Propensity to consume shown consumption expenditure at different levels of income in an economy.

Keynes believes that propensity to consume depends upon the level of disable income, but there are so many other factors which influence propensity to consume. The major determinants of propensity to consume are as follows:

1.    Rate of Interest. Higher interest rates, genially, lead to lower consumption expenditure. In fact, higher interest rate encourages saving, as the rewards for saving rises. With increase in interest rates the repayment liability of the borrowers increases rates lowers the value of assets, inducing households to save more to restore wealth and reduce their consumption expenditure.

However, increase in the deposit rate of interest will earn a higher return for the that households, and consequently, he may attain the targeted level of income even with lesser savings. As a result, the current level of consumption will rise.

2.    Wealth. Permanent income and life-cycle-theories of consumption hold the view that households save in order to accumulate wealth for unexpected future expenses and also to meet day-to-day needs after retirement. If there is unexpected rise in wealth then households will be inclined to save less and spend more on current consumption. Thus, increase in wealth also increases the propensity to consume, and vice-versa.

3.    Liquid Assets. These assets are defined as including such items as government securities, demand deposits, time deposits, currency, shares, etc. Liquid assets can be spent at any time because these assets can b readily converted into money. Such assets are for the consumers a potential source of purchasing power. On the basis of their empirical results, A. Zellers and others have concluded that liquid assets play and important role in determining consumption.

4.    Capital Gins. Capital gains (or losses) also have an impact on aggregate consumption. It is so because sudden and unexpected gains increase the in divided net worth, and thereby induce additional consumption. On the contrary, sudden and unexpected losses would reduce consumption.

5.    Expectations. The consumption of person is also influenced by expectation regarding future movement in income and prices.

Determinants of Propensity to Consume

•    Rate of interest
•    Size of Wealth
•    Possession of liquid assets
•    Capital gains
•    Expectations about future income and general price level
•    Stock of consumer durables
•    Availability consumer credit
•    Distribution of income
•    Taxation policy

For instance, if an individual expects his income to be lower in the future, he may  refrain from making a purchase today on two counts:

First, because any indebtedness associated with the purchase will have to be paid later out of his lower income.

Second, because he may desire to save today in order to be able to continue consumption at the same level in the future when his income declines.

On the other hand, if an individual expects higher level of income in the future, he may go into debt today in order to attain a high level of consumption because he feels that he not only can continue that level of consumption but also can pay back debts incrred as a result of today’s consumption out of his higher future income.

Similar reactions occur in regard to expected changes in product prices. Expectations of falling prices will cause consumers to postpone their present purchases, and thus save. This would lover the consumption function. Reverse may occur when prices are expected to rise. if prices are expected to rise, current consumption will be stimulated because any income saved will be worthless in the future when it will not buy as many goods and services as now. This would raise the consumption function.

6.    Stock of Consumer Durables. An individual’s stock of durable consumer goods has a dual effect on the possible level of his consumption expenditure:

First, possession of these goods undoubtedly reduces his desire to use a portion of his actual income (or currant income) to make additional purchase some he already had the. For instance, a family which possesses a refrigerator may not go in for another one.

Second, the possession of such durables may encourage them to purchase commodities of non-durable nature, for example, the stock of fruits, vegetables, milk, eggs, etc., more than what is needed to deep the refrigerator in full use. This causes an upward shift in the consumption function.

7.    Consumer Credit. Availability of credit to consumers on easy terms is an important factor influencing consumer purchases of durables. M.K. Evans has found that the use of installment consumer credit raises the aggregate demand in the economy interest payment, the consumers do not pay attention to it and spend more on consumption. Thus, consumer credit and credit purchases influence the level of consumption.

8.    Distribution of Income. Consumption is also influenced by the pattern of income distribution. The propensity to consume varies from one income group to another.
It is normally higher for low income groups than those of the high income groups. This is because the poors have a lot of unsatisfied wants and are likely to spend every additional unit of money that they obtaining satisfying those wants.

In contrast, the rich have a high standard of living and relatively less unguents wants remain to be satisfied. Additional income in their case, therefore, is more likely to be saved than spent on consumption.

Hence, given the total income, a more equal distribution of income will cause upward shift in consumption function.

9.    Taxation Policy. Taxation measures of the government may influence the average propensity to consume and bring about shift inc consumption function. An increase in direct taxes will reduce disposable income at all levels of income. As a result, the absolute level of consumption will fall at all levels of income, and reverse may occur when taxes are reduced. Similarly, highly progressive tax system that leads to better distribution of income also leads to increase in the level of consumption expenditure.

10.    Other Factor. There are other factors that influence consumption expenditure. These include age, education, occupation, family composition and the rural-urban  constant or approximately so. Changes in these factors, however, occur over a long period and can, therefore, be ignored in the short-run analysis.

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