KEYNES PSYCHOLOGICAL LAW OF CONSUMPTION

John Maynard Keynes has explained the consumption behaviour of the household sector through the Psychological Law of Consumption.in his work – The General Theory of Employment, Interest and Money  published in 1936. Therefore, this law is also known as “Keynesian psychological law of consumption”. It provides a key part of the consumption foundation upon which Keynesian economics is built.

The law basically captures and understands the essential spending behavior of the household sector. in any capitalistic or mixed economy

Keynes uses the term ‘psychology’ in his law it is not really a law of psychology or of psychological behavior. It is just a basic observation of consumption behavior and consumption expenditure by the households.

The Psychological Law of Consumption states the relationship between income and consumption pattern, such as the changes in the aggregate income of the economy and the expenditures on consumption by the household sector.

The law is thus, a macro framework of the operation of the economy as it applies more to the aggregate economy than to the individuals.

ACCORDING TO LORD JOHN MAYNARD KEYNES

“Current consumption depends upon current disposable income. A rise in income leads to a rise in consumption and a fall in consumption leads to a fall in consumption”.

In simple words aggregate consumption is a function of aggregate disposable income. The empirical consumption-income relationship is presented by the consumption function.

PROPOSITIONS OF PSYCHOLOGICAL LAW OF CONSUMPTION

The psychological law of consumption put forward by Keynes, is mainly based on the following three facts:

1Increased aggregate consumption (by a smaller amount) due to increased aggregate income:

When aggregate income increases, aggregate consumption increases but the increase in aggregate consumption is less than increase in aggregate income.

This is because as income increases more and more of our wants get satisfied. When the basic necessities or demand of the people are already fulfilled not as much is again spent on consumption as the increase in income.

Consumption expenditure will no doubt increase with increase in income but less than proportionately and therefore, savings also increase as income increases.

2Division of the increased income between the consumption and saving:

The second proposition is that when income increases, the increments of income will be always be bifurcated into saving and consumption this really follows from first proposition.

Consumption spending does not increase at the same rate as the increase in income, ie only a part is consumed. Therefore a part of the increased income is saved and ie what is not spent is saved.

Saving is thus the complement of consumption.

Thus, the increased income does get divided between the two in certain proportion and can be showed as:

∆Y= ∆C + ∆S

Where,             ∆ = signifies change

∆Y = change in Income

∆C = change in Consumption

∆S = change in Saving

Thus savings create a gap between Income and Consumption.

3An increase in income will increase both consumption and savings

The third proposition included in Keynes Psychological Law is that as aggregate income increases both consumption spending and savings will increase ie the consumers will spend a little more than before and also save more than before.

It is not possible for savings and consumption to decrease when income increases.

A rise in income will be accompanied by a rise in savings and a fall in income will be accompanied by a fall in savings. The rate of increase or decrease in savings will be greater in the initial stages of increase or decrease in income than in the later stages.

ASSUMPTIONS

Keynes psychological law of consumption is limited by the following assumptions.

 1. Normal Conditions:

The psychological law applies only under normal economic conditions and when there is no danger of war or cold war, depression, boom, political upheaval, revolution inflation etc in the economy.

2. The propensity to consume remains stable

The propensity to consume remains stable or same as habits of the people regarding spending do not change owing to the constancy of the existing psychological and institutional complexities influencing consumption expenditure.

3. Psychological and Institutional Complex remains the same:

It means that there is no change in the psychological and institutional complex. Among the factors influencing the consumer, only the income will change, other institutional factors such as, desire, income behaviour, fashion, tastes and preferences, availability of goods, habits of the people, advertisement, salesmanship, tax policy population, price, etc. related to psychology do not change.

4. Capitalist Economy based on Laissez- faire:

The psychological law applies to free and prosperous capitalists economies and does not hold well in socialist and under-developed economies.

This is because, in a free economy, the people can consume any kind of goods they want, according to their necessities and desires and also there is no interference of the government in the economic affairs.

TABULAR EXPLANATION

The Keynesian consumption function is now explained with the help of schedule and a curve.

