What is the life cycle theory of consumption?
The life-cycle theory of the consumption function was developed by Franco Modigliani, Alberto Ando and Brumberg. According to Modigliani, The point of departure of the life cycle model is the hypothesis that consumption and saving decisions of households at each point of time reflect more or less a conscious attempt at achieving ...
What is the life cycle hypothesis in economics?
The life cycle hypothesis accounts for the dependence of consumption and saving behaviour on the individual’s position in the life cycle. Young workers entering the labour force have relatively low incomes and low (possibly negative) saving rates. As income rises in middle-age years, so does the saving rate.
What are the assumptions of the life cycle model of spending?
The life-cycle theory assumes that household members choose their current expenditures optimally, taking account of their spending needs and future income over the remainder of their lifetimes. Modern versions of this model incorporate borrowing limits,…
What is the pattern of consumption and income in life cycle?
This pattern of consumption and income results in periods of dissaving in the early working years and the late stage of the life cycle, with positive saving over the high-income middle period of the life cycle.
What happens to consumption when stock market crashes?
When retirement fund values fall, it reduces consumer spending. A stock market crash will adversely affect the nation's gross domestic product as personal consumption and business investment are some of the major components of GDP. If stock prices stay depressed long enough, new businesses can't get funds to grow.
How does stock market affect consumption?
When stocks rise, people invested in the equity markets gain wealth. This increased wealth often leads to increased consumer spending, as consumers buy more goods and services when they're confident they are in a financial position to do so.
What happens in the event of a market crash?
A stock market crash happens when there is a sudden, unanticipated and significant drop in stock prices. The fall is rapid and usually ignited by a single cataclysmic event that sets off a series of smaller events.
What is life cycle consumption theory?
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 theory states that individuals seek to smooth consumption throughout their lifetime by borrowing when their income is low and saving when their income is high.
How did the stock market crash?
The main cause of the Wall Street crash of 1929 was the long period of speculation that preceded it, during which millions of people invested their savings or borrowed money to buy stocks, pushing prices to unsustainable levels.
What was the effect of the stock market crash in the 1920s?
The stock market crash of 1929 was not the sole cause of the Great Depression, but it did act to accelerate the global economic collapse of which it was also a symptom. By 1933, nearly half of America's banks had failed, and unemployment was approaching 15 million people, or 30 percent of the workforce.
What is it called when the market crashes?
A stock market crash is a sudden dramatic decline of stock prices across a major cross-section of a stock market, resulting in a significant loss of paper wealth. Crashes are driven by panic selling and underlying economic factors. They often follow speculation and economic bubbles.
What effect did the stock market crash have on banks?
Although only a small percentage of Americans had invested in the stock market, the crash affected everyone. Banks lost millions and, in response, foreclosed on business and personal loans, which in turn pressured customers to pay back their loans, whether or not they had the cash.
What is the consumption theory?
The theory is that if people receive an unanticipated amount of money that increases their disposable income, they will likely spend it and drive up consumption and spending in the economy.
What is the life cycle model of consumption and saving and what does that mean in macroeconomics?
The life-cycle model predicts that individuals should smooth consumption, in the sense of holding marginal utility constant, across stages of life. The model predicts borrowing prior to labor market entry, wealth accumulation during the working life, and dissaving in retirement.
What are the 4 stages of the organizational life cycle?
The Organizational Life Cycle is the theoretical pattern of phases that are typically followed by an organization. The Organizational Life Cycle consists of four phases: planning, growth, maturity, and decline. Each phase in the Organizational life cycle is characterized by specific activities and problems.
What are the three theories of consumption?
Economists have developed three major theories of consumption and saving behavior: (1) The life-cycle hypothesis (Modigliani and Brumberg, 1954; Modigliani and Ando, 1957; Ando and Modigliani, 1963); (2) the permanent income hypothesis (Friedman, 1957); and (3) the relative income hypothesis (Dusenberry, 1949). All three theories have their conceptual roots in the microeconomic theory of consumer choice. However, the life-cycle and permanent income hypotheses are the most similar; both theories assume that individuals attempt to maximize their utility or personal well-being by balancing a lifetime stream of earnings with a lifetime pattern of consumption. The relative income hypothesis is quite different. Dusenberry theorized that individuals are less concerned with their absolute level of consumption than with their relative level — the idea of "keeping up with the Joneses."
What is the life cycle of retirement?
