The circular flow model shows how money, products, and resources move between households, firms, the government, and the rest of the world. Gross domestic product (GDP) measures the value of the final goods and services that flow through that system in a year. Click flows in the diagram, then use the calculator to measure GDP and see which transactions it leaves out.
Part A is the circular flow diagram. Part B measures GDP two ways and flags items that do not belong. Part C shows why adding value added at each stage gives the same answer as counting only the final good.
| Transaction | Amount ($B) | Category | What the calculator does | Remove |
|---|
Households sell land, labor, capital, and entrepreneurship to firms in the factor market and receive wages, rent, interest, and profit. They spend that income on goods and services in the product market. Money flows one way around the loop; goods, services, and factors flow the other way.
The market value of all final goods and services produced within a country's borders in a given year. Ownership does not matter. A Japanese-owned car plant in Ohio adds to U.S. GDP.
Add consumption, investment, government purchases, and net exports. Imports are subtracted because spending on imports is already inside C, I, and G, and GDP counts only domestic production.
Investment is spending on new capital goods (machines, tools, factories), new residential housing, and changes in business inventories. Buying stocks or bonds is a financial transaction and adds nothing to GDP.
Intermediate goods are inputs used up to make something else. Their value is already in the final price, so GDP leaves them out. Adding the value added at each stage of production gives the same total as the final sale price.
Every dollar spent on final output becomes someone's income. Adding wages, rent, interest, and profit gives GDP too. Leakages (saving, taxes, imports) leave the spending stream; injections (investment, government purchases, exports) enter it.
Memorize these. AP multiple-choice questions on this topic are mostly this table in disguise.
| Transaction | In this year's U.S. GDP? | Where it goes, or why it is left out |
|---|---|---|
| A family buys a new refrigerator or a haircut | Yes | Consumption (C) |
| A firm buys new machinery or builds a factory | Yes | Investment (I): new capital goods |
| A builder completes a new house | Yes | Investment (I): new residential construction |
| Goods produced this year that are still unsold | Yes | Investment (I): inventory investment. When sold next year, inventories fall, so they are not counted twice. |
| A state builds a bridge or pays public school teachers | Yes | Government purchases (G) |
| Foreigners buy U.S.-made airplanes | Yes | Exports (X), added |
| Americans buy cars made in Germany | Subtracted | Imports (M). The spending is in C, so M is subtracted to remove it. |
| Social Security or unemployment benefits | No | Transfer payment: nothing is produced in return |
| Buying shares of stock or a bond | No | Financial transaction. The broker's fee does count (a service, C). |
| Buying a used car or an existing house | No | Used good, counted when it was made. A dealer's or agent's commission does count. |
| Steel bought by an automaker | No | Intermediate good. Its value is inside the price of the car. |
| Shoes made in a U.S.-owned factory in Vietnam | No | Produced outside U.S. borders. Counts in Vietnam's GDP and U.S. GNP. |
AP-style multiple choice. Pick an answer to see the explanation.
The vocabulary for topic 2.1. Read the list, flip through flashcards, or quiz yourself. For every term in the unit, see the Unit 2 terminology guide.