Notes

Almost all countries calculate a set of numbers known as the national income and product accounts. The national income and product accounts, often referred to simply as the national accounts, keep track of the spending of consumers, sales of producers, business investment spending, government purchases, and a variety of other flows of money among different sectors of the economy. In the United States, these numbers are calculated by the Bureau of Economic Analysis, a division of the U.S. government’s Department of Commerce. Let’s see how they work.

The Circular-Flow Diagram
To understand the principles behind the national accounts, it helps to look at a graphic called the circular-flow diagram. This diagram is a simplified representation of the macroeconomy. It shows the flows of money, goods and services, and factors of production through the economy and allows us to visualize the key concepts behind the national accounts. The underlying principle is that the flow of money into each market or sector is equal to the flow of money coming out of that market or sector.

The Simple Circular-Flow Diagram
AP® EXAM TIP
Be prepared to draw the simple circular-flow diagram with two markets (product markets and factor markets) and two sectors (firms and households), and add the government sector as shown in Figure 10.2. Correctly label the markets and sectors and the flows between them. Add the financial and international sectors to your diagram to help you understand the expanded model we will build throughout later Modules.

The U.S. economy is a vastly complex entity, with more than a hundred million workers employed by millions of companies, producing millions of different goods and services. Yet you can learn some very important things about the economy by considering a simple diagram, shown in Figure 10.1. This simple model of the macroeconomy represents the transactions that take place in the economy by two kinds of flows: physical things such as goods, services, labor, or raw materials flow in one direction, and payments for these things flow in the opposite direction. In this figure, the physical flows are shown in yellow and the money flows are shown in green.

A circular flow diagram shows how money flows through households, product markets, firms, and factor markets in an economy.
Figure 10.1 The Circular-Flow Diagram

This diagram represents the flows of money, factors of production, and goods and services in the economy. In the markets for goods and services, households purchase goods and services from firms, generating a flow of money to the firms and a flow of goods and services to the households. The money flows back to households as firms purchase factors of production from the households in factor markets.

Two cycles are shown. The first can be described as follows, starting from households on top and moving clockwise. An arrow labeled spending leads to product markets from households. An arrow labeled spending leads to firms from product markets, and an arrow labeled factor payments leads to factor markets from firms. An arrow labeled income leads to households, from factor markets and the cycle continues.

The second cycle can be described as follows, starting at the top and moving counterclockwise. An arrow labeled factors of production leads to factor markets from households. An arrow labeled factors of production leads to firms from factor markets. An arrow labeled goods and services leads to product markets from firms. An arrow labeled goods and services from product markets leads to households and the cycle continues.

The simplest circular-flow diagram illustrates an economy that contains only two groups: households and firms. A household consists of either an individual or a group of people who share their income. A firm is an organization that produces goods and services for sale—and that employs members of households. As you can see in Figure 10.1, households are shown on the top and firms are shown on the bottom.

There are two kinds of markets in the simple economy illustrated in Figure 10.1. To the right are product markets in which households buy the products (goods and services) they want from firms. Household payments for goods and services is called consumer spending. Consumer spending produces a flow of goods and services to the households and a return flow of money to the firms.

To the left are factor markets in which firms buy the factors of production (also known as resources) they need to produce goods and services from households. Households ultimately own, and receive income from, all of the factors of production: labor, land, capital, and entrepreneurship. While the best-known factor market is the labor market and most households derive the bulk of their income from wages earned by selling their labor, households receive income in the form of rent, interest, and profit as well as wages.

AP® EXAM TIP
Know that resources can be divided into four categories. You should become so familiar with the four categories of factors of production (labor, land, capital, and entrepreneurship) and the payments to those factors (wages, rent, interest, and profit) that you can remember and recite them from memory, backward and forward.

This simple circular-flow diagram omits a number of real-world complications. However, the diagram is a useful aid to thinking about the economy—and we can use it as the starting point for developing a more realistic (and therefore more complicated) circular-flow model.

The Expanded Circular-Flow Diagram
Figure 10.2 is an expanded circular-flow diagram that shows how the government is involved in flows between the households and firms in the economy.

A circular flow diagram shows how money flows through households, product markets, firms, factor markets, and the government in an economy.
Figure 10.2 An Expanded Circular-Flow Diagram: How Money Flows Through the Economy

A circular flow of funds connects the three sectors of the economy—households, firms, and government. Taxes flow to the government from both firms and households. Government spending on goods and services flows to the product market. Goods and services flow from the product market to the government and then on from the government to both households and firms.

Two outer cycles are shown. The first can be described as follows, starting from households on top and moving clockwise. An arrow labeled spending leads to product markets from households. An arrow labeled spending leads to firms from product markets, and an arrow labeled factor payments leads to factor markets from firms. An arrow labeled income leads to households, from factor markets and the cycle continues.

