Q.(a) Explain Keynes' Psychological law of Consumption function with diagram.
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Start your 14-day free trial to unlock the full solution →(a) Keynes' psychological law: when income rises, consumption rises but by less, so saving also rises. (b) Classical theory assumes full employment and self-adjustment (Say's law); Keynes shows underemployment equilibrium set by effective demand needing state intervention.
(a) Keynes' Psychological Law of Consumption:
Keynes stated that consumption depends mainly on income, and this relationship follows a definite psychological law with three propositions:
- When aggregate income increases, consumption expenditure also increases, but by a smaller amount than the increase in income.
- The increase in income is divided between consumption and saving — the marginal propensity to consume (MPC) lies between 0 and 1.
- As income rises, both consumption and saving increase; consumption never falls when income rises, but the proportion consumed (APC) tends to fall.
Diagram (described in words): On a graph with income (Y) on the horizontal axis and consumption (C) on the vertical axis, draw a 45° line where C = Y. The consumption function C = a + bY is drawn as an upward-sloping straight line that starts above the origin (autonomous consumption 'a') and is flatter than the 45° line. The two lines cross at the break-even point, where consumption equals income and saving is zero. To the left of this point consumption exceeds income (dissaving); to the right, income exceeds consumption and the gap between the 45° line and the consumption line measures saving, which widens as income rises — showing consumption growing less than income.
(b) Classical theory vs Keynesian theory:
| Basis | Classical theory | Keynesian theory |
|---|---|---|
| Employment | Assumes full employment as normal | Underemployment equilibrium is normal |
| Say's law | Supply creates its own demand | Demand creates supply; effective demand rules |
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