We understand that, as a rule, total spending must equal total income (this was explained in part 4 of the series). But this raises a question. Is it spending that determines income or, instead, income that determines spending? At first glance, it might seem plausible that income determines spending. After all, when an individual household receives income, it will invariably spend some of it. If a member of the household receives a pay increase at work, the household will have more income. It is quite likely the household will respond by increasing its spending, perhaps after a delay. It can now afford to spend more than before. All this is true. But notice that the effect of income on spending is not automatic. A household might decide to spend all of its after-tax income. Or it might
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peterc writes Short & Simple 20 – Graphing the Income-Expenditure Model
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peterc writes Short & Simple 18 – Income Determination in a Closed Economy
peterc writes Short & Simple 17 – A Notion of Macroeconomic Equilibrium
We understand that, as a rule, total spending must equal total income (this was explained in part 4 of the series). But this raises a question. Is it spending that determines income or, instead, income that determines spending?
At first glance, it might seem plausible that income determines spending. After all, when an individual household receives income, it will invariably spend some of it. If a member of the household receives a pay increase at work, the household will have more income. It is quite likely the household will respond by increasing its spending, perhaps after a delay. It can now afford to spend more than before.
All this is true. But notice that the effect of income on spending is not automatic. A household might decide to spend all of its after-tax income. Or it might decide to spend some and save some. And the fraction it chooses to spend could be very high or not so high. Or, for that matter, an individual household might decide to spend more than its income. It could do this either by drawing down savings accumulated in previous periods or by borrowing.
It is actually spending that is most subject to choice. A household or business can decide to spend more, but its ability to receive more income depends to a considerable degree on the decisions of others.
A worker might like to earn more wage income, but the employer will have to agree to pay the higher wages or offer extra hours of work before this can occur.
Likewise, a business might like to make more sales, and step up its sales efforts accordingly, but whether it succeeds in its aim will ultimately depend on the spending decisions of its customers.
When somebody decides to spend, this causes income to be received by somebody else. The spending creates income.
This idea is sometimes expressed as “spending determines income”.
This is only possible because some spending can occur independently of current income. For instance, a household might spend in excess of income by drawing down savings or borrowing.
