John Maynard Keynes’s “psychological law of consumption,” articulated in his seminal work The General Theory of Employment, Interest and Money (1936), represents a cornerstone of Macroeconomics, fundamentally altering the prevailing classical economic thought. At its core, this law describes a predictable human behavioral tendency regarding how aggregate consumption expenditure responds to changes in aggregate income. It posits that as aggregate income increases, aggregate consumption will also increase, but by a smaller proportion than the increase in income. This seemingly straightforward observation had profound implications for understanding economic fluctuations, the causes of unemployment, and the potential role of government intervention in managing economic activity, particularly during periods of recession or depression.

Before Keynes, classical economists largely believed that full employment was the natural state of an economy, maintained by flexible prices and wages. Any deviation from full employment was seen as temporary, with market forces swiftly bringing the economy back into equilibrium. Keynes, observing the persistent high unemployment of the Great Depression, challenged this notion, arguing that economies could indeed settle into an “underemployment equilibrium.” The psychological law of consumption provided a crucial mechanism for this argument, suggesting that an inherent tendency for a gap to emerge between increasing income and a comparatively slower increase in consumption meant that effective aggregate demand could be insufficient to absorb all potential output at full employment, leading to a deficiency of aggregate demand and thus, unemployment.

The Core Tenets of the Psychological Law of Consumption

Keynes’s psychological law of consumption is predicated on the idea that “men are disposed, as a rule and on the average, to increase their consumption as their income increases, but not by as much as the increase in their income.” This statement encapsulates several critical components and gives rise to specific economic concepts:

  1. Marginal Propensity to Consume (MPC): This refers to the proportion of an additional unit of income that is spent on consumption. According to Keynes’s law, the MPC is positive but less than unity (0 < MPC < 1). This means that for every extra dollar earned, a portion is consumed, and the remaining portion is saved. If MPC were 1, all additional income would be consumed, and if it were 0, none would be consumed. The condition 0 < MPC < 1 is central to the law.

  2. Marginal Propensity to Save (MPS): This is the proportion of an additional unit of income that is saved. Since income can either be consumed or saved, the MPC and MPS always sum to one (MPC + MPS = 1). As MPC is positive but less than one, it follows that MPS must also be positive but less than one (0 < MPS < 1).

  3. Average Propensity to Consume (APC): This is the ratio of total consumption to total income (C/Y). Keynes suggested that as income rises, the APC tends to fall. This implies that as people become wealthier, the proportion of their total income that they spend on consumption decreases, and a larger proportion is saved.

  4. Average Propensity to Save (APS): This is the ratio of total saving to total income (S/Y). Correspondingly, as income rises, the APS tends to increase. The APC and APS also sum to one (APC + APS = 1).

The “psychological” aspect of the law stems from the underlying human behavioral motivations that Keynes attributed to this pattern. He suggested that as income increases, people’s most urgent needs are met first. Beyond this point, additional income might be used to satisfy less pressing desires or, more importantly, to save for future security, unforeseen contingencies, or for the accumulation of wealth. This “satiation” of wants at higher income levels means that the desire for current consumption diminishes relative to the desire for future security or wealth accumulation. Keynes also alluded to the role of habit and custom in influencing consumption patterns, which tend to adjust more slowly to income changes.

Underlying Assumptions

For the psychological law of consumption to hold, Keynes implicitly and explicitly made several assumptions about the prevailing economic and social conditions:

  1. Normal and Constant Psychological and Institutional Conditions: The law is not universal but applies under “normal” conditions. This implies an absence of extraordinary events like hyperinflation, major wars, revolutions, or profound social upheavals that could drastically alter consumer behavior. If such conditions were present, the predictability of the consumption function would break down.

  2. Existence of a Capitalist Economy: The law is framed within the context of a free-market, capitalist economy where individuals make consumption and saving decisions based on their income and preferences, rather than a centrally planned system.

  3. No Significant Change in Income Distribution: The law assumes that the distribution of income among different segments of the population remains relatively stable. A significant redistribution of income (e.g., from the rich, who tend to have a lower MPC, to the poor, who tend to have a higher MPC) could alter the aggregate consumption function, even if total income remains constant.

  4. No Change in the Price Level: The law assumes that the general level of prices remains stable. Significant inflation or deflation could distort real income and wealth, thereby influencing consumption decisions in ways not captured by a simple relationship between nominal income and consumption.

  5. Lack of Significant Changes in Consumer Preferences or Habits: While the law acknowledges “psychology,” it assumes that the fundamental psychological disposition towards consumption and saving is relatively stable in the short run. Drastic shifts in consumer tastes, cultural norms, or technological innovations that drastically alter consumption patterns are not considered within its immediate scope.

