Consumption Function of a Community

Here we detail about the subjective and objective factors that affect consumption function of a community.

A. Subjective Factors:

Among the subjective factors are included those factors which induce and prompt people to save some part of their income.

First, people save because they want to provide for unforeseen contingencies, such as illness, unemployment, accidents, etc.

Secondly, people are induced to save because they want to provide for the expected future needs such as education of the children, marriages of their children, etc.

Thirdly, several people wish to save from their current incomes so that they may be able to use accumulated savings for investment which will increase their future income. Investments will bring them more income in the form of more profits and interest.

Fourthly, people are motivated to save so that they can accumulate large wealth which will increase their social status. With increased wealth they would think themselves to be economically more independent and they could buy many things with more wealth.

Further, many individuals also save so that they can use them for speculative purposes and other business projects. Besides, several people are prompted to save for the sake of leaving a good fortune for their heirs and children. Lastly, many people save because of their miserly instinct and habits. The accumulation of more wealth gives them a great psychic satisfaction.

The above subjective factors increase the propensity to save and therefore reduce the propensity to consume. These subjective factors play a crucial rule in determining the level and shape of the consumption function. However, Keynes pointed out and rightly so that some subjective factors raise the propensity to consume.

The desire for ostentation generally leads to greater consumption expenditure. People have a natural instant to imitate others’ consumption habits. As pointed out by Duesenberry, people in lower and middle income ranges imitate the consumption standards of the higher income groups and this increases their propensity to consume. This has been called demonstration effect which is a great subjective or psychological force that works in raising the propensity to consume.

Subjective factors also lead the business firms to save much or little from their incomes.

Many of the subjective factors which influence the savings of the firms are the following:

(1) Enterprise:

Many business industrial firms desire to save a part of their current income so that they can make investment in new enterprises and carry out expansion in the future. Business firms generally save a good part of their income for their further expansion.

(2) Liquidity:

Business firms also are induced to save so that they can face contingencies in the future. If they have good amount of liquid wealth in their hands, they would be able to meet the emergent situations more successfully. More cautious and farsighted firms will save more than others on this count.

(3) Successful Management:

Many managers of the business firms are motivated to save more because they want to prove themselves successful managers. With the investment of the saved money, the income of a firm increases and their managers are regarded as successful.

(4) Financial Prudence:

Business firms desire to save for making up the depreciation in plant and machinery. Since after some years business firms have to replace their plant and machinery, if a good part of their current income is not saved, it would not be possible for them to replace plant and machinery.

If the firms put aside a greater part of their income for depreciation or replacement purposes, they would pay lower dividends to the shareholders and this will generally lower the propensity to consume of a community. On the other hand, if the firms keep a relatively small amount for depreciation, they will pay larger amounts as dividends to the shareholders and this will generally increase the propensity to consume of the community. Lastly, firms also want to save because they have to repay their debts.

B. Objective Factors:

Keynes mentioned the following six types of objective factors which influence the consumption function:

(1) Changes in the General Price Level: Real Balance Effect:

The general price level is an important factor which influences the consumption of a community. When the general price level increases or, in other words, when inflation occurs, the consumption function shifts downward. This is because the rise in the general price level, real value (that is, purchasing power) of people’s money balances and financial assets with fixed monetary values declines.

This causes a downward shift in the consumption function. This is called real balance effect. Similarly, when the general price level falls, real value of money balances and financial assets increase. This will induce people to consume relatively more out of their current income. This will cause an upward shift in the consumption function.

(2) Fiscal Policy:

Fiscal policy of the Government, especially taxation policy, affects the propensity to consume of the country. By levying excise duties, sales tax, the Government can cut down the consumption and thereby increase savings of the community.

Likewise, when the Government reduces taxes, consumption of the people increases and this raises the propensity to consume. Rationing and price control by the Government also affects the propensity to consume, as was witnessed during the Second World War. In the modern times, pursuing of the welfare state policy by the Government under which progressive taxes have been levied on the rich people and the revenue obtained from them have been spent to provide many social security benefits and amenities to the poor people, has tended to raise the consumption function.

