John Maynard Keynes,The General Theory (BN Publishing, 2008), pp. 89–106.

I.

Terms defined, we are ready to go back to building back towards Keynes’ general theory. This chapter, as its title suggests, discusses the marginal propensity to consume (there is also a short second chapter broadly on the same subject that will be covered in a follow-up post). More generally, it is the first chapter of a series that will look almost exclusively on the aggregate demand function; remember from chapter three, and restated here: proceeds expected from employing N men.

Proceeds = sum spent on consumption at the given level of employment + that spent on investment at same time. Here Keynes will spend most of his time explaining what decides the former: the propensity to consume. A new function is introduced (C), related to employment (N). Going on his choice of units (chapter 4), however, Keynes changes the function a bit to (C w ) as related to income in terms of wage-units (Y w ). Keynes admits that maybe Y w is difficult to relate to N (the level of employment), given that different forms of employment may lead to variations in Y w (something he says he will return to in chapter twenty, where he will explain his employment function in further detail). But, more or less, Y w is sufficiently determined to N to make the argument that follows. This argument is that the propensity to consume is a “functional relationship X between Y w , a given level of income in terms of wage-units, and C w the expenditure on consumption out of that level of income, so that

C w = Y w or C = W × X(Y w )

What society consumes depends on,

Income; “Other objective attendant circumstances; “The subjective needs and the psychological propensities and habits.”

In short hand, relevant factors are put into two categories: objective and subjective factors. This chapter deals with the former. Since the latter is a historical study (or a psychological one) and not an economic one, the juice of Keynes’ MPC relies on changes in the objective factors.

II.

What are these objective factors that can influence MPC?

(1) Changes in wage-units: C is more of a function of real income than nominal income, but the former will fluctuate with regards to changes in wage-units (when total output increases, though, real income will rise at a progressively lesser rate, due to decreasing returns). Consumption is in some way proportional to changes in real income, since as real income changes consumption tends to change in the same direction.

(2) Change in difference between income and net income: Before, Keynes had established that consumption is based on net income (income minus supplementary costs [V]). While he doesn’t put much importance on this factor, his basic point is that changes in income that do not manifest in net income should not be considered, and changes in net income that do not manifest in income should. In any case, we will return to net income at some later in these notes.

(3) Windfall changes in capital-values not allowed for in net income: Remember, windfall changes are like supplementary costs, but unexpected (illustratively: non-insurable changes). These are important to figuring consumption, because they are unstable and unexpected. Keynes posits that this is more relevant for the “wealth-owning class,” but I’m not sure why.

(4) “Changes in the rate of time-discounting, i.e. in the ratio of exchange between present goods and future goods:” Not exactly the same as the rate of interest, according to Keynes, but approximate to it. According to the Classicals, a high rate of interest will cause consumption to fall, but Keynes says this is not proven and perhaps doubtful. He says that “short-period” changes will not affect the rate of consumption, for all practical purposes. Related to (3), he writes that they may be relevant when they relate to the value of securities and other forms of these types of asset investments. Changes in the rate of interest might have an effect if they fluctuate wildly or dramatically, or if it pays to have a life annuity over saving money (if the rate of interest is low enough). Lastly, maybe extreme uncertainty and its effects on consumption might be relevant to this factor.

(5) Changes in fiscal policy: Government policy can effect MPC. For example, taxes on unearned income (capital-profits, death-duties, etc.), and redistribution policies, can all increase the rate of consumption. On the other hand, payment of debt through sinking funds will decrease consumption.

(6) Changes in expectation of changes between present and future income: For society as a whole, Keynes contends that this is not likely to be a major factor (since it will average out between individuals).

When not considering changes in wage-units, Keynes suggests that MPC is essentially stable. Other factors may cause a fluctuation in MPC, but not likely (or may be secondary). That is, the volume of output (income) is the most concerning factor.

III.