Key Propositions and Economic Implications

The psychological law of consumption, with its core concept of MPC being positive but less than unity, underpins several crucial propositions and yields far-reaching economic implications that formed the basis of Keynesian economics.

  1. MPC is Positive but Less Than Unity (0 < MPC < 1): This is the most fundamental proposition. It signifies that any increase in aggregate income will lead to an increase in both consumption and saving. This is critical because it implies that not all income is re-spent immediately, creating a potential gap between aggregate supply and aggregate demand.

  2. The Marginal Propensity to Consume Tends to Fall as Income Rises: While not always strictly upheld by empirical data in the long run, Keynes hypothesized that as income continues to rise, the satisfaction of basic needs becomes complete, and individuals tend to save a larger proportion of their additional income. This means that the MPC itself might decline at higher income levels, reinforcing the tendency for consumption to grow slower than income.

  3. The Average Propensity to Consume Falls as Income Rises: Directly related to the previous point, if a larger proportion of additional income is saved at higher income levels, it logically follows that the average proportion of total income spent on consumption will decrease as income increases. This implies that richer societies might face a greater challenge in maintaining sufficient aggregate demand to absorb their productive capacity.

  4. The Paradox of Thrift: This is a famous implication. If individuals, fearing an economic downturn or motivated by a desire for greater security, decide to save more at every level of income (i.e., the consumption function shifts downwards), this increased saving translates to reduced aggregate demand for goods and services. If aggregate demand falls, businesses will reduce production, leading to lower national income and employment. Ultimately, the attempt by everyone to save more might lead to lower total saving for the economy as a whole, as income falls drastically. This paradox highlights the potential for individual rational behavior (saving more) to lead to a collectively irrational outcome (economic contraction).

  5. Possibility of Underemployment Equilibrium: Since consumption does not keep pace with increasing income, there is an inherent tendency for a “gap” to open up, which must be filled by investment expenditure to maintain full employment. If investment is insufficient to absorb the savings that accrue at full employment, the economy will not achieve full employment. Instead, it will settle at an equilibrium level of income where aggregate demand (consumption plus investment) equals aggregate supply at a lower, underemployment level. This challenged the classical notion that unemployment was always temporary.

  6. The Multiplier Effect: The MPC is central to the concept of the investment multiplier. An initial increase in autonomous investment (or government spending) leads to a much larger increase in national income. The formula for the simple multiplier is k = 1 / (1 - MPC). A higher MPC means a larger multiplier effect, making fiscal policy interventions (like government spending or tax cuts) more potent in stimulating economic activity. Conversely, a lower MPC (or higher MPS) reduces the multiplier’s effectiveness.

  7. Secular Stagnation: A long-run implication derived from the psychological law, particularly the idea of a falling APC at higher income levels, was the concern about “secular stagnation.” Pioneered by Alvin Hansen, this theory suggested that mature capitalist economies, having met basic needs and perhaps exhausted major investment opportunities (like frontier expansion or rapid population growth), would naturally suffer from a chronic deficiency of effective demand, leading to slow growth or stagnation. The tendency for saving to outstrip profitable investment opportunities would be exacerbated by a falling APC.

  8. Justification for Fiscal Policy: The psychological law provided a strong theoretical foundation for government intervention in the economy, particularly through fiscal policy. If private consumption and investment are insufficient to generate full employment, the government can step in to boost aggregate demand through increased public spending (e.g., infrastructure projects) or tax cuts (to encourage private consumption and investment). This was a radical departure from the classical laissez-faire approach.

Critical Discussion and Later Developments

While foundational, Keynes’s psychological law of consumption has faced significant critical scrutiny and has been refined by subsequent economic theories.

  1. Short-Run vs. Long-Run Stability: One of the most significant criticisms concerns the short-run nature of Keynes’s law. Keynes himself acknowledged that the relationship might be stable only in the short period, given “normal and constant” conditions. Empirical studies, particularly those using long-run time series data, often showed a remarkably stable Average Propensity to Consume (APC) over decades, contradicting Keynes’s hypothesis that APC falls as income rises. This led to the development of alternative consumption theories.

  2. Relative Income Hypothesis (James Duesenberry, 1949): Duesenberry argued that an individual’s consumption is not solely dependent on their absolute income but also on their income relative to others in their social group. People strive to maintain or improve their social status through consumption. This leads to the “demonstration effect,” where individuals emulate the consumption patterns of higher-income groups. Furthermore, Duesenberry introduced the “ratchet effect,” suggesting that consumption habits are difficult to reverse. Once a certain level of consumption is reached, it is hard to reduce it, even if income falls. This explains why APC might not fall significantly in the long run as income rises (people continuously adjust their “relative” consumption upwards) and why consumption doesn’t fall as much during recessions.

