Circular flow - circulation of money

Fig. 4.5

Private sector in the circular flow

• The private sector total income is called the national income. Since the private sector receives the entire return from the factors of production, the national income is equal to the GDP and we can use the symbol Y for national income as well. Note that in a more detailed analysis of the components of GDP, including for example depreciation and factor income from abroad, it is no longer the case that national income is exactly the same as GDP, but they will often be close to each other.

• The private sector pays taxes to the government. Here we must include all taxes, income taxes, value added taxes, selective purchase taxes and payroll taxes (which are ultimately paid by the private sector since it owns the firms).

• Part of these taxes will be returned to the private sector in the form of pensions, child allowances, sickness benefit, unemployment benefits and so on. All these are examples of transfers from the government.

Net tax is then defined as taxes minus transfers and is denoted by NT.

• National income minus net tax is called disposable income or personal disposable income and is denoted by YDisp where YDisp = Y - NT.

• Total consumption by the private sector is denoted by C. C need not be equal to disposable income as the private sector can save and borrow. We define the private sectors savings as SH = YDisp - C (H for household). If C > YDisp then SH < 0, which implies that the private sector (in the aggregate) is borrowing money.

The Government, Rest of the World and the financial markets

• The total expenditure of the government may be divided into two parts: transfers to the private sector and consumption.

Government expenditure is the total expenditure by the government on goods and services. Note that the salary paid to an officer in the army is included in the government expenditure while the pension to the same officer is part of the transfers. We denote government expenditure by G.

• Government revenue is from taxes paid by the private sector. Since part of the taxes is returned through transfers, the government has NT available for consumption.

• We say that the government has a balanced budget if G = NT. We also define government savings as SG = NT - G.

• The total value of all exports to the rest of the world is denoted by X, while the total value of all imports from the rest of the world is denoted by Im. If Im > X then the value of all goods and services received from the rest of the world is larger than the value of goods and services that we send to them. The difference, SR = Im - X is rest of the world savings and this is also the amount we borrow from the rest of the world, which must eventually be paid back by exporting more than we import.

• Firms borrow money from the financial markets in order to finance investments, denoted by I. Investments are financed by private sector savings, government savings and rest of the world savings, I = SH + SG + SR. Note that SH , SG and/or SR may be negative.

Components of GDP

• By considering all arrows to and from the goods market we see that Y + Im = C + I + G + X. The left hand side is the value of all finished goods flowing into the goods market and the right hand side decomposes all goods into four categories. Note that this is simply an accounting identity and it must always hold.

• Moving Im to the right hand side we have Y = C + I + G + X - Im. X - Im is called net exports, NX and NX = - SR. Note that net exports is equal to the amount that the rest of the world borrows from our country. Thus, we can write Y = C + I + G + NX where C, I, G, NX are called the components of GDP.

• We have another accounting identity from the financial markets: SH + SG + SR = I. Using SH = YDisp - C = Y - NT - C, SG = NT - G and SR = Im - X we get Y - NT - C + NT G + Im - X = I, which is equivalent to the accounting identity from the goods market. Thus, if the accounting identity from the financial markets holds, the identity from the goods market must hold and vice versa. But the most important relationship to remember is Y = C + I + G + NX

Four different measures of GDP

Using the circular flow model we see that there are four equivalent ways of measuring GDP:

• Using the definition: the market value of all finished goods (expenditure method)

• As the sum of all value added from all firms (value added method)

• As the sum of consumption (private and government), investment and net exports (components method)

• As the sum of all returns from the factor markets: wages, return on capital and so on (income method)


By capital we typically mean manufactured goods that are used to produce other goods and services but are not used up in the production process (such as machines and computers). Sometimes we use the term fixed capital instead of capital to distinguish capital from financial capital, which consists of bank deposits, stocks, bonds and other assets. Fixed capital is sometimes divided into physical capital and immaterial capital such as individual capital (talent, skills, knowledge) and social capital.


When we use the word investment, we typically mean "gross investment". Basically, gross investment consists of all finished goods that we have produced but not consumed. The important parts of gross investment are gross fixed investment and changes in inventories.

Gross fixed investment is the total amount of investment in fixed capital. If a firm produces more than it sells in a particular period of time, its inventory will increase. This will be counted as a positive investment. In the same way, we will have a negative inventory investment whenever inventories decrease.

By net investments we mean gross investments minus depreciation such that the actual increase in the amount of capital between two periods in time is equal to the net investment during this period. Keep in mind that while capital is a stock, investment is a flow. We may talk about a firm’s total amount of capital at a particular point in time and a firm’s total investment over a period of time.

Fig. 4.6

Components of GDP in numbers 200x


2 673

Privat konsumtion C

1 283

Investeringar I


Offending konsumtion G


Import Im

1 093

Export X

1 299

Nettoexport NX


C + I + G + NX

2 673

Table 4.1

< Prev   CONTENTS   Next >