Determinants of Keynes Consumption Function

I. Introduction:

The principal determinant of the Keynesian consumption function is income.

However, there are at least three theories that modify Keynesian absolute income hypothesis. First, James S. Duesenberry says that consumption depends on relative income.

People tend to consume more lo ‘keep up with the Joneses’. This means that consumption spending is largely influenced by incomes earned by neighbouring households. In other words, it is the relative income that determines consumption. This is called ’emulatory con­sumption’. Duesenberry’s hypothesis is known as ‘relative income hypothesis’. He demon-strates that in the long run MPC = APC, as opposed to Keynes’ short run consumption function hypothesis—MPC < APC (See Section 3.26.1).

Secondly, Milton Friedman argues that consumption depends on permanent income. Unexpected, transitory incomes have little effect on permanent consumption. Permanent consumption is always associated with permanent income. Friedman’s hypothesis of permanent income also suggests that in the long run, MPC tends to equal APC, i.e., MPC=APC (See Section 3.26.2).

Finally, Modigliani, F.A. Ando and R.E. Brumberg in their life cycle hypothesis, argue that people formulate their expenditure plans in accordance with their expected incomes over lifetime i.e., some perception of lifetime incomes. While making consumption decisions, individuals look at the total income to be earned over their lifetime. Modigliani, Andos’ ‘life cycle hypothesis’ also says that in the long run MPC = APC. All these theories hold the same conclusion: APC tends to decline as income rises.

II. Determinants of Consumption Function:

However, besides income, Keynes attached importance to other factors under the headings “objective” and “subjective” or “psychological” factors that determine aggregate consumption. Objective factors are also known as “economic factors” which are subject to change in the short run. Objective or economic factors are also quantifiable. On the other hand, subjective factors are psychological and, hence, are not subject to estimation. In addition, structural factors also influence aggregate consumption spending. Finally, Keynes paid attention to fiscal policy variable as another determinant of aggregate consumption.

When we show consumption-income relationship, we assume all the above- mentioned determinants of consumption spending to remain constant. As income changes, consumption changes. This is called movement along the consumption function.

Similarly, one obtains movement along the saving function when saving changes following a change in income, holding all other determinants of saving constant. But, if one of the subjective, objective or other determinants change then consumption function and saving function would shift. Assuming a constant aggregate income, an increase in the volume of wealth would lead to an increase in consumption—thereby shifting the consumption function upwards and the saving function downwards.

1. Objective Factors:

Objective or economic factors (which undergo change in the short run) that influences consumption function are considered here:

(i) The Rate of Interest:

Classicists assumed that consumption or saving depends on the rate of interest. They believed that an increase in interest rate encourages saving and, thus, consumption is discouraged.

However, there is another way to explain consumption/saving and interest rate rela­tionship. A rise in interest rate means a decline in the money value of bonds. This tends to discourage consumption propensities of bond­holders. The money value of fixed interest bearing assets falls when its interest rate rises. This makes owners of these assets poorer and, will discourage consumption. Or at a high rate of interest, preference for bond tends to rise. This will induce people to consume less.

Anyway, rate of interest may not be considered as a significant factor influencing consumption decisions as empirical evidence suggests a weak link between interest rate and consumption.

(ii) Sales Effort:

Advertising and various sales effort of producers of consumer goods are considered as a means for increasing consumption demand. It is quite likely that an increase or decrease in the amount of sales effort may lead to greater or lower demand for consumer goods. However/given the total income, an increase in sales effort may not lead to an increase in the demand for consumption goods. Further, there is no independent measure of the volume of effective selling effort. Hence, increase in demand following an increase in advertising outlay is difficult to estimate.

(iii) The Volume of Wealth:

The total wealth position of consumers is considered as an important determinant of consumption. Wealth like shares, bonds, house property, etc., influence consumption decisions. Owners of these assets do not have enough preference for these assets.

