Steve Bain

The Keynesian Theory of Consumption Explained

The Keynesian Theory of Consumption, first developed by John Maynard Keynes in the early 20th century, has formed the most influential body of work in economics in the post-WW2 era. It has revolutionized the way in which mainstream economists understand and analyze consumer behavior.

Today, the theory of consumption remains as influential as ever, shaping much of government and Federal Reserve policy and strategy. From the way governments stimulate spending to how businesses target their marketing efforts, the theory of consumption guides decision-making at every level.

In this article, we will explore the Keynesian theory of consumption, how it led to the Keynesian Consumption Function, and how its principles have evolved over time. I should acknowledge that my personal brand of economics does not align well with some key Keynesian principles, and I will emphasize the differences of opinion that exist within the main alternative economics schools of thought.

Development of the Keynesian Theory of Consumption

The theory of consumption has come a long way since its inception in the early 20th century. Initially introduced by John Maynard Keynes, it has undergone significant changes and refinements over time. Keynes argued that consumer spending drives economic growth and stability, and these ideas formed the basis of Keynesian economics.

The theory was developed off the back of the Great Depression of the 1930s, when aggregate demand in the US collapsed causing unemployment to soar to almost 25% of the labor force. Keynes argued that such collapses in demand should be offset by increased discretionary fiscal spending by the government i.e., demand management policy.

Keynes believed that, during recessions, individuals tend to hoard money. This leads to a decline in consumer spending and a contraction of the economy. To counter that, he advocated for government spending and monetary policies that promote investment and increase consumer purchasing power.

Prior to Keynes’ theory of consumption, classical economics had formed the main approach to management of the economy, and it took a much more hands off approach. In the long-run economy will self-correct, but Keynes aptly noted:

“In the long-run we are all dead.”

The point being that it may well take an unacceptably long period of time for the market to self-correct and, in such cases, it will be necessary for short-term considerations to prevail. Direct intervention in the economy is then encouraged.

At the core of Keynesian economics lies the concept of aggregate-demand, which refers to the total spending in the economy. Keynes argued that fluctuations in aggregate demand are the primary drivers of economic fluctuations. His theory challenged the classical view that markets naturally reach equilibrium and that government intervention is unnecessary.

One of the key concepts in Keynesian economics is the marginal propensity to consume (MPC). The MPC represents the proportion of additional income that individuals choose to spend rather than save. According to Keynes, when individuals receive additional income, they are likely to spend a portion of it, leading to a multiplier effect on aggregate demand. This multiplier effect occurs when increased consumption leads to increased production and income, which in turn stimulates further consumption.

Another important concept in Keynesian economics is the paradox of thrift. Keynes argued that when individuals become cautious and save more in times of economic downturn, it can actually worsen the situation. This is because increased saving reduces consumer spending, leading to a decrease in aggregate demand and a decline in economic activity. Keynes believed that during recessions, it is crucial for individuals to maintain their spending levels to stimulate economic recovery.

Modern Evolution of the Theory

One of the key developments in the evolution of the Keynesian theory of consumption was the recognition of the importance of psychological factors in shaping consumer behavior. Economists began to acknowledge that individuals don't always act rationally, and their decisions are influenced by emotions, social norms, and other non-economic factors. This led to the emergence of behavioral economics, which integrates psychological insights into economic analysis.

Another important aspect of the theory's evolution is the incorporation of technological advancements and changes in the global economy. With the rise of the internet and e-commerce, traditional consumption patterns have been disrupted, and new forms of consumption have emerged. This has led economists to reevaluate their understanding of consumer behavior and adapt the theory of consumption to the digital age.

Unfortunately, some modern developments around the theory are highly controversial and seemingly prescribe more and more government spending almost irrespective of circumstance. The developments by Paul Samuelson and other New-Keynesian economists have been criticized on these grounds. Modern Monetary Theory goes even further, and takes an extremely liberal view on the consequences of debt-fueled spending by the government.

Criticisms

Alternative schools of economics argue that a truly free market will have no cause to fall into a deep recession, let alone a depression. They point to the failures of the Federal Reserve Bank in the years prior to the Great Depression i.e., the roaring 20s when aggregate demand was allowed to soar out of control.

The Fed had, and continues to have, control of interest rate policy. The 1920s illustrate perfectly how the Fed failed to correctly set interest rates to a high enough level; if the free-market had been able to determine rates, they would have risen higher as the demand for money increased. In so doing, excessive levels of aggregate demand could have been deterred because the cost of borrowing would have been higher. The argument here is that, under a free-market, there would have been no unsustainable bubble in the 1920s, and no Great Depression as a result of it.

Additional criticisms of the Keynesian theory of consumption, in particular from the monetarist camp, point out that the Fed allowed the wholesale collapse of the banking sector throughout the depression. With most bank accounts uninsured at that time, bank failures destroyed their customer’s deposits, and something like 30% of the US money-supply was destroyed in the depression. As a result, prices also deflated by around 30%, because there were fewer dollars chasing goods & services. The Fed again has to take the blame here, because it failed to take any action to avert the bank failures – something that it was instituted to do.

Finally, the Austrian economists point to the artificially low interest rates that seem to characterize Federal Reserve monetary management, and to its effects on malinvestment. Malinvestment occurs when business ventures with extremely low (or zero) profit margins come into existence. These firms cannot survive in a world where interest rates reflect the supply and demand for money, because those rates would be higher and unaffordable. With artificially low interest rates, resources are allocated to these zombie companies that would be more efficiently allocated elsewhere in the economy.

The Austrians further insist that manipulation of interest rates, as a way of managing demand, not only fails to smooth out consumption and investment spending, it ultimately causes recessions as zombie companies inevitably fail.

Conclusion: The Enduring Relevance of the Theory of Consumption

From its origins with John Maynard Keynes to its evolution and application in modern economics, the Keynesian theory of consumption continues to shape economic thought and policy-making. Understanding consumer behavior and its impact on economic growth and stability is crucial for governments, businesses, and policymakers.

The theory of consumption provides valuable insights into the factors that drive consumer spending and influence economic performance. By analyzing consumer preferences, income levels, and other demographic factors, businesses can tailor their products and marketing efforts to target specific consumer segments. Governments and central banks still use, whether wisely or not, fiscal and monetary policies to stimulate consumer spending and aggregate demand.

While the theory of consumption has faced criticisms and alternative theories have emerged, its enduring relevance in guiding economic analysis and policy-making cannot be denied. By understanding principles of the Keynesian theory of consumption, and its limitations, we can navigate the complexities of the modern economy and strive for sustainable economic growth and prosperity.

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