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J.M. Keynes, in his book ‘General Theory’ analyzed the consumption behavior of the community on the basis of human psychology. He propounded a law which is known as Psychological Law of Consumption.

Statement:

According to the psychological law of consumption:

“The household sector spends a major part of its income on the purchase of consumer goods and services such as food, clothing, medicines, shelter etc., for personal satisfaction. The expenditure on consumption (C) is the largest component of aggregate expenditure. Whatever is not consumed out of disposable income is by definition called saving (S)”.

Formula:

Disposable Income = Consumption + Saving

I = C + S

Consumption Function:

According to Keynes, the level of consumption in a community depends upon the level of disposable income. As income increases, consumption also increases but it increases not as fast as income i.e., it increases at a diminishing rate. This relationship between consumption and disposable income is called consumption function.

In the words of Keynes:

“Men are disposable as a rule and on the average to increases their consumption as their income increases, but not by as much as the increases in their income.”

Properties:

The psychological law of consumption brings out the following properties of the consumption behavior of the community:

(i) The level of consumption is directly functionally related to the level of disposable income = C = f(y)

(ii) With the rise in the level of income, the consumption level also rises, but at a decreasing rate = ΔC < Δy

(iii) As the level of income increases, the households devote a part of the increase saving. Symbolically:

ΔY = ΔC + ΔS

The Keynesian consumption function is now explained with the help of schedule and a diagram:

Schedule:

In above schedule, it is shown that as the nation’s disposable income increases, the aggregate consumption at various levels of income also increases but at a decreasing rate.

Diagram:

Following are the observations about the functional relationship between the national disposable income and the economy’s aggregate expenditure.

(i) At every point on the 450 line OY, a vertical line drawn to the income axis is at the same distance from the origin as a horizontal line drawn to the consumption axis. The 450 line thus is the line along which expenditure equals real income.

(ii) The consumption function is represented by consumption line (C). The consumption line C is positively sloped indicating that as the disposable income increases, the expenditure in the economy also increases.

(iii) The consumption line (C) intercepts at Y axis showing negative saving of $50 billion during a short period.

(iv) At point B the consumption line (C) intersects the 450 helping line (OY) saving. At point B, consumption equals disposable income and there is zero saving. B is called the break even point.

(v) Left to the point B, the consumption line C is above the income line Y. It indicates negative saving.

(vi) Right to the point B, the consumption line C is below the income line Y. It denotes positive savings.

Summing up, the relationship between consumption and disposable income is referred to as consumption function. A consumption function tells how much households plan to consume at various levels of disposable income.