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KEYNESIAN ECONOMICS AND THE LAW OF

CONSUMPTION
INTRODUCTION
Keynesian economics is a macroeconomic theory based on the ideas of 20th-
century British economist John Maynard Keynes. Keynesian economics argues that
private sector decisions sometimes lead to inefficient macroeconomic outcomes and
therefore advocates active policy responses by the public sector, including monetary
policy actions by the central bank and fiscal policy actions by the government to
stabilize output over the business cycle. The theories forming the basis of Keynesian
economics were first presented in The General Theory of Employment, Interest and
Money, published in 1936; the interpretations of Keynes are contentious, and several
schools of thought claim his legacy.

Keynesian economics advocates a mixed economy—predominantly private sector,


but with a large role of government and public sector—and served as the economic
model during the latter part of the Great Depression, World War II, and the post-war
Golden Age of Capitalism, 1945–1973, though it lost some influence following the
stagflation of the 1970s. As a middle way between laissez-faire capitalism and
socialism, it has been and continues to be attacked from both the right and the left.
The advent of the global financial crisis in 2007 has caused a resurgence in
Keynesian thought. Keynesian economics has provided the theoretical underpinning
for the plans of President Barack Obama, Prime Minister Gordon Brown and other
global leaders to rescue the world economy.

In Keynes's theory, there are some micro-level actions of individuals and firms that
can lead to aggregate macroeconomic outcomes in which the economy operates
below its potential output and growth. Some classical economists had believed in
Say's Law, that supply creates its own demand, so that a "general glut" would
therefore be impossible. Keynes contended that aggregate demand for goods might
be insufficient during economic downturns, leading to unnecessarily high
unemployment and losses of potential output. Keynes argued that government
policies could be used to increase aggregate demand, thus increasing economic
activity and reducing unemployment and deflation.

Keynes argued that the solution to depression was to stimulate the economy
("inducement to invest") through some combination of two approaches: a reduction
in interest rates and government investment in infrastructure. Investment by
government injects income, which results in more spending in the general economy,
which in turn stimulates more production and investment involving still more income
and spending and so forth. The initial stimulation starts a cascade of events, whose
total increase in economic activity is a multiple of the original investment.
A central conclusion of Keynesian economics is that, in some situations, no strong
automatic mechanism moves output and employment towards full employment
levels. This conclusion conflicts with economic approaches that assume a general
tendency towards equilibrium. In the 'neoclassical synthesis', which combines
Keynesian macro concepts with a micro foundation, the conditions of general
equilibrium allow for price adjustment to achieve this goal.

More broadly, Keynes saw this as a general theory, in which utilization of resources
could be high or low, whereas previous economics focused on the particular case of
full utilization.

The new classical macroeconomics movement, which began in the late 1960s and
early 1970s, criticized Keynesian theories, while New Keynesian economics have
sought to base Keynes's idea on more rigorous theoretical foundations.

Some interpretations of Keynes have emphasized his stress on the international


coordination of Keynesian policies, the need for international economic institutions,
and the ways in which economic forces could lead to war or could promote peace.

OBJECTIVE & AIMS


1. Change in the Wage Level:

If the wage rate rises, the consumption function shifts upward. The
workers having a high propensity to consume spend more out of their
increased income and this tends to shift the С curve upward.

2. Windfall Gains or Losses:

Unexpected changes in the stock market leading to gains or losses tend


to shift the consumption function upward or downward.

3. Changes in the Fiscal Policy:

Changes in fiscal policy in the form of taxation and public expenditure


affect the consumption function. Heavy commodity taxation adversely
affects the con-sumption function by reducing the disposable income of
the people.
4. Changes in Expectations:

On the contrary, if it is expected that prices are likely to fall in the future,
people would buy only those things which are very essential. It will lead
to a fall in consumption demand and to a downward shift of the
consumption function.

5. Changes in the Rate of Interest:

Substantial changes in the market rate of interest may influence the


consumption function indirectly. There are several ways in which the rate
of interest may affect the consumption function. A rise in rate to interest
will lead to a fall in the price of bonds, thereby discouraging the
propensity to consume to the bond holders.

6. Financial Policies of Corporations:

Financial policies of corporations with regard to income retention,


dividend payments and reinvestments tend to affect the consumption
function in several ways. If corporations keep more money in the form of
reserves, dividend payments to shareholders will be less, this will have
the effect of reducing the income of the shareholders and the
consumption function will shift downward.

7. Holding of Liquid Assets:

The amount of liquid assets in the form of cash balances, savings and
government bonds in the hands of consumers also influence the
consumption function.

