Gross National Product: The Circular Flow of Expenditure and Income

The Circular Flow of Expenditure and Income National income and product accounting demonstrates that expenditure on final products generates income; but this is not a one-time affair. Instead the income in turn generates purchases of final products, which then result in more income as the process goes on and on. We can illustrate the continual flow of expenditure and income with a circular flow diagram similar to the one used in Chapter 5. However, with our enhanced knowledge of the NIPA accounts, we now can further investigate the relationship between the sources and uses of income by showing how the financial system, governments, and international trade affect the economy. The enhanced circular flow diagram is drawn in Box 7. The upper loop of the big circle represents expenditures on final products, while the lower loop represents a flow of income generated by the purchases. Where does the expenditure that generates income originate? To find out, let's start at the box marked households. Households purchase about 66 percent of GNP for consumption (C). Now move along the upper loop and notice that investment purchases (I) add to the flow of expenditures as funds from the nation's financial system are used to finance acquisition of machinery, new structures, and other investment goods. Then as you reach the top of the loop, government purchases (G) represent another addition to the flow of spending. Finally, moving down along the upper loop toward the box marked "business firms," notice that some spending is for import purchases (M) from international trade. Expenditures by U.S. buyers for such goods as Japanese computers and televisions, German automobiles, and Korean shoes end up as receipts to foreign sellers rather than to U.S. businesses. The spending for imports is therefore removed from the circular flow and does not end up as income to U.S. businesses and households. However, U.S. exports (E) are foreign purchases of U.S. products that help generate income in the United States from international trade. The difference E - M represents net exports (NE). By the time you get to the box marked "business firms," the total spending has grown to the sum C + 1 + G + NE, which you now know represents GNP expressed as a sum of its expenditure components. The expenditure on GNP generates the aggregate income earned by owners of business firms and members of households. This income is paid out as compensation to employees, net interest on funds borrowed, and rents, and a portion is set aside (saved) by business firms as capital consumption allowances. The remainder is profit. We can now trace the uses of income by moving along the lower loop of the circle. Some of the income earned "leaks out'" of the lower loop to pay taxes to governments. A portion of the taxes paid by U.S. households and businsses is used to finance transfers that are added to income and thus become available for spending. However, net taxes, which are the difference between taxes and transfers, are positive because taxes exceed transfers. Net taxes (T) are then used to finance government purchases, which were shown in the upper loop. Finally, a portion of income earned also flows out of the lower loop as saving, which is channeled to the financial system to provide funds for investment purchases. Some business saving (capital consumption allowances) are channeled to financial markets. Personal saving is the portion of household income that is not used to make purchases or to pay taxes over the year. Governments also absorb some of the saving during the year when they run a budget deficit. When this is the case the government must borrow through the financial system, as shown by the flow of funds from the financial system to government. In the 1980s the federal government was absorbing as much as $200 billion of annual savings to finance its enormous deficits. Some funds are supplied to the financial system by foreigners saving in the United States. When foreigners acquire more dollars during the year than they spend on U.S. products, the excess dollars end up as dollar deposits in U.S. banks. These dollars then enter the U.S. financial system as net foreign saving in the United States (see Box 7). When the net export component of GNP is negative, the United States runs a balance of trade deficit.* Now you're back to the box marked households, and the process begins all over again. Expenditure on final products during the year has provided households with the income necessary to finance their consumption. Income is used for consumption purchases (C), household and business savings (S), or to pay the difference between taxes and government transfers (net taxes = T). GNP expressed as the sum of uses of income is GNP = C + S + T