DISPOSABLE INCOME (Y)CONSUMPTION (C)SAVING (S)APC (C/Y)MPC (ΔC/ΔY)
050-50  
10010001.000.5
200150500.750.5
3002001000.670.5

In the schedule, it is shown that as the nation’s disposable income increases, the aggregate consumption at various levels of income also increases but at a decreasing rate.

DIAGRAMMATIC EXPLANATION

Following are the observations about the functional relationship between the national disposable income and the economy’s aggregate expenditure.

(i) At every point on the 450 line OY, a vertical line drawn to the income axis is at the same distance from the origin as a horizontal line drawn to the consumption axis. The 450 line thus is the line along which expenditure equals real income.

 (ii) The consumption function is represented by consumption line (C). The consumption line C is positively sloped indicating that as the disposable income increases, the expenditure in the economy also increases.

(iii) The consumption line (C) intercepts at Y axis showing negative saving of $50 billion during a short period.

(iv) At point B the consumption line (C) intersects the 450 helping line (OY) saving. At point B, consumption equals disposable income and there is zero saving. B is called the break even point.

(v) Left to the point B, the consumption line C is above the income line Y. It indicates negative saving.

(vi) Right to the point B, the consumption line C is below the income line Y. It denotes positive savings.

SIGNIFICANCE/ RELEVANCE/ IMPORTANCE OF THE PSYCHOLOGICAL LAW OF CONSUMPTION

Vital Importance of Investment:

One of the most important implications of Keynes’ psychological law of consumption is that it brings about the crucial importance of investment if we want to attain higher level of income and employment. The law says when income increases the gap between income and consumption increases.

The gap is to be filled by bringing more and more investment failing which there will be shortage of effective demand and the economy would slip down. Thus the law highlights the vital importance of investment.

General over Production:

Since the marginal propensity to consume is less than unity, with every increase in income, consumption would tend to lag behind income which would result in overproduction and unemployment. Thus the law tells us that there can occur a general overproduction and unemployment.

Repudiation of Say’s Law:

Keynes with the help of his law of consumption repudiates Say’s law which states supply creates its own demand. Since the marginal propensity to consume is less than unity all that is supplied is not automatically demanded. The supply fails to create its own demand resulting in glut of products in the market.

Need for State Intervention:

As there is no automatic and self-adjusting mechanism between supply and demand the government should interfere actively to ensure that aggregate effective demand does not fall below aggregate supply.

Over Saving Gap:

Since the increase in consumption expenditure does not keep pace with the increase in income, there arises the danger of over-saving gap. This danger is more for rich countries than for poor countries.

Decline in MEC:

As a result of the propensity to consume remaining stable with an increase in income the expected rate of profitability or the marginal efficiency of capital may tend to decline. This can be prevented only by increasing consumption with an increase in income because ultimately the decisions to undertake investments are guided by the volume of consumption.

Income Propagation:

Keynesian theory explains the slow nature of income propagation. Since the marginal propensity to consume is less than unity, injection of increasing purchasing power into the income stream leads to smaller and smaller successive increments to income.

Under Employment Equilibrium:

Equilibrium would be attained at full employment only if investment demand happens to be equal to the gap between aggregate income corresponding to full employment and aggregate consumption expenditure out of that income. But Keynes believed that the typical investment demand would not be adequate to fill the gap between the amount of income corresponding to full employment and the consumption demand out of that income. As such the aggregate demand and supply schedules would intersect at a point less than full employment.

Secular Stagnation:

With the increase in income, since consumption cannot be easily increased and investment demand becomes weaker and weaker the economy may sooner or later reach a stage where it may not be able to provide outlets for its growing savings which is necessary for maintaining full employment. This stage is known as secular stagnation. Such a situation could be avoided if the consumption function were not stable.

Turning Points of Trade Cycle:

Keynes’ psychological law of consumption is very helpful in explaining the turning points of the trade cycle. When the business cycle reaches the highest point of prosperity, income has increased, but the marginal propensity to consume being less than unity, consumption does not increase correspondingly and the result is the downward start of the cycle.

Similarly when the business cycle reaches the lowest point, income has declined very low but since people do not reduce their consumption to the full extent of decline in income, the upward phase of the cycle starts. Thus consumption function occupies a very important place in the theory of employment.

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