Understanding the Circular Flow of the Macroeconomy
Firms provide goods and services to households through the product market. Households pay firms
for these goods and services.
Households supply firms with the factors of production (also ca!led resources) through the factor
market. Firms pay households for resources ,(land, labor, capita!, and entrepreneurial sldll).
The income firms payto households includes rent, wages, interest, and profits. It equals the dollar
value of the output sold as shown in the circular flow diagram in Figure 2-1.1. The flow on the diagram
that includes expenditures for goods and services produced and sold in the product market represents
gross domestic product (GDP). The approach to measuring GDP using this flowis called the expenditures
Student Alert: Using the expenditures approach,
The details about this equation for GDP are developed in a later activity. For now, make sure you
understand how the expenditures approach measures GDP, and that this equation forms the basis for
models developed throughout the rest of the course.
The flow on the diagram that.includes payments for the resources used to produce goods and services in
the factor market is another way to represent GDP. The approach to measuring GDP using this flowis called
the income approach.
In addition to the basic flow'of economic activity illustrated by the flows between the product and factor