Keynes - The General Theory - Chapter VIII

Chapter VIII is the first of three relating to the propensity to consume. In this chapter Keynes discusses the objective factors which affect the propensity to consume. These factors are as follows:

(I) A change in the wage-unit - Keynes argues that consumption is more a function of real income than of money-income, and because of this changes in the wage unit lead to changes in consumption. He continues that, "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." Thus, any effect a change in wages has on the propensity to consume has already been imputed in the definition.

(II) A change in the difference between income and net income - It is important to recall Keynes' distinction between income and net income for this section. If we look back to chapter VI, we see that Keynes defines income as the "excess of the value of his finished output sold during the period over his prime cost." Net income - according to Keynes - is the portion of income available for consumption, or income adjusted for the factors outlined in the discussion of chapter VI (i.e. windfall loss and supplementary cost). Given these definitions, Keynes continues that there exists a stable relationship between the two, so any change in income usually corresponds to a change in net income based on this relationship. However, if net income increases and is not reflected in a change in income, this will affect the propensity to consume. This seems to make sense, if a normally reckless spender sees a decrease in his net income he may become more frugal. Practically, this is rarely seen as the obscene amount of debt in our society shows profligate people will spend money whether or not they possess the means to do so.

(III) Windfall changes in capital-values not allowed for in calculating net income - Keynes believes this factor to be much more important in modifying the propensity to consume than the previous one, because it is not related to income by some stable function. Keynes writes, "the consumption of the wealth-owning class may be extremely susceptible to unforeseen changes in the money-value of its wealth." Keynes is arguing that when the wealthy - he is not specific on what it means to be a part of the wealth-owning class - reap an unforeseen increase in money, they will strongly alter the propensity to consume in the short run. This also is susceptible to a practical criticism, as Eric has pointed out previously our Father would be highly unlikely to increase his spending if he won the lottery.

(IV) Changes in the rate of time-discounting, i.e. in the ratio of exchange between present goods and future goods - In fewer words, Keynes is discussing the effect of the interest rate on the propensity to consume. Keynes argues that in the short term any change in the interest rate will be highly unlikely to change the propensity to consume, but any long term change in the interest rate is capable of altering societal habits and ultimately affecting the propensity to consume. Since the interest rate affects investment decisions, it seems to follow that when people increase investment current consumption will fall. There will always be people who will consume almost all of their income no matter what the interest rate, and others who will favor saving and investment no matter how low the interest rate. Thus, individual have their own time preference which is reflected in the interest rate, but to say that this leads to a connection between the interest rate and society's propensity to consume - a term that has very little meaning - is a stretch.

(V) Changes in fiscal policy - This is a fairly simple point. When the government intervenes in the economy and people's lives through taxation, it is going to affect the amount of income individuals can devote to consumption. If a portion of your income is seized by the government every year, you are obviously not going to be able to buy an PS3 with that money. Keynes reveals his fondness for government intervention when he states, "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." Just take money from the productive and give it to the poor to spend on consumer goods and the economy will grow forever.

(VI) Changes in expectations of the relation between the present and future level of income - Keynes, briefly states that although this factor may affect individual propensities to consume, it will most likely average out for the community as a whole.

After discussing these six objective factors, Keynes argues that the propensity to consume is a fairly stable function. Given that changes in the wage-unit are already imputed in the calculation of the propensity to consume, the factors exerting the most influence are windfall changes in capital values, long term and significant changes in the interest rate, and fiscal policy.

In the next section, Keynes looks past the factors which affect the propensity to consume in order to determine the shape and behavior of the function as a whole. His first conclusion is that as income increases, the gap between consumption and income widens. This is an observable fact, as a certain portion of one's income must be spent on the essentials, food, shelter, clothing, etc. If these comprise 95% of one's income their is little room for saving, especially if they buy the new big screen tv. Conversely, if these essentials comprise 10% of a man's income he will have room to consume luxuries as well as save a large portion of his income.

In the last section, Keynes steps away from the propensity to consume in order to look at investment because net income is equal to consumption plus net investment. Changes in investment patterns can cause a change in consumption, thus relating back to the propensity to consume in the end. Keynes goes into an empirical analysis of investment in the United States from 1925-1933 and Great Britain from 1928-1931. In the U.S. net capital formation falls from $23,021 to $1,237 in 1932. Until 1929, net capital investment remained at or above $23,000. According to Keynes, the problem is that "the deduction for entrepreneur's repairs, maintenance, depreciation and depletion remained at a high figure even at the bottom of the slump." This leads to a heavy drag on the propensity to consume even under conditions when the public is ready to consume a large portion of its income. Keynes is blatantly wrong in his analysis of the Great Depression, neglecting the fact that the majority of the capital invested during the 1920s was not real savings and thus created the bubble that led to the bust. I will refrain from a discussion of business cycle theory for the time being, but it is interesting to note Keynes' analysis of the time.

Keynes goes on to postulate that "financial prudence" - saving money for future use - lowers aggregate demand and harms employment. He continues with the claim that there must be "sufficient unemployment to keep us so poor that our consumption falls short of our income by no more than the equivalent of the physical provision for future consumption which it pays to produce today." I fail to see the logic in the popularity of an economist who believes the only way to avoid economic problems is to keep everyone poor. Keynes believes that if we get too rich, we will increase savings and investment until we have built all "the houses and roads and town halls and electric grids" that will ever be needed. What then are we to do? I think Keynes problem is that he does not begin his analysis from the point of view of the individual, as Mises demonstrated is essential to economic analysis. If we build all the roads, the consumers will demand better roads. Consumers will always look to better themselves, and entrepreneurs will always exist to satisfy those demands.