We have seen that total spending equals total income (part 4). It has been argued that it is spending that creates (or determines) income (part 9). This can be inferred from the observation that some spending can occur independently of income (part 10).
Now that we have introduced ‘government money‘ and ‘commercial bank money‘, we are in a position to understand in basic terms how fiscal policy (government spending and taxing) is conducted and its direct financial effects. At this stage, the treatment is still cursory. There are more details that can be added in at a later time.
We have seen that a national currency enters the economy when government spends, and that the recipients of the government spending can use the currency for various purposes, including to purchase goods and services. Government is therefore an original source of funds.
There is another original source of funds that gives people the ability to make purchases. This other source is private credit creation. Put simply, a household or firm can borrow from a bank or other financial institution and use the funds to spend.
We saw in part 2 that to establish a currency, government needs to do three things:
1. Define a unit of account (e.g. dollar).
2. Impose taxes that can only be paid in that unit of account.
3. Spend or lend the currency into existence.
The most basic purpose of taxation (introduced in step 2 of the sequence) is to create a demand for the currency. Provided taxes are effectively enforced, we in the non-government will have a need to obtain the currency, because it is the only means of paying taxes.
Money can be thought of as an IOU (“I owe you”). The issuer of an IOU can buy goods or services from anybody who is willing to accept the IOU as payment.
It was mentioned (in part 2) that a currency-issuing government issues its currency in the act of spending. An implication of this is that a currency-issuing government does not need income in order to spend. We have also noted (in parts 5 and 9) that a household or business can spend independently of current income. They can do this either by drawing down past savings or through borrowing.
A prominent flow measure for the economy as a whole is Gross Domestic Product (GDP). This is a measure of the total output produced within the domestic economy over a year.