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Question
Why should the aggregate final expenditure of an economy be equal to the aggregate factor payments? Explain.
Solution
In a two sector economy, consisting of households and firms, the only way in which the households can dispose their income is on the goods and services produced by the firms. The factors of production use their remuneration to purchase goods and services. Thus, the income will come back to the producers in the form of sales’ revenue. So, there is no difference between the amount that firms distribute in the form of factor payments and consumption expenditure incurred by the households. The same process continues year after year. However, if there has been any leakage in the form of savings, imports or taxes, then there arises a difference between the aggregate consumption expenditure and aggregate factor payments. In the case of some leakage, the households will spend less than their factor incomes. Consequently, the firms will receive lesser amount in the form of revenue, which will reduce the production level and employment level. This process will continue in every successive round and production and employment levels will continue to drop. Thus, the equality between the aggregate consumption expenditure and the aggregate factor payments is very necessary for the smooth functioning of the economy.
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