In the theory of work-leisure choice, individuals are assumed to maximize their utility derived from the consumption of goods and services, as well as from leisure. However, the consumption of goods and services requires income that, in turn, must be generated by earnings or savings. In this context, the retirement decision is based on the tradeoff between the utility gained from leisure time spent in retirement and the consumption of goods and services. Since retirement usually implies a substantial reduction of, or total absence of, wage income, the retirement decision is based on the point where an individual's savings accumulation has reached the level where it is sufficient to support the levels of consumption and leisure that maximizes his or her utility.
What is the relative income hypothesis?
Dusenberry theorized that individuals are less concerned with their absolute level of consumption than with their relative level — the idea of "keeping up with the Joneses.". The life-cycle hypothesis has been utilized extensively to examine savings and retirement behavior of older persons.
Why do young people have little savings?
Younger people tend to have consumption needs that exceed their income. Their needs tend to be mainly for housing and education, and therefore they have little savings. In middle age, earnings generally rise, enabling debts accumulated earlier in life to be paid off and savings to be accumulated.
How does the discount rate affect the income stream?
The discount rate can greatly influence the size of the income stream generated by an asset. In addition to the choice of an appropriate discount rate, there is the problem of changes in the size of income streams produced by assets at different stages in the life cycle.
Is the life cycle theory inconclusive?
As noted earlier, a substantial literature has attempted to identify which effect dominates, but this literature remains inconclusive. The vast majority of the research on the life-cycle theory has focused on patterns of savings behavior. Savings, however, are only half of the story.
Explanation to the Theory of Consumption
The life-cycle theory of the consumption function was developed by Franco Modigliani, Alberto Ando and Brumberg.
The Reconciliation
The life cycle hypothesis can explain the puzzles that emerged from the early empirical work on consumption functions. According to the life cycle hypothesis, the relationship between consumption and current income would be non-proportional, as seems to be the case in short-run time series estimates.
Critics of the Life Cycle Hypothesis
Although the life cycle hypothesis explains several features of the consumption- income relationship, the approach is not without its critics.
16.23 The Life-Cycle Model of Consumption
The life-cycle model of consumption looks at the lifetime consumption and saving decisions of an individual. The choices made about consumption and saving depend on income earned over an individual’s entire lifetime. The model has two key components: the lifetime budget constraint and individual choice given that constraint.
More Formally
Suppose an individual expects to work for a total of N years and to be retired for R years. Suppose his disposable income is equal to Yd in every year, and he receives annual retirement income of Z. Then lifetime income, assuming a zero real interest rate, is given as follows:
What is the life cycle theory?
The life-cycle theory assumes that household members choose their current expenditures optimally, taking account of their spending needs and future income over the remainder of their lifetimes.
What is the theory of personal savings?
…of personal savings, termed the life-cycle theory. The theory posits that individuals build up a store of wealth during their younger working lives not to pass on these savings to their descendents but to consume during their own old age. The theory helped explain the varying rates of savings in…
Implications For Retirement Behavior
- The life-cycle hypothesis is closely related to the theory of work-leisure choice, which has been widely applied in the retirement literature. In the theory of work-leisure choice, individuals are assumed to maximize their utility derived from the consumption of goods and services, as well as from leisure. However, the consumption of goods and services requires income that, in turn, mu…
Implications For Income Adequacy
- In considering the economic status of current and future older persons, few would argue that money income alone is the best measure. Another approach is to usehousehold net worth as a measure of economic status. Net worth is defined as the total market value of all assets, such as home equity, stocks and bonds, and savings accounts, minus all debts, such as mortgages, sch…
Implications For Aggregate Savings and Consumption Patterns
- The life-cycle hypothesis suggests that population aging will initially lead to an increase in national savings as the proportion of the population in the maximum savings years increases. Cantor and Yuengart (1994) estimate that saving by the baby boom generation may add as much as 1.4 percent to the national savings rate between 1990 and 2010. As ...
Bibliography
- Ando, A., and Modligliani, F. "The Life-Cycle Hypothesis of Saving: Aggregate Implications and Tests." American Economic Review 53 (1963): 55–84. Bertaut, C., and Haliassos, M. "Precautionary Portfolio Behavior from a Life-Cycle Perspective." Journal of Economic Dynamics and Control 21 (1997): 1511–1542. Borsch-Supan, A. "Saving and Consumption Patterns of the …