Life-cycle hypothesis

Life-cycle hypothesis

The life-cycle hypothesis (LCH) is an economic theory that describes the spending and saving habits of people over the course of a lifetime. The concept was developed by Franco Modigliani and his student Richard Brumberg in the early 1950s. The theory is that individuals seek to smooth consumption  throughout their lifetime by borrowing when their income is low and saving when their income is high.
the life-cycle hypothesis (LCH) is a model that strives to explain the consumption patterns of individuals.

The life-cycle hypothesis suggests that individuals plan their consumption and savings behaviour over their life-cycle.Modigliani and Brumberg observed that individuals build up assets at the initial stages of their working lives. Later on during retirement, they make use of their stock of assets. The working people save up for their post-retirement lives and alter their consumption patterns according to their needs at different stages of their lives.

Related post 👉Permanent-income-hypothesis

ASSUMPTIONS :-

The life-cycle hypothesis (LCH) is based on some assumptions,that are given below

1 There is no change in the price level in the lifetime of the consumer.

2 The interest rate remains constant.

3 The consumer does not inherit any assets and his Net assets are the result of his own savings.

The theory states consumption will be a function of wealth, expected lifetime earnings and the number of years until retirement.

Consumption will depend on

C= consumption
W = Wealth
R = Years until retirement. Remaining years of work
Y = Income
T= Remaining years of life
It suggests for the whole economy consumption will be a function of both wealth and income.

If every individual in the economy plans consumption in this manner, then the aggregate consumption function will be quite similar to the individual one. Thus, the aggregate consumption function of the economy is

The main purpose of the consumers is to maximize their satisfaction over a lifetime
Which will further depend on the total income or resources. If Given a limit of person's life ,his Consumption would be in proportion to his resources.But consumer who have Plans to spend the resources (income) in a way that in the early years of his life His expenses increases, in the middle of his life expenses Is high over the years and at the time of retires Decreases sharply.
Therefore,they take on debt and save less when they are young, assuming future income will enable them to pay it off. They then save during middle age in order to maintain their level of consumption when they retire.Eventually the person's level of consumption remains almost constant or slightly increasing throughout life as shown by the CC1 curve in Figure 8..
Y0,Y,Y1 Curve represent lifetime income of an individual through the T years of his life.

 


20 years are the initial time of an individual life and CB is the level of consumption which is depend upon debt Y0,B,C.
At the middle age between 20 to 65 year of age ,a consumer will pay off his debt and save B,Y,S  for his furure.
After 65 year of an individual's age,he took retirement and he will use his savings(B,Y,S) for the consumption.
According to this theory, consumption is a function of expected income of one's life,which is further depend on the resources.
There is also some resources which Includes current income (Yt), current value of future expected labor income(Ylt) and current value of assets (At). Therefore, representation of consumption function :-

Ct+f(Vt).........(1)

And

Vt=f(Yt+Ylt+At).....(2)

After Substituting equation (2) in (1) and linearizing (2) and separating The weighted average of the income categories then the total consumption function :-

where Ct= Consumption expenditure in a period t.

YLt = Income earned from doing some labour in the current period t.

YeL = the average annual income expected to be earned from labour during the further years of working life.

Wt – wealth currently owned

a1 represents marginal propensity to consume out of current income

a2 is marginal propensity to consume out of expected lifetime income, and

a3 is the marginal propensity to consume out of wealth.

Now for APC , Consumption function :-

In Long run or over time, APC is stable because of current earnings,the share of labor income and the ratio of total assets to current income remains fixed,When the economy grows.
Based on the life-cycle theory, Endo and Modigliani Conducted several studies to produce long-term consumption functions.Form there studies,it found that maximum individuals were belongs to the minimum-income level because they were on the last period of their life.Thus,their APC was higher.On the other hand, higher than average people belonging to the higher income group were at higher income levels Because they were in the middle years of their lives. Thus their APC is relatively
Was low. Overall ,as income grows,As a result, the APC was declining which resulted in APC> MPC.An examination of US data showed that in the long run APC was stable at = 0.7.

The Ando-Modigliani short-run consumption function is shown by the Cs. curve in Fig. 2 At any given point of time, the CS curve can be considered as a constant and during short-run income fluctuation, when wealth remains fairly constant, it looks like the Keynesian consumption function. But it- intercept will change as a result of accumulation of wealth (assets) through savings.

Fig. 2

As wealth increases overtime, the non-proportional short-run consumption function Cs shifts upward to CS1 to trace out the long-run proportional consumption function. The long-run consumption function is CL, showing a constant APC as income grows along the trend. It is a straight line passing through the origin. The APC is constant over time because the share of labour income in total income and the ratio of wealth (assets) to total income are constant as the economy grows along the trend.

Conclusion:

Despite these, the life cycle hypothesis is superior to the other hypotheses on consumption function because it includes not only wealth as a variable in the consumption function but also explains why APC > MPC in the short-run and APC is constant in the long-run.