That is why their desire to save is less since they are already the owners of these assets. People who do not own assets intend to save more and consume less now in order to have assets in future. In other words, property-owners have the greater desire to consume while desire to save is the greatest to the people who do not own assets. Such is known as Pigou effect, after the name of the classical economist A. C. Pigou.

Pigou effect states that the more saving a man has, the less the strength of his desire to save more. If two men have identical tastes and incomes, but one has already acquired huge wealth, his incentive to increase current savings will be less than the other one who is yet to enjoy large property. According to Pigou, propensity to consume depends on the real value, and not on money value, of cash balances or liquid assets.

The nominal value of cash balances or wealth rises or falls with the fall or rise in general price level. If these real cash balances are considered as net financial assets of the economy, changes in the price level will bring about a change in net wealth position of the economy. For instance, if price level declines, the real cash balances would rise, net wealth would rise and consumption spending would rise. This is the essence of the Pigou effect or real balance effect.

(iv) Terms of Consumer Credit:

The hire- purchase system of buying durable consumer goods has become popular in these days. However, such spending greatly depends on the terms and conditions of credit. If consumer credit is available on reasonable terms, some sort of spending spree will develop. However, it is agreed that the interest rate on instalment buying is of relatively less significance than the size of required down-payments, the length of the period over which the balances must be repaid.

(v) Deferred Payment:

Sometimes, parti­cularly during war time, consumer spending declines due to restraint on spending. Once such restraints are removed, backlog of pent- up consumer demand might get exposure leading to a rise in spending.

2. Psychological Factors:

Psychological or subjective factors that remain constant in the short run determine the form of the consumption function.

Keynes attached importance to the psychological or subjective factors which consist of basic values, attitudes, states of mind, etc. These are not quantifiable or specific like economic factors. Motives behind consumption, according to Keynes, are enjoyment, short-sightedness, generosity, miscalculation, extravagance and ostentation. However, these elements do not change significantly in the short run. Despite this, these subjective and cultural factors are capable of changing the shape and the level of the function.

Of all these subjective factors, expectations and attitudes of consumers do play an important role. Rational behaviour suggests that a consumer who expects a rise in income or in the price level may consume more than who expects no such change in near future. Again, among similar individuals (same age) with the same level of incomes, it may be found that some individuals consume more than others because of the differences in their attitudes towards thrift.

Further, in a status-symbol society, con­sumption spending is greatly influenced by the consumption pattern of the society in which the individual lives. “To keep up with the Joneses”, individuals imitate consumption patterns of their neighbours and workmates so that their status is not impaired.

Duesenberry calls such imitating consumption pattern “demonstration effect”.

Finally, one point is to be remembered here. Keynes argued that expectations and attitudes, demonstration effect, etc., do have some influencing effect on individual’s consumption. But, aggregate consumption virtually remains unchanged in an economy since attitudes and expectations vary from person to person and different expectations and attitudes, therefore, cancel each other.

3. Structural Factors:

Structural factors like income distribution, demographic factors, etc., do have some bearing on the aggregate consumption spending in the long run.

The first important structural factor is the income distribution. It is said that the marginal propensity to consume (MPC) is high of low- income families and low for high-income families. Thus, if there is a redistribution of income in favour of the poor-income families, aggregate consumption would rise since the MPC of these people is high.

Secondly, demographic factors are responsible for differences in consumption spending with identical incomes. Demog­raphic factors include size of family, stage in the family life cycle, place of residence, occupation, race, etc. It is true that large families or families with more children and aged persons consume more than small families. However, in the short run analysis, these demographic factors can be ignored.

Fiscal Policy:

Tax-expenditure pro­grammes of the government can influence consumption spending. If rich people are asked to pay more taxes and if these revenues are given as subsidies to poor people, aggregate consumption would rise. High taxes curtail consumption by reducing disposable income.

Now, if subsidies like flood relief, old- age pension, distribution of food grains at a subsidised rate, etc. are given definitely con­sumption spending of the recipient of these subsidies would rise. These are the people whose MPC is high. Thus, tax-expenditure programme shifts the consumption function through redistribution of income.