hi everybody this circular flow of income is a very useful way of modeling the economy and from this model we can derive two very important conclusions one conclusion is how we can look at economic growth the second conclusion is how we can measure economic growth ie how we can get to GDP well let's get straight into it shall we so in our very simple economy here we've got two fundamental economic agents we've got households and we have firms or businesses households provide therefore factors of production to firms in the form of land labor capital and enterprise there's four fundamental factors of production they go to firms what the firms do with those factors of production they combine them and they make goods and services out of them in reward in return for providing their factors of production households receive factor incomes from firms that's the reward for providing the factors of production each factor production has a reward let's take labour the reward to labor is wages and salaries the reward for land is rent the reward for entrepreneurship is profit the reward for capital is interest so these are the four factor incomes that households receive and what do they do with those incomes they spend them on the goods and services made by firms so if we model all of that we get this this is a very simple model of the economy it's the circular flow of income the movement of spending and income throughout the economy that's what we have but it's very clear from this model that we've simplified things far too much we've ignored two fundamental sectors of the economy you could argue we've ignored the government completely they have a very important role to play in an economy and also the international sector as well well we can add that to our model here so let's look at factor incomes we've assumed that all incomes earned by households are going to be spent on goods and services in the economy that's a ludicrous assumption not all of the income that we earned is actually spent in the economy we can do other things with that income for example we could save a part of that income savings known as s what else could happen to our income it could be taxed away into using gunmen here absolutely it could be taxed away taxation known as T what else could happen we don't have to spend our income on goods and services made in our economy necessarily we could spend some of it on goods and services made abroad imports pending imports pending inputs here known as M the letters are important we need to know the letters here so these are ways in which incomes that are earned in the economy may leak out of the circular flow may not be spent directly on goods and services produced in our economy these three s T and M unknown as leakages unknown as leakages from the circular flow another name is also withdraws how incomes can go out of the economy and not be spent on goods and services produced in the economy but at the same time we've assumed that the only expenditure on goods and services produced in our economy is going to be by households is going to be by consumers well that's another crazy assumption there are many other ways in which expenditure can take place on goods and services made in an economy firms could spend that's known as investment that's known as investment the letter I who asked can spend on goods and services made in our economy government government can so there could be government spending and government spending is denoted by the letter G who asked can spend on goods and services in an economy or foreigners can write when they buy goods and services made in our economy that's known as exports for us so exports here denoted by the letter X absolutely so you have investment the technical definition for ISM for investment is when firms spend on capital goods so when firms spend on capital goods investment government spending and exports these three things are known as injections into the circular float ways in which money can enter our economy outside of Consumer Expenditure investment government spending and exports so we have injections and we have leakages ways in which we can bring in the government ways in which we can bring in the international sector this is now known as the full sector circular flow much more realistic view of our economy fantastic done with that but how can we get to these two fundamental conclusions let's understand by comparing the level of injections and leakages we can show whether the economy is growing or not so looking here if injections are greater than leakages there is more money entering the economy than is leaving it then economic growth is going to be rising if vice versa if the level of injections are less than the level of leakages it means more money is going to be exiting our economy than is going to be entering it therefore economic growth is going to be decreasing and if the two are equal to each other economic growth will neither be increasing nor decreasing therefore we call that macroeconomic equilibrium leakages and injections are imbalance they are equal to each other so we can illustrate economic growth using our circle flow of income but we can also get to an actual figure of GDP our measure of economic growth to GDP is our measure of economic growth standing for gross domestic product here and if we can measure any one of these three things in our circular flow of income we can get a precise number for GDP and then year on year we can see if that number is rising or falling and therefore we can precisely measure economic growth well let's have a look how we can do that from our circular flow we can measure number one number one is known as the output method of calculating GDP and that is looking at the final value of all goods and services produced in an economy in a year so adding up the final value of all goods and services produced in an economy in a year that is the output method of getting to GDP we could also calculate number two the income method by adding up all the factor incomes earned in an economy in a year that is adding up all wages and salaries that's adding up all profit or interest and all rent all the four factor incomes add them up and we get the income method to get to GDP or we can add up the total expenditure on a country's goods and services in a year that's Consumer Expenditure that's investment as government spending and its net exports see plus I plus G Plus in brackets X minus M that's also the equation for aggregate demand which we're going to see later in this playlist the total expenditure on all goods and services produced in an economy year is the expenditure method that's a third way of getting to GDP here fantastic doesn't matter which one we use no because all three are going to be equal to each other output equals income equals expenditure obviously we are measuring the same circular flow of income therefore we can't have three different numbers they're all trying to indicate the same flow and therefore by definition they're all going to be equal to each other the other very logical intuitive way of looking at it is by looking at an example of a transaction in an economy I love cricket guys let's make that very clear I absolutely adore cricket so let's say I go to a cricket shop and I'm looking to buy a cricket bat my spending on that cricket bat is going to be equal to the value of that output is going to be equal to the price of the cricket bat the value of the output absolutely and when I spend my money is going to go to the shop owner in the form of income for the shop owner so my spending on the cricket bat is equal to the value of the cricket bat the value of the output which then becomes the income of the shop owner spending equals output equals income the three are always going to be equal to each other whenever a transaction takes place in the economy therefore it doesn't matter which method we use we're gonna get to GDP therefore we're gonna get a measure of economic growth and we can see how that number changes over time that is the power of the circular flow not just getting a model but also giving us two fundamental conclusions that's it that's all you need to know thank you so much for watching guys I'll see you all in the next video [Music]