The Six Objective Factors of the Propensity to Consume

1. A change in the hourly-common-wage

Consumption C is obviously much more a function of (in some sense) real income than of money-income.

A man’s real income will rise and fall with the amount of the command from his hourly-common-labor, measured in hourly-common-wage.

But when the aggregate volume of output changes, his real income will (owing to the operation of decreasing returns) rise less than in proportion to his income measured in hourly-common-wage.

Thus, if the hourly-common-wage changes, the expenditure on consumption corresponding to a given level of employment will, like prices, change in the same proportion.

But sometimes, we may have to make an allowance for the possible reactions on aggregate consumption of the change in the distribution of a given real income between entrepreneurs and rentiers resulting from a change in the wage-unit.

Apart from this, we have already allowed for changes in the wage-unit by defining the propensity to consume in terms of income measured in terms of wage-units.

2. A change in the difference between income and net income.

The amount of consumption depends on net income rather than on income. This is because a man bases his consumption on his net income.

If, however, this should not be the case, such part of any change in income as is not reflected in net income must be neglected since it will have no effect on consumption;

Similarly, a change in net income, not reflected in income, must be allowed for. Save in exceptional circumstances, however, I doubt the practical importance of this factor. We will return to a fuller discussion of the effect on consumption of the difference between income and net income in the fourth section of this chapter.

3. Windfall changes in capital-values not allowed for in calculating net income.

These are much more important in modifying the propensity to consume, since they will bear no stable or regular relationship to the amount of income.

The consumption of the wealth-owning class may be extremely susceptible to unforeseen changes in the money-value of its wealth. This should be classified amongst the major factors capable of causing short-period changes in the propensity to consume.

4. Changes in the rate of time-discounting

This is the ratio of exchange between present goods and future goods.

This is not quite the same thing as the rate of interest, since it allows for future changes in the purchasing power of money in so far as these are foreseen. Account has also to be taken of all kinds of risks, such as the prospect of not living to enjoy the future goods or of confiscatory taxation.

As an approximation, however, we can identify this with the rate of interest. The influence of this factor on the rate of spending out of a given income is open to a good deal of doubt. For the classical theory of the rate of interest,[1] which was based on the idea that the rate of interest was the factor which brought the supply and demand for savings into equilibrium, it was convenient to suppose that expenditure on consumption is cet. par. negatively sensitive to changes in the rate of interest, so that any rise in the rate of interest would appreciably diminish consumption.

The total effect of changes in interest rates on the readiness to spend on present consumption is complex and uncertain, being dependent on conflicting tendencies, since some of the subjective motives towards saving will be more easily satisfied if the rate of interest rises, whilst others will be weakened.

Over a long period, substantial changes in the rate of interest probably tend to modify social habits considerably, thus affecting the subjective propensity to spend — though in which direction it would be hard to say, except in the light of actual experience.

The usual type of short-period fluctuation in the rate of interest is not likely, however, to have much direct influence on spending either way. There are not many people who will alter their way of living because the rate of interest has fallen from 5 to 4%, if their aggregate income is the same as before.

Indirectly there may be more effects, though not all in the same direction.

Perhaps the most important influence, operating through changes in the rate of interest, on the readiness to spend out of a given income, depends on the effect of these changes on the appreciation or depreciation in the price of securities and other assets.

For if a man is enjoying a windfall increment in the value of his capital, it is natural that his motives towards current spending should be strengthened, even though in terms of income his capital is worth no more than before; and weakened if he is suffering capital losses. But this indirect influence we have allowed for already under (3) above.

Apart from this, the main conclusion suggested by experience is, I think, that the short-period influence of the rate of interest on individual spending out of a given income is secondary and relatively unimportant, except, perhaps, where unusually large changes are in question.

When the rate of interest falls very low indeed, the increase in the ratio between an annuity purchasable for a given sum and the annual interest on that sum may, however, provide an important source of negative saving by encouraging the practice of providing for old age by the purchase of an annuity. The abnormal situation, where the propensity to consume may be sharply affected by the development of extreme uncertainty concerning the future and what it may bring forth, should also, perhaps, be classified under this heading.

5. Changes in fiscal policy

In so far as the inducement to the individual to save depends on the future return which he expects, it clearly depends not only on the rate of interest but on the fiscal policy of the Government.