(3) Rate of Interest:

Rate of interest also affects the propensity to consume and save. It is generally believed that higher rate of interest induces the people to save more and this results in reducing their propensity to consume. But this is not true in the case of all the people. Some individuals are of such types who want a certain fixed income in the future.

And when the rate of interest rises these individuals consume more and save less because with higher rate of interest they can obtain the given fixed income with lesser savings. Therefore, when the rate of interest rises such individuals save less than before. Thus, it cannot be said with certainty whether with the changes in the rate of interest the propensity to consume of the whole community will change or not.

(4) Stock of Wealth:

The stock of wealth owned by the households in the economy is also an important factor that determines propensity to consume. In wealth we include not only real assets such as land, houses, automobiles but also financial assets such as cash balances, saving and fixed deposits with banks, stocks and bonds possessed by households.

The greater the amount of wealth accumulated by households in the economy, the greater is generally the propensity to consume (i. e., the greater the amount of consumption out of any level of current income). The important motive of the people to save is to accumulate wealth. Generally speaking, the greater the wealth which people have accumulated, the weaker is the incentive to save further. In other words, the other things remaining the same the increase in wealth generally causes an upward shift in the consumption function and decrease is wealth causes a downward shift in the consumption function.

An important example which is often cited to emphasize the importance of wealth as a determinant of consumption is the stock market crash of 1929 in England (i.e., drastic fall in share prices) which substantially reduced the financial wealth of the households overnight resulting in shifting the consumption function downward.

(5) Credit Conditions and Consumer Indebtedness:

The availability of easy credit causes an increase in consumption and shifts the consumption function upward. It is now a common experience in India that in recent years lowering of lending interest rates by Indian banks on loans for houses, cars, computers and other durable consumer goods has greatly increased the consumption of the people and shifted consumption function upward.

On the other hand, tightening of credit produces an opposite effect, that is, causes a downward shift in the consumption function, Furthermore, the recent increase in facilities of Credit Cards by banks and their acceptance by sellers of consumer goods have also worked to shift the consumption function upward in India.

Similarly, the level of consumer indebtedness also greatly affects the propensity to consume of the people. If the households are heavily indebted, say 25 to 30 per cent of their current income, they are committed to save (i.e., consume less) to that extent so that they are able to pay their installments of previous credit taken. Thus, the greater the degree of indebtedness of households in the economy, the higher will be the consumption function curve and vice versa.

(6) Income Distribution:

Lastly, distribution of income in a society also determines the level of consumption function. If national income is more unequally distributed, the lower will be the propensity to consume. This is because propensity to consume of the rich is relatively less as compared to that of the poor. Therefore, if inequalities in income distribution increase, this reduces the consumption out of any given level of national income and thus causes a downward shift in the consumption function.

(7) Windfall Gains and Losses:

Windfall gains and losses also affect the propensity to consume. When the prices of the shares go up, the shareholders begin to think themselves better off and this raises their consumption. On the other hand, when the prices of the shares go down, the shareholders have to suffer sudden losses and they begin to think themselves relatively poorer than before. This induces them to reduce their consumption. We thus see that the windfall gains and losses affect the propensity to consume.

(8) Change in Expectations:

Changes in the expectations of the people also influence the propensity to consume. When people expect that war will break out in the near future and they expect prices to go up, then they will try to spend more on goods so as to meet the needs of the immediate future. This raises the consumption function in the current period. On the other hand, when people expect the prices to fall they reduce their current consumption so that they should spend more when the prices actually fall.

We have explained above various subjective and objective factors which taken together determine the consumption function of a community. It is worth noting that propensity to consume does not generally change in the short run, because it depends more on psychological and institutional factors which change only in the long run.

The institutional factors which determine the distribution of income in the society are important forces determining the consumption function. And these institutional factors do not change in the short run. Therefore, Keynes was of the view that consumption function remains stable in the short run.