Time to talk about the shape of the consumption function. Since we “know” a priori (but, through experience…?) some aspects of human nature, we also know that as income rises so does consumption, but not by the same amount. More mathematically, this means that the ∆C w and ∆Y w are of the same sign; where dC w /dY w is positive, but less than one. Keynes posits that while savings will rise during increases in income, they will decrease during falls in income (during “short periods,” like during fluctuations of employment), because he believes individuals would rather maintain their present living standards. A fall in consumption due to a fall in income, if any, would be, at best, imperfect.

As already stated in the third chapter, Keynes repeats that increases in the absolute level of income will “widen the gap between” income and consumption — i.e. an increase in savings. He rationalizes this through his belief that an individual has primary needs of higher priority than saving, but once these are met that there is less incentive to presently consume increases in income. He argues that economic stability lies in this rule being true. On the other hand, again, a fall in income will lead to a proportionally higher fraction of income to be presently consumed, which Keynes believes to be a stabilizing function during periods of fluctuations in employment. In any case, the most important conclusion here is that an increase in income will necessitate an increase in investment.

IV.

Employment is a function of expected consumption and expected investment, and consumption is a function of net income (which is consumption + net investment), or more accurately net investment. This focus on net investment is important, because as savings increase these might exceed investment to maintain capital (or protect against depreciation). So, an even greater quantity of investment is necessary to stabilize income. This is true also if depreciation isn’t accounted for (example [p. 99]: a house that depreciates is a drag on employment, made good only when the house is replaced).

This can be a problem in dynamic markets, especially after investment booms. The latter may be characterized by an increased in spending on durable capital goods, where then entrepreneurs respond by setting aside funds to replace these when the time comes. Thus, as these items depreciate income falls until the point where all these capital goods are finally replaced, elevating income once again.

Keynes believes that 1929 United States is a good example of this phenomenon. He writes that the investment book of the mid-1920s had led to entrepreneurs to set up sinking funds and depreciation allowances for the expectation of future replacements. This required a large volume of net investment, but without avenues of investment (no new investments to be had) it was impossible to maintain full employment income. Thus, the economy slump; this latter event was elongated by an even greater hoarding of funds to protect against depreciation.

Contemporaneous Great Britain is another example. A housing boom, and another increases in investment, spurred growth in sinking funds — money set aside to pay future debts or pay for capital replacement —, including by government agencies (at a growing rate). This public control of investment, with growing sinking funds, contributed to increases in unemployment, since there was no new (net) investment maintaining income. Another example, within the same history, is the fact that many new homeowners increased savings to remain debt-free by the time their new house depreciated completely. Between pages 102–105 he goes over several statistical studies to show the relationship between net investment and fluctuations in employment.

What Keynes is trying to show is that these types of savings — prematurely deferring from present consumption to pay future depreciation — create a drag on consumption that needn’t occur. This is especially paramount to understand within the context of Keynes’ belief that there is some limit to net investment. Consumption is also important to Keynes because he understands that aggregate demand is imputed from present consumption. This is doubly true when financing and physical production are two separate actions, such that deferred consumption may not necessarily lead to the physical provisioning for future consumption. Finally, Keynes repeats the belief that there are only a limited number of investments that can be made. As such, the problem of growing income and growing savings is a riddle that plagues the market economy.

Keynes also looks at the problem from the angle of disinvestment (past production? surplus inventory? is this consistent with his previous uses of the word “disinvestment?”), where any consumption satiated through past production leads to a reduction in aggregate demand. L.A. Hahn, in The Economics of Illusion (pp. 207–208), makes it sound like an over-production argument. Is this right? Keynes writes, “New capital-investment can only take place in excess of current capital-disinvestment if future expenditure on consumption is expected to rise” (p. 105). He notes, too, the lack of consistency on the part of those who argue the same thing when criticizing public investment (but, I think, misses the essence of these criticisms; it’s not about over-production, but failing to provide for what a dynamic consumer wants).

He seals the chapter with the crux of his argument: capital goods are not self-subsistent. A fall in the marginal propensity to consume will lead to a fall in demand for capital.