The circular flow of income in an economy Figure 1. The circular flow and measurement of GDP. The complete circular flow has five sectors: a household sector, a firm sector, a government sector, a foreign sector, and a financial sector. Opens in new window

As the circular flow diagram depicts, firms sell goods and services to three groups:

  1. domestic households,
  2. foreign (overseas) firms and households,
  3. and the government.

To produce goods and services firms use factors of production Opens in new window: labor, capital, natural resources and entrepreneurship. Households supply the factors of production to firms in exchange for income.

We divide income into four categories:

  1. wages,
  2. interest,
  3. rent and
  4. profit
Firms pay wages to households in exchange for labor services, interest for the use of capital and rent for natural resources such as land.

Profit is the income that remains after a firm has paid wages, interest and rent.

Profit is the return to entrepreneurs Opens in new window for organizing the other factors of production and for bearing the risk of producing and selling goods and services.

As the diagram illustrates, federal, state and local governments make payments of wages and interest to households in exchange for hiring workers and other factors of production Opens in new window.

Governments also make transfer payments to households.

Transfer payments are payments by the government to individuals for which the government does not receive a good or service in return and include social security payments to retired and disabled people, unemployment benefits to unemployed workers and a variety of other payments to families.

These payments are not included in GDP Opens in new window because they are not received in exchange for production of a new good or service.

The sum of wages, interest, rent and profit is total income in the economy.

We can measure GDP as the total income received by households.

The circular flow diagram also allows us to trace the ways that households use their income.

Households spend some of their income on goods and services.

Some of this spending is on domestically produced goods and services, and some is on foreign produced goods and services.

Expenditure by foreign firms and households (shown as the ‘Rest of the world’ in the diagram) on domestically produced goods and services are called exports.

Spending on foreign produced goods and services is known as imports. Households also use some of their income to pay taxes to the government. (Note that firms also pay taxes to the government.)

Some of the income earned by households is not spent on goods and services or paid in taxes, but is deposited in savings accounts in banks or is used to buy shares or bonds.

Banks and share and bond markets make up the financial system.

The flow of funds from households into the financial system makes it possible for the government and firms to borrow.

The health of the financial system is of vital importance to an economy.

Without the ability to borrow funds through the financial system firms will have difficulty expanding and adopting new technologies.

No country without a well-developed financial system has been able to sustain high levels of economic growth.

The circular flow diagram shows that we can measure GDP either by calculating the total value of expenditures on final goods and services or by calculating the value of total income.

We get the same monetary (dollar) value of GDP with either approach.