2.1 The Circular Flow and GDP

The Circular Flow Model

The circular flow model shows how money, goods, and services move between households and firms through product markets and factor (resource) markets. Households supply resources (labor, land, capital) to firms and receive income; firms provide goods/services to households in exchange for spending. Adding government, financial markets, and the foreign sector creates a more complete picture of the economy.

Defining and Measuring GDP

Gross Domestic Product (GDP) is the market value of all final goods and services produced within a country's borders in a given time period. It excludes intermediate goods (to avoid double-counting) and nonmarket/non-production transactions like used goods sales, financial transactions, and illegal activity. GDP can be calculated using the expenditure approach: GDP = C + I + G + Nx (consumption + investment + government spending + net exports).

Expenditure vs. Income Approach

Besides the expenditure approach, GDP can be measured with the income approach, summing all income earned producing goods/services (wages, rents, interest, profits). Both approaches should yield the same total since one entity's spending is another's income — this reflects the circular flow. GDP is a flow measure of output, not a measure of wealth or well-being.

Key terms

Circular Flow Model

A diagram showing how money, goods, and resources move between households and firms through product and factor markets.

GDP (Gross Domestic Product)

The market value of all final goods and services produced within a country's borders in a given period.

Expenditure Approach

GDP = C + I + G + Nx (consumption + investment + government spending + net exports).

Intermediate Goods

Goods used to produce final goods; excluded from GDP to avoid double-counting.

Income Approach

Calculates GDP by summing all income earned in production: wages, rents, interest, and profits.

Try an AP-style question

What is GDP?

1. $1,150B
2. $1,000B
3. $950B
4. $1,300B