2.1 The Circular Flow and GDP

The simplest version has two groups and two markets. Households own the factors of production (land, labor, capital and entrepreneurship). Firms use them to make goods and services.

In the factor market (also called the resource market), households sell their resources to firms and receive income: wages, rent, interest and profit. In the product market, households spend that income buying goods and services from firms. Money flows one way around the circle and real things (resources, then products) flow the other way.

The key lesson: every dollar someone spends is a dollar of income for someone else. That's why GDP can be measured either by adding up spending or by adding up income. Fuller versions add the government (which collects taxes, buys goods and makes transfer payments) and the rest of the world (exports and imports).

GDP is the market value of all final goods and services produced within a country's borders in a given period, usually a year. Each part of that definition matters.

"Market value" means things are added up using their prices, so you can combine haircuts and cars. "Final" means sold to the end user, not used up to make something else; this avoids counting the same thing twice. "Within a country's borders" means a Japanese-owned car plant in Kentucky counts in U.S. GDP, but a U.S.-owned factory in Mexico counts in Mexico's GDP. "In a given period" means only things produced this year count.

• Not counted: intermediate goods (the flour a bakery buys), used goods (a 2015 car resold this year), purely financial deals (buying stocks or bonds), transfer payments (Social Security, unemployment benefits) and nonmarket work (cleaning your own house).
• Counted: new goods and services sold to final users, new homes, business purchases of new equipment, and goods made this year but not yet sold (added to inventories).

Expenditure approach: GDP = C + I + G + Xn. C is consumption (household spending). I is investment, which in economics means business spending on new capital, new home construction and changes in inventories, not buying stocks. G is government purchases of goods and services (transfer payments are left out because nothing is produced in exchange). Xn is net exports, exports minus imports. Imports are subtracted because they were made in another country but show up in C, I or G.

Income approach: add up all the income earned from producing output: wages, rent, interest and profit, plus some accounting adjustments. In theory it gives the same total as the spending approach, because spending and income are two sides of the same flow.

Value-added approach: at each stage of production, take the sale price minus the cost of the inputs bought from other firms. Adding the value added at every stage gives the price of the final good, without double counting.