12 Objective Factors Affecting Consumption | Keynes’ Psychological Law

The following points highlight the twelve objectives factors affecting consumption. The factors are: 1. Income 2. Distribution of Income 3. Financial Policies of Corporations 4. Changes in Expectations 5. Windfall Gains or Losses 6. Fiscal Policy 7. Demographic Factors 8. Terms of Credit on Consumer Durables 9. Wages and Propensity to Consume 10. Wealth and Stock of Money  and Others.

Factor # 1. Income:

Income is by far the must important factor that determines a community’s propensity to consume.

As its income rises or falls, consumption spending also rises and falls. The figures given afore show changes in consumption caused by an increase in income (with no change in the propensity to consume) and changes in consumption caused by a change in the propensity to consume (with no change in income).

Factor # 2. Distribution of Income:

Another factor determining how much will be spent for consumption out of a given income of the community is the way in which income is distributed. There is great inequality in the distribution of income in the modern capitalist societies with the result that the rich find it easy to save. This widespread inequality of income lowers the overall propensity to consume as the rich have already fulfilled most of their basic wants. A more equal distribution of wealth will raise the propensity to consume.

Factor # 3. Financial Policies of Corporations:

The policies of joint stock companies and corporations with respect to dividend payments and investment also affect consumption in various ways. If corporations and companies keep, more reserves and distribute less of their profits as dividends, it will lower the disposable income with consumers. On the other hand, if more income is distributed in the form of dividends, more will be spent on consumption.

Factor # 4. Changes in Expectations:

Expectations of the people regarding future events also affect their propensity to consume. Individuals may rush to purchase goods much in excess of current needs if they expect a war or fear a shortage on account of any other reason. Thus, the amount of consumption as a ratio of current income will rise and consumption function will shift upwards (without any rise in income).

Factor # 5. Windfall Gains or Losses:

Sudden and unexpected gains and losses in income affect consumption accordingly. It is believed that the well-to-do increase their consumption well above the normal level as a result of windfall gains. In the late twenties, there were huge windfall gains on account of the boom conditions in the American economy and the consumption function shifted upwards. Keynes gave specific recognition to the possibility that consumption spending might be influenced not only by income but by capital gains also. 

Factor # 6. Fiscal Policy:

The fiscal policy of the Government relating to taxation, expenditure and public debt, and the changes therein have significant effects on the consumption function. The Government’s fiscal policy resulting in highly progressive tax system bring about more equitable distribution of income, thereby shifting the consumption function upwards, as more equal distribution of wealth increases the propensity to consume. On the other hand, a regressive tax structure (involving heavy indirect taxes) will reduce total consumption in the economy.

Factor # 7. Demographic Factors:

Even at a given level of income the expenditure of consumers may vary widely from one family to another. These variations in expenditure are due to demographic factors, which include factors like; the size of the family, stage in the family ‘life cycle’, place of residence, occupation etc. Large families spend more than small families—families with children of college-going age have a different pattern of expenditure than rural families. Demographic changes like age, sex composition of families occur over a long period and may, therefore, be ignored in short run analysis.

Factor # 8. Terms of Credit on Consumer Durables:

Terms of credit specially relating to consumer durables like electric gadgets—machines, radios, television-sets, cars, scooters etc.—constitute an important influence on consumption expenditure. Recently, not to speak of advanced economies, even in developing economies like India, there has been considerable increase in the volume of purchases of consumer durables financed by consumer credit; as such its cost and availability have assumed great importance. Besides, the rate of interest, the size of down payments, length of the periods during which balances must be paid are important considerations affecting consumer expenditures.

Factor # 9. Wages and Propensity to Consume:

Classical economists laid stress on the stimulating effects of wage-cuts on the propensity to consume. Their argument was that a general reduction in wages will result in a general reduction in prices (because marginal costs fill on account of the pressure of lower wage rates). The lower prices will increase consumption. But such an approach represented a vague attempt to apply certain principles relating to price and demand for particular products to the problem of total consumption.

Actually, the effects of wage-cuts are likely to be unfavorable on the propensity to consume. It has been found that wage-cuts may result in more unequal distribution of income as income may be shifted from high- consuming groups (the poor) to the high-saving group (the rich) and thus may lower rather than raise the consumption function.

When wages are cut while the incomes of other groups like renters and businessmen remain the same, the wage-profit relationship will be upset. While wages fall, profit and rent continue to increase relatively. As a result, the propensity to consume of the workers is adversely affected because their purchasing power is reduced as a result of wage- cuts.

Further, if the general cut in money-wages is expected to be repeated indefinitely, consumers will tend to withhold their demand in anticipation of a further fall in prices, thereby shifting the saving function upwards and depressing the consumption function. It is held that many wage-cuts, by redistributing income in favour of groups with lower marginal propensity to consume (and high MPS), will cause income and output, as also employment, to decline.

