Lack of purchasing power
For example, consider a company ConceptCorp Ltd that conceives of a new product and obtains a loan from a bank to finance its development.
Consider the finances of one of ConceptCorp's employees, Joe, who is paid £10,000 for his work on the new product. Out of this income he has to pay tax, he spends a portion, and saves the rest.
The money Joe spends into the economy becomes someone else's income. Again they will pay tax on that income and decide what to do with the rest. And so on.
If we think of the initial loan becoming a flow that trickles round the economy, the flow lubricates many people even though the flow diminishes as it circulates, losing to tax and savings.
Labelling the people 1,2,3 ..., taking the tax as 34%, and the saving as 10% of disposable income, this table shows the flows:
[ Δ means 'change in']
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| People | Δ Income | Δ Tax (34%) | Δ Disposable income | Δ Consumption | Δ Saving (10%) |
|---|
Analysis
The £10,000 expenditure on Joe has overall generated an increased income for around JC_NUM_PLAYERS people totalling JC_INCOME. This income was spent as follows: JC_CONSUMPTION on consumption, JC_TAX on tax and JC_SAVING on saving.
Note that the sum of all the tax paid plus all of the savings equals the initial £10,000 expenditure on Joe: the money injected at the beginning of the flow is conserved and exits as tax and savings #.
The 'velocity of money' (spending multiplier), being the GDP divided by the quantity of money, is (JC_INCOME / £10,000) = JC_MULTIPLIER.
For simplicity's sake, let's assume that everyone spends their new income on ConceptCorp's new product #. If the loan originally received from the bank covered the expenditure on Joe (£10,000), this loan is easily paid back plus interest from the resulting JC_CONSUMPTION of consumption spent on the new product.
Again for simplicity sake, let's assume that everyone involved was on the payroll of ConceptCorp #. The income of each person is paid by ConceptCorp and so makes up part of the cost to ConceptCorp of making the product. The total cost of making the product - ending up as the price - is the total of all the incomes (JC_INCOME).
However, the total consumption of ConceptCorp's product is only JC_CONSUMPTION, resulting in a shortfall of JC_SHORTFALL. There is a lack of purchasing power due to the outflow of tax and savings, and this needs to be made up by an adequate injection, either from savings or from the state.
Savings
'Savings' in this context means money that is not spent on anything - it is sequestered as numbers in a bank account (or in a mattress). 'Savings' does not connote investment: investment is a form of spending into the economy.
It might be thought that banks use people's savings to invest in projects such as ConceptCorp, but in fact banks do not act as intermediaries - they loan on the basis of the profitability of the project in question. The bank who loaned the £10,000 to ConceptCorp did not need to have this money in their vaults prior to making the loan #; they act as a franchisee of the state and make this loan pure and simply by writing those numbers into ConceptCorp's account.
The injection of credit from the bank ends up as savings and tax. Where the savings end up depends on the overall state of the economy. For more on this question see here:
A third argument