While Keynes used the term "psychology" to name this law, it is not really a law of psychology or of psychological behavior. Rather, it is a basic observation about consumption and consumer behavior. It postulates the likely relation between income, specifically changes in aggregate income for the economy, and consumption, specifically consumption expenditures by the household sector.

Moreover, it is a law that applies to the aggregate economy more so than individuals. Individuals prone to violate this law from time to time, but the overall economy almost never does.

Have More, Spend More

Consider an example. Suppose that Duncan Thurly, a typical human being consumer, receives a $1,000 end-of-the-year holiday profit-sharing bonus from his employer. The psychological law indicates that he is likely to spend a large portion of this bonus, say $900, on something like a new computer. However, he then keeps the remaining portion, $100, unspent in his savings account.

Alternatively, should Duncan have a drop income of $1,000 due to a period of involuntary unemployment, then he is likely to reduce his spending by only $900, also reducing saving by $100.

The Consumption Line

Consumption Line

The red line, labeled C, is the consumption line. This line has a positive slope, indicating that greater levels of consumption expenditures result from greater levels of income. Moreover, the slope of the line is numerically less than one. That is, the change in consumption expenditures is less than the change in income.

The relation between consumption and income is termed induced consumption and is measured by the marginal propensity to consume, which is the numerical measure of the slope of the consumption line.

Effective Demand

Effective demand was proposed first by Thomas Malthus and later by Keynes as a counter to Say's law that supply creates its own demand. Effective demand, in contrast, suggests that demand creates its own supply (at least up to full employment).