David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

CHAPTER 15 Introduction to macroeconomics
The recent recession has temporarily reduced inflationary pressures. But, as we will see in later chapters, the
government's recent attempt to offset the recession and save the banking system has hugely increased both
government debt and its budget deficit. People worry that, sooner or later, the government will resort to
money creation in order to finance its deficit. In Part Four we will need to understand public finances, the
role of money creation, and the prospects for future inflation.
Figure 15.3 shows yearly fluctuations in output growth for the US, the UK and the eurozone.
It confirms that output growth is rarely smooth, and that nobody escaped the crash of 2009 .
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An overview
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The economy comprises millions of individual economic units: households, firms and the departments of
central and local government. Together, their individual decisions determine the economy's total spending,
income and output.
The circular flow
Initially, we ignore the government and other countries. Table 15. l shows transactions between households
and firms. Households own the factors of production (inputs to production). Households rent labour to
firms in exchange for wages. Households are also the ultimate owners of firms and get their profits. Capital
and land, even if held by firms, are ultimately owned by households.
Table 1 S.1
Households
Transactions by households and firms
Firms
Supply factor services to firms
Receive factor incomes from firms
Buy output of firms
Use factors to make output
Rent factor services from households
Sell output to households
The circular flow shows how
real resources and financial
payments flow between firms
and households.
Households supply factor services to firms, which use these inputs to make output.
The second row shows the corresponding payments. Households earn factor
incomes (wages, rents, profits), which are payments by firms for these factor
services. The third row shows that households spend their incomes buying the output
of firms, giving firms the money to pay for production inputs. Figure 15.4 shows
this circular flow between firms and households.
The inner loop shows flows of real resources between the two sectors. The outer loop shows the corresponding
flows of money in a market economy. A centrally planned economy could arrange the resource transfers
on the inner loop without using the outer loop.
Figure 15.4 suggests three ways to measure economic activity in an economy: (a) the value of goods and
services produced, (b) the level of factor earnings, which represent the value of factor services supplied, or
(c) the value of spending on goods and services. All payments are the counterparts of real resources. For
the moment, we assume all payments are spent buying real resources. Hence, we get the same estimate of
total economic activity whether we use the value of production, the level of factor incomes or spending on
goods and services.
Factor incomes equal household spending if all income is spent. The value of output equals total spending
on goods and services if all goods are sold. The value of output also equals the value of household incomes.
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