The second cycle can be described as follows, starting at the top and moving counterclockwise. An arrow labeled factors of production leads to factor markets from households. An arrow labeled factors of production leads to firms from factor markets. An arrow labeled goods and services leads to product markets from firms. An arrow labeled goods and services from product markets leads to households and the cycle continues.

In addition to the two outer cycles, the flowchart shows the following transactions: An arrow labeled taxes leads to government from households; and a segmented arrow labeled goods services and transfers leads to households from the government. An arrow labeled taxes leads to government from firms; and a segmented arrow labeled goods services and transfers leads to firms from the government. An arrow labeled government spending leads to product markets from the government and an arrow labeled goods and services leads to the government from product markets. An arrow labeled factor payments leads to factor markets from the government and an arrow labeled factors of production leads to the government from product markets.

In Figure 10.2, the flows between households and firms remain, but flows to and from the government are added. The government injects funds into the circular flow through government spending, and funds leak out of the circular flow through taxing. Government spending is the total of purchases made by federal, state, and local governments, including everything from national military spending on ammunition to your local public school’s spending on chalk, erasers, and teacher salaries. The government uses tax payments received from households and firms to finance much of its spending. Taxes are payments that firms and households are required to make to the government, and tax revenue refers to the funds the government receives from taxes.

Firms must pay taxes on the consumer and government spending they receive through the product markets. The funds remaining after taxes are then allocated to pay wages, rent, interest, and profit to households through the factor markets. Households must also pay taxes to the government. After paying taxes, households allocate their remaining income—disposable income—to consumer spending. Disposable income is the total amount of household income available to spend on consumption.

In addition to collecting taxes from households and firms, the government makes payments and transfers goods and services to households and firms. Government transfers are payments that the government makes to households or firms without expecting a good or service in return. So in addition to receiving income from selling factors of production, some households receive income in the form of government transfers. Unemployment insurance payments are one example of a government transfer. Finally, the government uses part of its spending to provide goods and services to households and firms.

Adding Financial Markets to the Circular Flow
The circular-flow diagram can be made even more realistic, and more complicated, by adding the financial markets. Because a circular-flow diagram becomes very complicated when we include financial markets, let’s simply use the idea of flows between markets and sectors we learned from Figures 10.1 and 10.2 to discuss how financial markets are involved in the financial flows in the economy.

Some households do not spend all of their disposable income on goods and services. But that unspent income does not disappear from the circular flow. Household income that is not spent on consumption becomes the household’s saving. Since household savings is not spent, it leaks out of the circular flow. This private saving is frequently held by financial institutions (such as banks) that inject it back into the circular flow in the form of loans. Financial markets channel private savings into government borrowing and investment spending. The government borrows funds to pay for government spending not covered by tax revenue and firms borrow funds to finance investment spending. The financial sector of the economy is discussed in detail in Section 5.

Investment spending includes firms’ spending on new productive capital. For example, an automobile company that is building a new factory will buy investment goods—machinery like stamping presses and welding robots. Firms also accumulate an inventory of finished cars in preparation for shipment to dealers. Inventories are goods and raw materials that firms hold to facilitate their operations. The national accounts include inventories as part of investment spending. Increases in inventories of finished goods are counted as investment spending because, like machinery, they influence the ability of a firm to make future sales. Spending on additional inventory is a form of investment spending by a firm. Conversely, decreasing inventories reduces investment spending because it leads to lower future sales.

It’s also important to understand that investment spending includes spending on the construction of any structure, including a new house. Why include the construction of homes as investment spending? Because, like a factory, a new house produces a future stream of output—housing services for its occupants.

Adding the Rest of the World to the Circular Flow
The rest of the world participates in the U.S. economy in three ways. First, some of the goods and services produced in the United States are sold to residents of other countries. For example, more than half of America’s annual wheat and cotton crops are sold abroad. Goods and services sold to other countries are known as exports. Payments for exports lead to an injection of funds from the rest of the world into the United States’ circular flow. Second, some of the goods and services purchased by residents of the United States are produced abroad. For example, many consumer goods are made in China. Goods and services purchased from other countries are known as imports. Import purchases lead to a leakage of funds out of the United States’ circular flow. Third, foreigners can participate in U.S. financial markets. Foreign lending—lending by foreigners to borrowers in the United States—generates a flow of funds into the United States from the rest of the world. Conversely, foreign borrowing—borrowing by foreigners from U.S. lenders—leads to a flow of funds out of the United States to the rest of the world. The international sector of the economy is discussed in detail in Section 8.

A photo shows people working on individualized tasks in a toy production unit.
The United States is a net importer of goods and services, such as these toys made on a production line in China.

The underlying principle of this expanded circular flow is still that the inflow of money into each market or sector must equal the outflow of money coming from that market or sector. And we can use the monetary flows within the circular-flow model to measure the size of an economy. Calculating the dollar value of all the final goods and services produced in an economy, shown in the circular flow, gives us the economy’s gross domestic product, one of the most important measures used to track the macroeconomy.