Psychological law of consumption, the Keynesian concept states that people frequently have a tendency to increase their consumption when their income rises, however not to the same degree as the growth in income because some of the income is also saved. In general, as wealth rises, the community spends more and saves more money.
In this article, we will discuss this law in detail along with the propositions on which this law is based.
Psychological Law of Consumption
Keynes explains the psychological law of consumption on the basis of the fundamental psychological law. It says that humans tend to increase their consumption as their income increases. Simply put, it indicates that the marginal propensity to consume is less than unity but it is positive.
In 1936, John Maynard Keynes proposed the psychological law in his work “The General Theory of Employment, Interest and Money”. The fundamental expenditure patterns of the household sector are essentially captured and understood by this law. Keynes refers to his law as “psychology,” yet it is merely an observation of consumer behaviour and consumption. It outlines the connection between income and consumption patterns, including changes in the economy’s overall income and household sector spending on consumption.
Hence, the psychological law of consumption is a framework of functions of the economy on a broad scale as it refers more to the aggregate economy than the individuals.
The psychological law of consumption is based on propositions:
- With the increase in the total income of a community, its consumption expenditure also increases but less proportionately.
- This means that an increase in income always results in a trade-off between spending and saving.
- Any increment in income will result in an increase in savings as well, not just consumption. This indicates that we cannot often anticipate a decrease in total consumption or total savings with a rise in communal income. Savings typically increase when income increases, and decline when income declines. In the early phases of a rise or fall in income, the pace of savings growth or decline will be faster than in the latter stages.
Keynes’ psychological law of consumption mainly depends on income and that the recipients do not always tend to spend all their increased income on consumption. Keynes’ concept of consumption is mainly based upon this primary maxim.
The Limiting Assumptions
Just like every coin has two sides, Keynes’s psychological law of consumption also has some limiting factors. All the limiting assumptions are explained below.
Psychological and Institutional Factors’ Constancy
Due to the persistence of the institutional and psychological complications impacting consumption expenditure, consumption propensity will stay steady.
Natural Economic Conditions
The general economic conditions are usually normal as there are no extraordinary and abnormal situations like revolution, war, inflation, etc.
It is assumed that there is a free market economy with no governmental controls on consumption rising with income.
Implications- The psychological Law of Consumption
If you go through more details in Keynes’ law then you will notice the following important implications.
The Importance of Investment in an Economy
The main point of the law focuses on the tendency of people not to spend the full amount of increase in their income on consumption. Therefore, there is a gap between aggregate consumption and aggregate income.
If the consumption function remains constant in the short run, the “gap” will widen as income rises. The issue of investing is brought up as a result. In order to bridge the gap between income and consumption, investment should be raised. Keynes emphasises the importance of investment as the key driver of income and employment levels.
Discarding Say’s Law
It discards Say’s law of market as it indicates the possibility of over-production and demand deficiency.
Business Cycle Explanation
This law also gives an explanation of the turning points of a business cycle. A decline in capital’s marginal efficiency results from a boom’s upper turning point because, throughout the prosperity period, consumption expenditures do not keep up with income growth.
Similar to how it explains the resurgence of capital’s marginal efficiency and the turning point in the recovery from the depression, the rule also explains why consumption expenditure does not fall in proportion to a loss in income.
The Bottom Line
That was all about the psychological law of consumption. Keynes acknowledged that a variety of subjective and objective factors, such as the interest rate and wealth, affected the level of consumption expenditure, but he highlighted that the consumption spending of a person and society as a whole relied on the current level of income.
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