John Maynard Keynes, in 1936, proposed the psychological law in his work - The General Theory of Employment, Interest and Money. The law basically captures and understands the essential spending behavior of the household sector. Keynes uses the term 'psychology' in his law but the law is just a basic observation of consumer behavior and consumption. It states the relationship between income and consumption pattern, such as the changes in the aggregate income of the economy and the expenditures on consumption by the household sector.[1] The law is thus, a macro framework of the operation of the economy as it applies more to the aggregate economy than to the individuals.Therefore,in Keynesian macroeconomics, the Fundamental Psychological Law underlying the consumption function states that marginal propensity to consume (MPC) and marginal propensity to save (MPS) are greater than zero(0) but less than one(1) MPC+MPS = 1 e.g. Whenever national income rises by $1 part of this will be consumed and part of this will be saved
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Three main assumptions of the Psychological Law are:
1.Normal Conditions: Firstly, the psychological law applies only under normal conditions and when there is no danger of war or cold war, depression, boom, political upheaval, revolution etc.
2.Psychological and Institutional Complex remains the same: It means that there is no change in the psychological and institutional complex, such as population, tastes and preferences, habits of the people, fashion, prices etc except change in income.
3.Capitalist Economy based on Laissez- faire: The psychological law applies to free and prosperous economies and does not hold well in socialist and under-developed economies. This is because, in a free economy, the people can consume any kind of goods they want, according to their necessities and desires and also there is no interference of the government in the economic affairs.[2]
Psychological Law of Consumption Keynes defines Psychological Law of Consumption in terms of, “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 the income.” [3] It simply means that Marginal Propensity to consume is positive but less than unity (0>1).
1.Increased aggregate consumption (by a smaller amount) due to increased aggregate income – aggregate consumption increases with increase in aggregate income but the increase in consumption is less than the increase in the income. This is because when the basic necessities or demand of the people are already fulfilled, the people will start saving the extra additional income. Thus, saving increases.
2.Division of the increased income between the consumption and saving: we have already mentioned that increased income increases consumption and also saving. Saving is that part of the income which is kept and not spent. Thus, the increased income does get divided between the two in certain proportion and can be showed as:
∆Y= ∆C + ∆S
Where,
∆ = signifies change
∆Y = change in Income
∆C = change in Consumption
∆S = change in Saving
3.The increase in aggregate income will lead to increased consumption or saving: it is not possible for savings and consumption to decrease when income increases.[4]
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