But first, a few simplifications: accounting for housing and land rent is really weird; furthermore, economists don't consider land rent to be that economically interesting, since we can't create any more land. Therefore, we usually just ignore land and rent, and focus on labor and capital. Since we ignore land rent, and we're lazy, we often use the letter L for Labor. The "rent" that people pay their landlords is consumption of goods and services, i.e. the physical building, which has to be actually built, and which wears out over time. Similarly, building a house is investment, i.e. production of capital. However, our current model does not have any notion of a stock of capital, so we're just going to ignore housing completely for now, until we improve our model.
Transactions that count as macro flow include:
- Alice's household buys $100 of food from Zelda's Groceries (C = $PQ)
- Bob's household receives a $100 paycheck from Yarrow's Electronics (FL = $wL)
- Carol's household buys a new printing press for $1000 (I = $PQ)
- The Daily Press pays $100 rent to Carol's household to use her printing press (FK = $rK)
The equations in parentheses indicate how we account for each transaction. For 1 and 3, on the left, we have C and I: Consumption spending and Investment spending. These refer to spending on the bottom arrow of the diagram. For 2 and 4, we have FL and FK, compensation for the Factors of Production, i.e. Labor and Capital
Transactions that don't count as macro flow include:
- Zelda's Groceries buys $100 of carrots from Andy's Farm; we'll count this income when they sell the carrots to consumers
- Betty's household buys a $100 used car from Yarrow; no new production has occurred; we're just shuffling assets
- Carl's household borrows $10 from Dana's household; again, we're just shuffling assets around
One interesting thing to note is that on average, the money paid to the factors of production should exactly equal the money spent on consumption and investment. Therefore, we can measure the national economy just by looking at one side or the other. Traditionally, economists look at the household spending side, because that's easier to measure. Thus, we say the nominal national income (Y) equals consumption (C) plus investment (I): Y = C + I.
This equation shows nominal income, i.e. all the variables are denominated in money; economists typically use capital letters to denote nominal values. We're also interested in real values: how much actual stuff is being produced and consumed? If we produced the exact same amount of stuff, but all the prices of stuff doubled, Y (and C and I) would double, but we wouldn't be materially better off. To handle this situation, we look at the price level (P), which is just a weighted average of the prices of individual goods and services. Therefore, real income (y) = nominal income (Y) divided by the price level (P): y = Y/P.
Another interesting thing to note is that a coin, a given physical unit of money, will be spent multiple times across the household/firm boundary. In our model, every household and firm spends all its money every sub-period, so if our sub-period is a week, and all households spend their money on Monday (go to the market), and all firms spend their money on Friday (and everyone stays home on Saturday and Sunday), then every coin will cross the household/firm boundary once a week on both arrows. The number of times, on average, a coin crosses the household/firm boundary on the income side (remember, the income side is equal to the factors side), is called the velocity of money (V). Therefore, if we have a given physical quantity of money (M), then the nominal income (Y) equals the total amount of money (M) times the velocity. Because we like to look at real income (Y = pY), we throw in the price level (P) to get the fundamental accounting identity, M*V = P*y.