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In economics, the income effect is the change in the consumption of goods caused by a change in income, whether income goes up or down. The income effect can be direct or indirect.

For example, let’s say John spends 25% of his income on food and 25% on entertainment. His company decides to lower his salary, so he decides to spend less on entertainment. This is a direct change in his income, resulting in his spending less due to the income effect.

Now let’s say John’s salary does not change, but the price of food goes up. Indirectly, John’s income has gone down, since he now has less money to spend on other things after paying more for food. So he reduces his spending on entertainment. This is also the income effect.

In other words, income increase effectively increases a person’s—or an economy’s—discretionary income. Therefore, the person or economy will likely spend more on goods and services.

The inverse is also true. Any decrease in income will cause a decrease in consumption due to the income effect.

The substitution effect is closely related to the income effect. This describes how an increase in the price of one good causes people to purchase a substitute good instead, and vice versa. Therefore, a rise in prices will have two effects: it will cause people to reduce overall consumption, and to move to other goods.

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