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Macroeconomic policy 
describes the policies and actions a government takes to control economic 
issues, including economic growth, inflation, employment and trade performance.
We look in detail at macroeconomic policy and objectives later in this chapter (in Section 8). We now 
turn our attention to the flow of income and expenditure in an economy.
1.1 Income and expenditure flows 
There is a circular flow of income in an economy, which means that expenditure, output and income will 
all have the same total value.
Firms must pay households for the factors of production (this generally means that firms pay wages to 
members of households) and households must pay firms for goods and services. The income of firms is 
the sales revenue from the sales of goods and services.
This creates a circular flow of income and expenditure, as illustrated in Figure 1. This is a basic 
closed 
economy
, without foreign trade. It assumes the economy has only two sectors (firms and households), 
with no government intervention and no imports or exports. In this model, we assume that households 
spend all that they earn (in economics this spending is known as consumption), and all the firms' goods 
and services are sold to the households. 
 EXAM FOCUS POINT 
You might consider macroeconomic factors to be a peripheral area of this syllabus, but the detail in 
this chapter does lend itself to the type of questions which are set under this examination. 
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CHAPTER 3
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THE MACROECONOMIC ENVIRONMENT 
 
59 
FIRMS
HOUSEHOLDS
Productive resources
Goods and services
Factor incomes paid by firms
Expenditure on goods and services
Figure 1 Circular flow of income 
Households earn