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The Life-Cycle Hypothesis

In examining why people spend the amount they do, a logical starting point is to ask what goals they have. Two goals seem reasonable for a great many people. First, they prefer a higher standard of living to a lower standard of living. In other words, people want the highest level of consumption spending they can get. Second, most people prefer to have a roughly constant standard of living through time. They do not like to live on a roller coaster, with one year of feast followed by a year of famine.1

Put together, these two goals suggest that we assume that people try to maintain the highest, smooth consumption path that they can get. Presented in this way, discussion of consumption behavior becomes a problem that the tools of microeconomics are designed to examine (with budget lines and indifference curves).

Consider, for example, a person who will earn $100000 this year and $50000 next year. Ignoring all future years, how should he spend? The idea that he wants a smooth consumption path suggests that he should save part of this year's income and spend it next year. Alternatively, if the person earned the $50000 this year and the $100000 next year, the goal of a high smooth consumption path suggests that he borrow in the first year and pay back in the second. An important function of financial markets from the point of view of consumers is that these markets help one maintain a constant standard of living despite fluctuations in income.

The idea that people have fluctuations in income that they want to smooth is the basis of the life-cycle hypothesis of consumption. In a series of articles in the 1950s and 1960s, Franco Modigliani, Richard Brumberg, and Albert Ando asked why people save. They answered that people generally live longer than they earn income—that is, people usually retire. If people are to keep spending after they no longer earn income, they must have accumulated assets while they were earning so that they can dissave. (Few are willing to lend to those who have no prospect of future income.)

Suppose a 20-year-old person expects to live 50 years more, but only to work for 40 of those years. He expects to earn $20,000 each year. Ignoring interest, this person will have earnings of $800,000 to spread over 50 years. If he spends $16,000 a year, he will die with zero assets left. To get this spending pattern, he saves $4,000 each year while he works, and at retirement will have assets of $160,000.

Now suppose that the person in the above example begins with assets of $200,000. He will then have a lifetime amount of $1,000,000 that can be spent. He will be able to spend $20,000 each year and die with zero assets. Thus the life-cycle hypothesis introduces wealth as a factor into the consumption function. Consumption can be financed either through income or through the sale of assets, and an increase in either should increase consumption.

By looking at what a "typical" individual should do, the life-cycle hypothesis builds microeconomic footings for the consumption function. Behavior is goal-directed in the life-cycle hypothesis, while it is not in the original Keynesian consumption function. This latter consumption function is mechanical without a reason. Since economists prefer behavior that can be explained in terms of people pursuing goals, it is no surprise that the life-cycle hypothesis has become popular.

The life-cycle hypothesis can be expanded to take into account uncertainty of when death will occur, the existence of social security, the interest rate, savings for bequests for heirs, and various patterns of lifetime earnings. It does not deal well with what should happen if incomes fluctuate erratically over time, but for this situation another theory, the permanent-income hypothesis, provides an answer. The permanent-income and life-cycle hypotheses are not contradictory theories, but theories that nicely complement each other.

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1It is widely recognized that it is much easier to adjust living standard upward than downward. As we move up, what had been luxuries become necessities, and it is very had to give them up. One can live without power windows and locks on a car, a fast computer, a television without remote control, but once one gets used to them, it is painful to give them up. Since adjusting standard of living downward is difficult, sensible people avoid raising their standard of living unless they are confident they can sustain it. If the author were permitted to editorialize a bit, he would suggest that many people in financial straits are there because they adapted to an unsustainable standard of living, something the easy availability of credit encourages.

Copyright Robert Schenk