In macroeconomics we study the economy of one country Then try to understand how 2 countries interact and trade And hopefully, understand the global economy So today, we are going to study the circular flow of income Let’s make things really simple Imagine we are alone on an isolated island There’s no government, no trade, no savings I told you, it’s simple! There’s only firms and households Firms provide households with goods and services Out of thin air? Nah.. Firms gotta get factors of production from households It can be labor, land, capital or… Face it. Some of us in households are going to be entrepreneurs So…entrepreneurship For free? You wish! We don’t get freebies from firms We don’t provide labor for free either So there’s money flowing in the opposite direction Households gotta pay firms for the goods they get Firms also gotta pay households in the form of wages, rents, interests or profits But this is a little weird We don’t spend everything we earn in real life So let’s add savings Savings is money we don’t spend So there’s money flowing out Hey, savings don’t just sit in banks… Banks invest in firms by lending to them Cos firms need money to buy capital equipment or cover other costs of production So there’s investments flowing into the economy Bravo! Awesome! But this is a little too simplified Let’s add government Government buys stuff as well So there’s money flowing in Government gets money from taxes Taxes?!? So there’s money flowing out Cos for the money we’re paying as taxes, we cannot spend it Lastly, countries interact with one another Imagine this is an American economy Let’s add trade America imports stuff For example, America can import shoes from China Shoes flow from China into America And money spent on imports flows out of America into China America exports too America can produce software and export it to foreigners Money then flows from foreign countries into America This is America’s export earnings Investments, Government Spending and Export earnings are called Injections Cos money is flowing in Savings, Taxes and Import spending are called Leakages or Withdrawals Cos money leaks out of the system And hey, Injections and Leakages are sort of related Investments come from Savings Government spending comes from Taxes America makes money from foreigners by Exporting But foreigners also make money from America when America Imports Wow! No wonder it’s Circular Flow of Income It tells us roughly how an economy functions How do we measure the size of an economy then? By measuring Gross Domestic Product or GDP GDP is the total value of all final goods and services produced within the borders of a country during a given period. Why must it be FINAL goods and services? If you like this video remember to like and subscribe Next up: Measuring GDP: Output Approach