8. The Distribution of Income:

The distribution of income in the community also determines the shape


of the consumption function.
Importance
1. Vital Importance of Investment:

One of the most important implications of Keynesian psychological law


of consumption is that it establishes the vital and crucial role of
investment when the community spends less than the increment in
income.

Increased output and employment will not be possible to maintain,


unless investment (on capital goods) is sufficient to fill the gap between
income and consumption.

The existence of such a gap implies that sales fall short of costs
necessary to provide current output; with the consumption function
becoming stable, the fluctuations in income, output and employment are
to be sought in the instability of investment. Thus Keynes’ consumption
functions and its stable nature, especially in the short run, clearly brings
out the strategic importance of investment in any kind of income
analysis.

2. Repudiation of Say’s Law:

Keynes’ Law explains general over-production and general


unemployment. The marginal propensity to consume of less than unity
explains that the whole production (income) is not automatically spent. In
other words, entrepreneurs fail to receive, by means of sales, an amount
that must be had to justify current output; supply fails to create its own
demand and exceeds the demand simply to create a glut of goods and
services thereby leading to general unemployment. Thus, the
assumption of MPC being less than one helps us to invalidate Say’s Law
of Markets. It is contended that in the long period the demand is likely to
be sufficient to buy all that economy is capable of supplying.

This long term adjustment is brought about by the market forces of


demand and supply: Consumption function tells us that this is true only
as far as increasing income is spent on consumption.
3. Decline in MPC:

The expected rate of profitability or the marginal efficiency of capital may


decline with consumption remaining unchanged failing to rise as much
as the rise in income. Declining tendency of the marginal efficiency of
capital could be avoided if consumption spending could be increased at
the same rate as an increase in income.

4. Over Saving Gap:

If consumption spending does not rise with a rise in income, then a


permanent over saving gap may come to exist. Over saving gap refers to
the difference between the amount people wish to save (out of full
employment income) and the volume of private investment. For
example, if people want to save Rs. 60 crores out of a full employment
income of Rs. 300 crores and businessmen find it profitable to invest
only Rs. 40 crores (according to the existing investment opportunities),
then there will be an over saving gap of Rs. 20 crores annually.

The propensity to consume being less than one creates a knotty


problem of offsetting a large amount of saving to maintain full
employment. In the absence of sizable investment opportunities in the
face of stable consumption function, it may not be easy to wipe off this
over saving gap. A real solution lies in somehow raising the consumption
function.

CONCLUSION

Psychological Law of Consumption is based upon his observations can


conclusion derived from the study of consumption function. Consumption
function is the functional relationship between the income and
consumption of the people. This can be stated as follow as follows:

C = f(Y)

Where C shows the consumption expenditure, Y shows the level of


income and F indicates the functional relationship between them.
When the aggregate income of a person increase, his expenditure on
consumption would also increase, but the increase in the income. This is
because as the income increase, more and more of wants are satisfied.
Hence, comparatively less and less is being spent when income
increase. Of course, consumption expenditure does increase when the
income rises, though only by a small amount.

The second proposition relating the law of consumption is that with an


increase in income, the additional income will be divided in some
proportion between saving and consumption. This obviously follows from
the first proposition. Since the expenditure on consumption does not
increase at the same rate as an increase at the same rate as an
increase in income, a part of income is bound to be saved. Thus,
consumption and savings go hand in hand. what is not consumed , is
saved.

The third proposition regarding the law of consumption is that with the
increase in income, both saving and spending would go up. An increase
in income is unlikely to reduce the level of consumption and saving from
their earlier position. It is not generally seen that a person decrease his
consumption when the income increases. In fact, when the income rises,
he would spend a little more than before And at the same time is savings
would also be a little higher than the previous level.

These three observations regarding the behavior of consumption with an


increase in income have come to be popularly known as Keynes’
Psychological Law of Consumption. The law, as enunciated by these
observations would hold good on by when the following three
assumptions are satisfied.

SUGGESTIONS

“The amount of aggregate consumption depends mainly on the amount


of aggregate income. The fundamental psychological law, upon which
we are entitled to depend with great confidence both a priori from our
knowledge of human nature and from the detailed facts of experience is
that men (and women, too) are disposed, as a rule and on an average to
increase their consumption as their income increases, but not by as
much as the increase in their income”

References

 Keynes, J. M. (1937), "The General Theory of


Employment", Quarterly Journal of Economics, 51: 209–
223, doi:10.2307/1882087.

 Albert Hahn, L (1949). The Economics of Illusion:Critical analysis


of contemporary economic theory and policy. USA: Squier
Publishing company.

 Murad, Anatol. What Keynes Means. USA.

 Hirai, Toshiaki (2008). Keynes Theoretical Development- from the


tract to the General theory. Milton Park, Abingdon: Routledge.