Factor # 10. Wealth and Stock of Money:

The total wealth position of consumers has been thought to be a significant influence on consumer spending. Wealth has been analysed most thoroughly and tested most extensively as a determinant of consumption. A consumption function with wealth assets as one of the important influences has been proposed by E. Modigliani and others for wealth may be used to balance income- streams over tong periods of time; it is the life-time resources available to the consumer rather than the volume of income over the short-period.

Such a formulation of consumer behaviour is usually known as the ‘life-cycle hypothesis’. They pose a consumption function in which individual consumption depends on the resources available to the individual, the rate of return on capital, and the age of the consumer unit. Available resources are defined as existing net worth (wealth) plus the present value of all current and future non-property (that is labour) earnings.

According to this approach, the rational consumer considers all his existing resources when planning his consumption. F. Modigliani states; “The cornerstone of the model is the notion that the purpose of saving is to enable the household to redistribute the resources it gets (and expects to get) over its life-cycle in order to secure the most desirable pattern of consumption over life.” What is important to realise is that the inclusion of wealth significantly improves the explanation of consumer behaviour.

However, the formulation on the basis of wealth alone may lead to grossly undependable results regarding both short-run and long-run behaviour of consumers. But the functional relationship that consumption depends on income and wealth both, gives results compatible with established patterns of consumer behaviour. A portion of total consumer wealth is held in the form of money.

As such, wealth effect would probably be applicable to any change in consumer money-holding if such changes were not offset by equivalent changes in other wealth. Mere liquidity increase will stimulate consumption directly.

Factor # 11. Liquid Assets, Consumption and Pigou Effect:

Liquid assets (currency, bank deposits, government bonds, and so on) and changes therein also affect propensity to consume. It has been seen that when people have large amounts of liquid assets (e.g., cash balances, saving accounts, Government bonds, shares and securities), they show a tendency to spend more on consumption. This is specially true where these assets are more evenly distributed over the various income groups. Increased liquidity, as a result of the method of financing World War II, undoubtedly had a strong and a stimulating effect on consumption during the years following the War.

It is clear, therefore, that the more liquid people are, the greater will be the rate of consumption out of any given income. Prof. Pigou argued that a general fall in prices induced by the general wage-cut would increase the real value of cash balances and other forms of saving thereby leading to a higher rate of consumption. This latter relationship (between the real value of liquid assets and consumption) has come to be known as the Pigou Effect. Pigou Effect, in brief, means that the real value of money assets rises as a result of general wage-cuts and prices.

The rise in the real value of money assets shifts the consumption function upwards. It is also called ‘Real Value of Money Assets Effect’. But validity of the ‘Pigou Effect’ has been questioned by modem economists, partly on the ground that a large number of persons do not possess money assets and partly on the ground that those who possess such assets want to possess still more. Under such circumstances, it is highly doubtful whether propensity to consume will be raised through the ‘Pigou Effect’. As against this, the advocates of liquid-assets effect argue that these are a strategic component of wealth for influencing consumption.

The question of whether liquid assets are significant in a post-War consumption function is open to a number of interpretations. Although some research workers have found that liquid asset holdings are not significant in influencing consumption function, other econometricians have estimated consumption functions that do contain significant liquid-assets influences.

Factor # 12. Changes in the Rate of Interest:

Changes in the rate of interest may also alter the propensity to consume, though the direction of change is not certain. If the rate of interest goes up, people will consume less and save more in order to gain from lending on the higher rate of interest. On the other hand, people may consume more and save less with a fall in the rate of interest. Further, a person who desires a fixed income in future is likely to save less at a higher rate of interest than at a lower rate of interest.

What actually will be the effect on consumption is by no means certain. The classical theories of interest generally held that saving would vary directly with the rate of interest. However, Keynes regarded the effect of interest rate changes on saving as highly complex and uncertain. Keynes held that “the short-period influence of the interest rate on individual spending out of a given income is secondary and relatively unimportant, except perhaps where unusually large changes are in question.”

It is in the long period that substantial changes in the rate of interest tend to modify social habits affecting the propensity to spend (consume). However, the rate of interest makes, itself felt the greatest in the purchase of consumer durables which are bought on installment basis, for a rise in interest rates makes installment buying more expensive thereby discouraging consumption. Thus, whether a rise of the interest rate lowers propensity to consume depends upon the relative strength of the opposing forces.

Our conclusion, therefore, is that except for quite abnormal or ‘revolutionary’ changes in what we call ‘objective’ factors—induced by unusual events such as war, strikes, floods, earthquakes, revolutions, changes in tax structure, exceptional windfall gains, sudden heavy losses etc.—Apart from such drastic changes, shifts in the “propensity to consume out of a given income” are not likely to be of any major importance.

Clearly, the determination of aggregate consumption spending is a much more complicated matter than some early enthusiastic Keynesians realised. The relationship does not simply relate current income to current consumption; rather it involves some complex average of the past and the expected income and consumption spending.