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Raaj Rayat, Stephanie Scott, Ed Mullen, Yibo Chen
22 September 2015
Briefly, what is Modigliani’s life-cycle theory of consumption? For an individual, draw someone’s consumption schedule over their life. Now draw their wealth over their life. At which periods are they saving and dissaving?
According to Modigliani’s model, individuals make rational decisions about how much they want to spend at each age, irrespective of their income at that age. They are constrained by the amount of resources which are available to them over the course of their lives. Working people build up and run down assets at different stages of their lives so they are able to tailor their consumption patterns to their requirements at different stages in their lives, independent of their incomes. A key assumption of the model is that individuals aim to maintain a steady lifestyle (level of consumption) throughout their lives. A key implication, therefore, is that individual’s consumption patterns remain are approximately the same from one period to the next.
Under the assumptions of this model, an individual will tailor their level of saving, given their income, so as to maintain a relatively constant level of consumption over the course of their life. During the working life of an individual, saving allows the individual to accumulate a stock of wealth, and will therefore be positive for this period. When the individual reaches retirement, they no longer have a source of income and so must rely on the consumption of their accumulated wealth to maintain a steady lifestyle. During this stage saving becomes negative and is thusly a period of dissaving. As a result, an individual’s wealth will be greatest in the period before retirement.
What effects do population growth and economic growth have on savings rates?
When there is positive population growth in an economy, the young working population are saving more than the retired population are dissaving, as there are more young than old. More saving than dissaving means there is positive net saving.
When there is economic growth, incomes are increasing. As the working population have higher incomes than the retired population had, they will save on a larger scale than the retired. This will increase the level of saving in the economy. The theory implies that the faster the rate of economic growth, the higher the saving rate. It is not the level of economic or population growth which dictates the savings rate, but the rate at which the population or the economy is growing.
In the Modigliani model, do consumers consume from current income?
According to the model, consumers consume not from income, but from the value of resources they expect to own across their lifetime. Based on the key assumption of the model that individuals aim to maintain a steady lifestyle (level of consumption) throughout their lives, the model implies that present income is not the sole determinant of the level of consumption. This situation changes for individuals as they enter different stages of life. A young graduate would expect to save more, and thusly consume a smaller fraction of income, for retirement, than when in middle age. According to the life-cycle consumption theory, at this stage we would expect that the individual would have a similar level of consumption, however, this level would be a smaller proportion of income. A key assumption of the model is that individuals aim to maintain a steady lifestyle (level of consumption) throughout their lives. A key implication, therefore, is that individual’s consumption patterns remain are approximately the same from one period to the next.
What is the impact in the model of an increase in transitory income?
Transitory income refers to a level of income which is not permanent. Transitory income is calculated as the difference between measured income and permanent income. This in part explains why saving rates increase more sharply among groups which are exposed to variations in transitory income, such as farmers or small business proprietors, when increases in transitory incomes are observed.
What are the implications of the theory for savings rates over the economic cycle?
Modigliani and Brumberg (1980) argued that in the macroeconomic context, ceteris parabis (vis-a-vis holding the growth rate of the economy constant), the saving ratio should be constant over the long run. In the short run, however, it will vary pro-cyclically over the business cycle. Modigliani and Brumberg (1980) argue that over the business and life-cycle, consumption is smoother than income, implying that, at the macro level, individuals do in fact maintain a relatively stable level of consumption and that this level is not as strongly affected by income as previously thought.
Deaton, A 2005,“Franco Modigliani and the Life Cycle Theory of Consumption”, retrieved from: http://ssrn.com/abstract=686475