Economics: The Circular Flow Model

Economics

Economics has progressed significantly, with economists creating hypotheses, principles, and models to fit the developed economics. The main premise of economics is the effective distribution of society's scarce resources to suit the infinite human demands. A few fundamental principles guide resource allocation, resulting in successful decision making. Economists must generate hypotheses, test assumptions, and build economic models based on test results in order to make effective judgments. Some of these models, such as the circular flow model, describe interactions between economic actors, such as households and corporations. Others, such as the Gross Domestic Product and Consumer Price Index, indicate the progress and trends in a country's economy as a whole. Principles of allocation of scarce resources

Principles of Resource Allocation

The society utilizes four principles to allocate limited resources. The trade-offs principle involves giving up on a goal or something you like to get another thing. Making of decisions require individuals in society to trade-off some desires. The second principle is that society has to forego the cost or value of something to gain an item that is more within the limit of available resources. Hence, the cost of something is what you forego to acquire (Condorelli, 2008). The third principle usually assumes that people are rational. The society often makes decisions by comparing the marginal costs and benefits. A rational person only takes decisions if marginal benefits exceed marginal costs (Condorelli, 2008). Lastly, the society does respond to incentives. The incentives induce people to behave in a certain way, for instance, high gasoline taxes forces people to drive fuel-efficient cars.

The Circular Flow Model

The economic interactions in a society can be well illustrated using the circular flow model. The circular flow model is a continuous flow of products, income, and resources between the households and firms (Mankiw, 2008). The households own factors of production; land, capital, and labor (inputs) needed in the production of goods and services. They rent or sell the resources to businesses through resources markets in exchange for resources payments in the form of salary, wages, profits, or rental payments. The households use the income to purchase goods and services produced by firms (Outputs) in products markets. The firms receive product payments, that is, revenue which is equal to Gross Domestic Product (GDP) of an economy (Mankiw, 2008).

The Gross Domestic Product (GDP)

In simple terms, GDP is the monetary value of finished products produced within a country's geographic boundaries in a definite period, usually annually or quarterly. In calculating a country's GDP, four components of the economy are included, net exports, investments, consumption and purchases by the government (Mankiw, 2008). Thus;

GDP = net exports + investments + consumption + government purchases

Net export of a country is equal to the whole country exports less total imports to the country. Consumption is the total spending by households for both goods and services. Investments are the spending by businesses on resources that will be used for producing goods and services for future, for example, capital equipment such as machines. Lastly, government purchases include goods and services bought by the government to offer services, for instance, paying off the government workers.

A country's GDP may be calculated either considering changes in prices of goods and services or not.

Nominal GDP is the aggregate economic value of goods and services produced within a country's boundaries (Mankiw, 2008). The nominal GDP does not consider the effects of inflation on the value of goods and services. Therefore, the GDP is usually calculated using the current prices of the current year. Real GDP which is lower than nominal GDP takes into account the effects of inflation and is usually adjusted to changes in general prices level (Mankiw, 2008). Economists usually calculate the real GDP by valuing the products produced the current year with a base year.

Consumer Price Index (CPI)

The CPI is a statistical estimation of changes in prices of goods and service households purchase for consumption. Sample representatives of a market basket of commodities consumed by households over a specified time are used to reach to a country's CPI. As noted by Mankiw (2008) economists usually use four steps in the construction of CPI; first, they survey the households to determine the appropriate "basket of goods." Then, they record the price of every commodity in each year; thirdly, the economists calculate the price of the basket in each year. Finally, they establish a base year and work out the CPI for the current year. Thus;

CPI = value of basket in the current year / value of basket in a base year x 100

For example, the present CPI for the USA by December 2016 was 202.416 (BLS, 2017). In calculating the index, Bureau of Labour Statistics considered prices of important commodities Americans bought for the day-to-day living. The index measures price changes from a designed reference date which is 1982-84 equal 100.

Inflation Rate

The CPI of an economy is used to compute the inflation as the percentage change in the CPI from the previous year to the current year. Hence;

Inflation rate = (CPI of current year - CPI for previous year) / CPI for previous year x 100

In the USA, inflation rates are calculated monthly and annually. For instance, the inflation rate for December 2015-December 2016 was 2.07% (BLS, 2017).

The CPI is a suitable way of to compute cost of living in a given period of time.

Each good and service in the basket of goods are assigned an expenditure weight that represents its relative importance in household spending patterns. The expenditure weight helps in estimating the minimum cost needed to maintain a certain standard of living. Therefore, CPI is used as a proxy measure of the cost of living or purchasing power.

References

Bureau of Labor Statistics (BLS) (2017). News release: CONSUMER PRICE INDEX – DECEMBER 2016. Available at: www.bls.gov/cpi

Condorelli, D. (2009). Market and non-market mechanisms for the optimal allocation of scarce resources (No. 1483). Discussion Paper, Center for Mathematical Studies in Economics and Management Science.

Mankiw, N. G. (2008). Principles of macroeconomics. Toronto: Thomson Nelson