Life-Cycle Hypothesis
Life-Cycle Hypothesis
FROM THE GENERAL THEORY TO LCH
EMPIRICAL EVIDENCE FROM THE UNITED STATES AND CROSS-COUNTRY STUDIES
The life-cycle hypothesis (LCH) is the theory of private consumption and saving developed by the Italian-born American economist Franco Modigliani (1918–2003) and his collaborators in the 1950s and 1960s. The LCH posits that individuals, trying to maintain a stable level of consumption over time, save in their working years for retirement. Consequently, lifetime resources, rather than current income, are what determine the level of consumption. On an aggregate level, growth in aggregate lifetime resources, often as a result of growth in productivity and a shift in demographics, ultimately determines the savingincome ratio in an economy. The macroeconomic implications of the LCH set it apart from the prevailing Keynesian theory at the time, which assumed that the savingincome ratio was determined by level of income.
Modigliani was awarded the Nobel Prize in economics in 1985, thanks in part to his construction and development of the life-cycle hypothesis. According to the Royal Swedish Academy of Sciences, the LCH represents “a new paradigm in studies of consumption and saving.”
FROM THE GENERAL THEORY TO LCH
The standard consumption theory prior to LCH was established by John Maynard Keynes (1883–1946) in his groundbreaking General Theory, published in 1936. Keynes observed that aggregate consumption was determined by (current) income and would increase as income increased, but not as much. A theory of saving was not formally developed in Keynes’s General Theory ; however, it could be derived from the consumption function that the saving-income ratio was determined by the level of income and would increase as income increased. This implication was later found to contradict empirical evidence. U.S. national income accounts data did not show a rising saving rate over time. Nor did cross-country studies reveal that rich countries necessarily saved more.
In 1954 Modigliani first articulated the life-cycle hypothesis in a paper coauthored with Richard Brumberg (d. 1955). The LCH starts out from the framework that a household makes its consumption and saving decisions at any given time based on the household’s lifetime resources. In other words, consumers choose their level of consumption in each period to maximize their utility subject to the constraint of their lifetime resources. With the added assumption that consumers prefer a stable pattern of consumption over time, it can be readily shown that households must save in their productive years for consumption after retirement.
The seemingly simple formulation of the LCH differed fundamentally with the accepted theory of the time. In the LCH setting, consumption in any period does not depend on current income but rather on lifetime resources; savings in any period, therefore, depend on the difference between lifetime resources and current income. In contrast to the traditional theory, which predicts that the rich save and the poor dissave, the LCH predicts that the rich and the poor save a similar share of their lifetime resources.
Milton Friedman independently reached the same conclusion at about the same time. In the setting of Friedman’s permanent income hypothesis (PIH), lifetime resources are referred to as permanent income, and the difference between permanent income and current income as transitory income. A change in the level of permanent income affects the level of consumption much more than a change in transitory income. However, thanks to Friedman’s assumption of an infinite life span for individuals, the PIH does not share the most important implication of the LCH presented below—that is, the aggregate saving-income ratio is first and foremost determined by the growth in an economy.
It is important to note that the LCH defines savings, S, as the change in aggregate private wealth, W, that is, S = ΔW. Therefore, the saving rate, s, is simply
where ρ is the growth rate of the economy and w is the wealth-income ratio.
The two common sources of growth in an economy are population growth and productivity growth. In the case of population growth, the intuition is that as more young laborers enter the workforce, they would save more than what the retirees dissave and drive up the saving rate in the economy. Similarly, in the case of productivity growth, the younger population will have higher levels of consumption in their productive years and will save more as well, such that they can maintain their higher level of consumption after retirement. In aggregate, they will save more than the retirees dissave, and the saving rate will go up.
Some of the implications of the LCH are counterintuitive. As one can see from equation (1), the saving rate in an economy is not affected by per capita income in any way. When the wealth-income ratio is constant, the saving rate depends entirely on the growth rate. If there is zero growth in the economy, the saving rate will be zero. A country with a higher long-run growth rate will save more proportionately than a country with lower growth, irrespective of the per capita income level.
The LCH also predicts that the wealth-income ratio is a decreasing function of growth and is largely determined by the typical length of retirement in the economy.
THE EXTENDED LCH
Although the LCH emphasizes the role of growth in savings determination, alternative saving motives and macroeconomic variables can also be analyzed in its framework. These extensions enhance the explanatory power of the pure LCH model.