Income taxes, especially when they discriminate against “unearned” income, taxes on capital-profits, death-duties and the like are as relevant as the rate of interest; whilst the range of possible changes in fiscal policy may be greater, in expectation at least, than for the rate of interest itself. If fiscal policy is used as a deliberate instrument for the more equal distribution of incomes, its effect in increasing the propensity to consume is, of course, all the greater.[2]

We must also take account of the effect on the aggregate propensity to consume of Government sinking funds for the discharge of debt paid for out of ordinary taxation. For these represent a species of corporate saving, so that a policy of substantial sinking funds must be regarded in given circumstances as reducing the propensity to consume. It is for this reason that a change-over from a policy of Government borrowing to the opposite policy of providing sinking funds (or vice versa) is capable of causing a severe contraction (or marked expansion) of effective demand.

6. Changes in expectations of the relation between the present and the future level of income.

We must catalogue this factor for the sake of formal completeness. But, whilst it may affect considerably a particular individual’s propensity to consume, it is likely to average out for the community as a whole. Moreover, it is a matter about which there is, as a rule, too much uncertainty for it to exert much influence. We are left therefore, with the conclusion that in a given situation the propensity to consume may be considered a fairly stable function, provided that we have eliminated changes in the wage-unit in terms of money.

Windfall changes in capital-values will be capable of changing the propensity to consume, and substantial changes in the rate of interest and in fiscal policy may make some difference; but the other objective factors which might affect it, whilst they must not be overlooked, are not likely to be important in ordinary circumstances.

The fact that, given the general economic situation, the expenditure on consumption in terms of the wage-unit depends in the main, on the volume of output and employment is the justification for summing up the other factors in the portmanteau function “propensity to consume”. For whilst the other factors are capable of varying (and this must not be forgotten), the aggregate income measured in terms of the wage-unit is, as a rule, the principal variable upon which the consumption-constituent of the aggregate demand function will depend.

The propensity to consume is a fairly stable function.

As a rule, the amount of aggregate consumption mainly depends on the amount of aggregate income (both measured in terms of wage-units), changes in the propensity itself being treated as a secondary influence, what is the normal shape of this function?

The fundamental psychological law, upon which we are entitled to depend with great confidence both a priori from our knowledge of human nature and from the detailed facts of experience, is 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.

If Cw is the amount of consumption and Yw is income (both measured in wage-units) ΔCw has the same sign as ΔYw but is smaller in amount, i.e. dCw/dYw is positive and less than unity.

This is especially the case where we have short periods in view, as in the case of the so-called cyclical fluctuations of employment during which habits, as distinct from more permanent psychological propensities, are not given time enough to adapt themselves to changed objective circumstances.

For a man’s habitual standard of life usually has the first claim on his income, and he is apt to save the difference which discovers itself between his actual income and the expense of his habitual standard; or, if he does adjust his expenditure to changes in his income, he will over short periods do so imperfectly. Thus a rising income will often be accompanied by increased saving, and a falling income by decreased saving, on a greater scale at first than subsequently.

But, apart from short-period changes in the level of income, it is also obvious that a higher absolute level of income will tend, as a rule, to widen the gap between income and consumption. For the satisfaction of the immediate primary needs of a man and his family is usually a stronger motive than the motives towards accumulation, which only acquire effective sway when a margin of comfort has been attained.

These reasons will lead, as a rule, to a greater proportion of income being saved as real income increases. But whether or not a greater proportion is saved, we take it as a fundamental psychological rule of any modern community that, when its real income is increased, it will not increase its consumption by an equal absolute amount, so that a greater absolute amount must be saved, unless a large and unusual change is occurring at the same time in other factors.

The stability of the economic system essentially depends on this rule prevailing in practice.

If employment increases, then aggregate income increases.

Not all the additional employment will be required to satisfy the needs of additional consumption.

On the other hand, a big decline in income due to a decline in the level of employment may even cause consumption to exceed income by:

• individuals and institutions by using up savings
• the Government by running into a budgetary deficit by providing unemployment relief by borrowing money

Thus, when employment falls to a low level, aggregate consumption will decline by a smaller amount than that by which real income has declined. This is because both of the habitual behaviour of individuals and also of the probable policy of governments; which is the explanation why a new position of equilibrium can usually be reached within a modest range of fluctuation. Otherwise a fall in employment and income, once started, might proceed to extreme lengths.

This simple principle leads, it will be seen, to the same conclusion as before, namely, that employment can only increase pari passu with an increase in investment; unless, indeed, there is a change in the propensity to consume.

For since consumers will spend less than the increase in aggregate supply price when employment is increased, the increased employment will prove unprofitable unless there is an increase in investment to fill the gap.