  3. Permanent Income Hypothesis (Milton Friedman, 1957): Friedman proposed that consumption is determined by “Permanent Income Hypothesis” rather than current income. Permanent income is the long-term average expected income, reflecting an individual’s lifetime earning capacity. Transitory changes in income (e.g., a one-time bonus or a temporary layoff) have little effect on permanent income and, therefore, on consumption. Consumers smooth their consumption over time. This theory suggests a relatively stable long-run APC, as consumption is a stable fraction of permanent income. This directly challenges Keynes’s idea of a falling APC.

  4. Life Cycle Hypothesis (Franco Modigliani, Richard Brumberg, Albert Ando, 1950s-1960s): Similar to Friedman’s idea, the Life Cycle Hypothesis posits that individuals plan their consumption and saving decisions over their entire lifetime to achieve a smooth consumption path. They save during their working years (when income is high) to finance consumption during retirement (when income is low). Current income is only one factor; expected future income, wealth, and age are also crucial determinants. This theory also predicts a relatively stable long-run APC, as individuals adjust their saving rates throughout their lives to achieve their lifetime consumption goals.

  5. Other Determinants of Consumption: Critics have pointed out that Keynes’s law focuses almost exclusively on income as the primary determinant of consumption. In reality, numerous other factors influence consumption decisions:

    • Wealth: An increase in household wealth (e.g., rising stock prices or housing values) can lead to increased consumption, even if current income remains unchanged (the “wealth effect”).
    • Interest Rates: Higher real interest rates can encourage saving and discourage borrowing for consumption, while lower rates have the opposite effect.
    • Consumer Confidence and Expectations: Optimistic expectations about future income or economic conditions can boost current consumption, while pessimism can lead to increased saving.
    • Availability of Credit: Easier access to loans and credit facilities can enable higher consumption, even with stable income.
    • Income Distribution: As Keynes acknowledged, significant changes in income distribution can alter the aggregate consumption function.
    • Demographic Factors: Age structure, household size, and urbanization can all influence aggregate consumption patterns.
    • Fiscal Policy: Taxation levels directly impact disposable income, and government intervention can directly substitute for or complement private consumption.

  6. Micro vs. Macro: While the psychological law might hold true for individual households (especially at lower to middle-income levels), its aggregation to the entire economy can be problematic without considering the distribution of income and other macro-level factors.

Enduring Legacy and Modern Relevance

Despite the criticisms and refinements, Keynes’s psychological law of consumption remains a cornerstone of macroeconomic theory and policy. Its enduring legacy is multifaceted:

Firstly, it provided the initial theoretical framework for understanding the demand-side constraints on economic growth and the possibility of persistent unemployment. Before Keynes, the idea of an economy stuck in a low-level equilibrium due to insufficient aggregate demand was largely alien. The psychological law laid the groundwork for this revolutionary insight.

Secondly, the concept of the Marginal Propensity to Consume (MPC) and its relationship to the multiplier effect continues to be an indispensable tool for economic analysis. Policymakers regularly estimate the MPC to gauge the potential impact of fiscal stimulus packages or austerity measures on national income and employment. Understanding that a portion of any additional income will be saved is crucial for forecasting economic responses to policy changes.

Thirdly, the law’s emphasis on “psychological” factors foreshadowed modern behavioral economics. While Keynes did not delve into the cognitive biases and heuristics that shape consumer behavior, his recognition that human “disposition” plays a crucial role in economic outcomes paved the way for later research into the non-rational elements of economic decision-making. Habit formation, framing effects, and intertemporal choices, now explored extensively in behavioral economics, resonate with the spirit of Keynes’s original insight.

Finally, the psychological law directly informed and continues to justify the active role of government in managing the economy, particularly during recessions. If private consumption and investment are insufficient to achieve full employment, the law provides a rationale for counter-cyclical fiscal policies aimed at boosting aggregate demand. It underscores the idea that a purely self-regulating market may not always lead to optimal societal outcomes, especially in times of crisis.

Keynes’s psychological law of consumption fundamentally transformed economic thought by highlighting the critical role of aggregate demand and human behavioral patterns in determining economic activity. It moved beyond the simplistic classical assumption that supply creates its own demand and introduced a more nuanced understanding of how income is allocated between consumption and saving. While subsequent economic theories, particularly the Permanent Income Hypothesis and Life Cycle Hypotheses, offered more sophisticated explanations for long-run consumption behavior and challenged some of its specific propositions, the core insight of a marginal propensity to consume less than unity remains a foundational concept. It continues to inform our understanding of business cycles, the multiplier process, and the potential efficacy of fiscal policy in stabilizing the economy, solidifying its place as one of the most influential ideas in Macroeconomics.