Bequest had long been considered to be the primary motive for saving before the LCH. It is now generally considered part of the supporting cast. In the extended LCH setup with bequest, receiving an inheritance increases permanent income, and a bequest to the next generation can be considered a choice for the household in addition to consumption in any period. Bequest raises the wealth-income ratio and hence the saving rate. The net effect on consumption depends on whether households pass on more than they inherit.
Literature on the precautionary motive also dates back to well before the LCH. In the extended LCH formulation with uncertainty in future income, households save more so that they can maintain a smooth consumption pattern in case of an unanticipated drop in income. This effect should be more profound for young and old households because they have fewer assets to tap into for this purpose.
Another area of research is forced savings programs, such as Social Security in the United States and pensions. It is intuitive to see the substitute effect of these programs in that they replace private saving. In reality, however, these programs often have the unintended effect of inducing participants to retire early as benefits decline for people working beyond retirement age. The net result is unclear from a theoretical perspective. Ignoring these programs, however, will bias the savings and income measures downward.
Liquidity constraint prevents households from borrowing to maintain their preferred level of consumption when current income falls below permanent income. In the extended LCH with liquidity constraint, households cannot consume more than their current income, which typically results in higher levels of consumption in later years than in earlier years.
Periods of high inflation often cause consumers to overestimate their real income, which leads to undersaving. In addition, when the return on assets does not fully adjust to the increase in the price level, inflation will reduce the real value of such nominal assets as bank deposits and bonds, and will consequently lower permanent income.
EMPIRICAL EVIDENCE FROM THE UNITED STATES AND CROSS-COUNTRY STUDIES
The LCH variables are not directly observable, making the hypothesis difficult to test. In addition to equation (1), the most commonly tested LCH equation is the consumption function in the form of
where C is consumption, YP is labor income, W is wealth, and r is asset return. Note that, under the LCH, YL is not consistent with current income in the national accounts; consumption does not include the portion of housing and durables purchased in a period but consumed later; and saving is not the residual of current income and current consumption but a comprehensive measure of change in nominal and real assets.
Despite these challenges, the LCH has been successful in explaining the saving behavior in many cross-section and time-series studies. Research in the 1960s, when data regarding private wealth in the United States and national income accounts for many Organization for Economic Cooperation and Development (OECD) countries first became available, accounted for the low saving-income ratio in the United States versus “poorer” countries under the LCH framework. Growth has also been proved to be the driving force behind the high saving-income ratio in Japan in the 1960s to 1970s and in China from the 1980s to 1990s.
Many studies have also documented evidence supporting the various extended versions of the LCH discussed above. Bequest and precautionary motives help explain why the wealth-income ratio does not decline as fast as the pure LCH predicts. Renewed interest in liquidity constraint has found the concept helpful in explaining the lower level of consumption in households’ early years.
The LCH lends itself well to studying implications of policies designed to influence private consumption and saving, such as the Social Security program discussed above. Interest rate policy affects permanent income through the asset return variable directly and through its impact on housing and stock prices indirectly. In contrast to bequest, deficit financing increases current generations’ permanent income at the cost of future generations.
SEE ALSO Absolute Income Hypothesis; Consumption; Expectations; Modigliani, Franco; Permanent Income Hypothesis; Relative Income Hypothesis
BIBLIOGRAPHY
Ando, Albert, and Franco Modigliani. 1963. The “Life-Cycle” Hypothesis of Saving: Aggregate Implications and Tests. American Economic Review 53 (1): 55–84.
Friedman, Milton. 1957. A Theory of the Consumption Function. Princeton, NJ: Princeton University Press.
Modigliani, Franco, and Richard Brumberg. 1954. Utility Analysis and the Consumption Function: An Interpretation of Cross-Section Data. In Post-Keynesian Economics, ed. Kenneth K. Kurihara, 388–436. New Brunswick, NJ: Rutgers University Press.
Modigliani, Franco, and Shi Larry Cao. 2004. The Chinese Saving Puzzle and the Life-Cycle Hypothesis. Journal of Economic Literature 42: 145–170.
Royal Swedish Academy of Sciences. 1985. Press Release: This Year’s Economics Prize Awarded for Pioneering Studies of Saving and of Financial Markets. http://nobelprize.org/nobel_prizes/economics/laureates/1985/press.html.
Shi Larry Cao