life cycle hypothesis consumption function

Life-Cycle Hypothesis

Definition: The Life-cycle hypothesis was developed by Franco Modigliani in 1957. The theory states that individuals seek to smooth consumption over the course of a lifetime – borrowing in times of low-income and saving during periods of high income.

As a student, it is rational to borrow to fund education.
Then during your working life, you pay off student loans and begin saving for your retirement.
This saving during working life enables you to maintain similar levels of income during your retirement.

It suggests wealth will build up in working age, but then fall in retirement.

Wealth in the Life-Cycle Hypothesis

life cycle hypothesis consumption function

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
R = Years until retirement. Remaining years of work
T= Remaining years of life

It suggests for the whole economy consumption will be a function of both wealth and income.

Prior to life-cycle theories, it was assumed that consumption was a function of income. For example, the Keynesian consumption function saw a more direct link between income and spending.

However, this failed to account for how consumption may vary depending on the position in life-cycle.

Motivation for life-cycle consumption patterns

Diminishing marginal utility of income. If income is high during working life, there is a diminishing marginal utility of spending extra money at that particular time.
Harder to work and earn money, in old age. Life Cycle enables people to work hard and spend less.

Does the Life-cycle theory happen in reality?

Mervyn King suggests life-cycle consumption patterns can be found in approx 75% of the population. However, 20-25% don’t plan in the long term. (NBER paper on economics of saving )

Reasons for why people don’t smooth consumption over a lifetime.

Present focus bias – People can find it hard to value income a long time in the future
Inertia and status quo bias . Planning for retirement requires effort, forward thinking and knowledge of financial instruments such as pensions. People may prefer to procrastinate – even though they know they should save more – and so saving gets put off.

Criticisms of Life Cycle Theory

It assumes people run down wealth in old age, but often this doesn’t happen as people would like to pass on inherited wealth to children. Also, there can be an attachment to wealth and an unwillingness to run it down. See: Prospect theory and the endowment effect.
It assumes people are rational and forward planning. Behavioural economics suggests many people have motivations to avoid planning.
People may lack the self-control to reduce spending now and save more for future.
Life-cycle is easier for people on high incomes. They are more likely to have financial knowledge, also they have the ‘luxury’ of being able to save. People on low-incomes, with high credit card debts, may feel there is no disposable income to save.
Leisure. Rather than smoothing out consumption, individuals may prefer to smooth out leisure – working fewer hours during working age, and continuing to work part-time in retirement.
Government means-tested benefits for old-age people may provide an incentive not to save because lower savings will lead to more social security payments.

Other theories

Permanent income hypothesis of Milton Friedman – This states people only spend more when they see it as an increase in permanent income.
Ricardian Equivalence – consumers may see tax cuts as only a temporary rise in income so will not alter spending.
Autonomous consumption – In Keynesian consumption function, the level of consumption that is independent of income.
Marginal propensity to consume – how much of extra income is spent.

15 thoughts on “Life-Cycle Hypothesis”

Thanks for the reminder of the theory… Am a moi university Economic student in Nairobi Kenya.

Thanks for the most summarised note ever. it will help me with presentation. Gulu university. JALON

prof premraj pushpakaran writes — 2018 marks the 100th birth year of Franco Modigliani!!!

Thanks for the analysis on the hypothesis

Nice piece of work for economist. Been applicable in my presentation at Kyambogo university Uganda

This piece of paper is very important as far as consumption is concerned…

This piece is the best I have seen so far, this is a great work

Thanks for this work.it Will help me in my presentation at metropolitan international University

Very coincise and well articulated. This work reconnects me with themechanics of consumption theories. I appreaciate for a job well done.

Very nice and comprensive information. It will help me in my exams at university of jos Nigeria, studying economics

thank u for the summarized notes,it will help me in my exam at Kibabii university

Great job. Thanks for this masterpiece.

Good job. Thanks for this masterpiece. It reconnects me with the consumption theories.

A good summarised piece of work on life cycle hypothesis, it will help me in my group presentation. Kenyatta University economics student.

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What Is the Life-Cycle Hypothesis (LCH)?

Understanding the life-cycle hypothesis, life-cycle hypothesis vs. keynesian theory, special considerations for the life-cycle hypothesis, who wrote the life cycle hypothesis (lch) theory, what is the concept of the life cycle hypothesis, what is an example of the life cycle hypothesis, the bottom line.

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What Is the Life-Cycle Hypothesis in Economics?

Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master's in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem.

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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.

The concept was developed by economists Franco Modigliani and his student Richard Brumberg in the early 1950s.

Key Takeaways

The life-cycle hypothesis (LCH) is an economic theory developed in the early 1950s that posits that people plan their spending throughout their lifetimes, factoring in their future income.
A graph of the LCH shows a hump-shaped pattern of wealth accumulation that is low during youth and old age and high in middle age.
One implication is that younger people have a greater capacity to take investment risks than older individuals who need to draw down accumulated savings.

The LCH assumes that individuals plan their spending over their lifetimes, taking into account their future income. Accordingly, they take on debt 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.

A graph of an individual's spending over time thus shows a hump-shaped pattern in which wealth accumulation is low during youth and old age and high during middle age.

The LCH replaced an earlier hypothesis developed by economist John Maynard Keynes in 1937. Keynes believed that savings were just another good and that the percentage that individuals allocated to their savings would grow as their incomes rose. This presented a potential problem as it implied that as a nation’s incomes grew, a savings glut would result, and aggregate demand and economic output would stagnate.

Another problem with Keynes's theory is that he did not address people's consumption patterns over time. For example, an individual in middle age who is the head of a family will consume more than a retiree. Although subsequent research has generally supported the LCH, it also has its problems.

The LCH has largely supplanted Keynesian economic thinking about spending and savings patterns.

The LCH makes several assumptions. For example, the theory assumes that people deplete their wealth during old age. Often, however, the wealth is passed on to children, or older people may be unwilling to spend their wealth. The theory also assumes that people plan ahead when it comes to building wealth, but many procrastinate or lack the discipline to save.

Another assumption is that people earn the most when they are of working age. However, some people choose to work less when they are relatively young and continue working part-time when they reach retirement age.

As a result, one implication is that younger people are more able to take on investment risks than older individuals, which remains a widely accepted tenet of personal finance.

Other notable assumptions are that those with high incomes are more able to save and have greater financial savvy than those on low incomes. People with low incomes may have credit card debt and less disposable income. Lastly, safety nets or means-tested benefits for aging adults may discourage people from saving as they anticipate receiving a higher social security payment when they retire.

Economists Franco Modigliani and his student Richard Brumberg developed the LCH in the early 1950s.

This economic theory says that people try to maintain approximately the same level of consumption throughout their lives. That means, generally speaking, when they are young they may take on debt; when they are in their prime earning years they save more. and and when they are old they live off the wealth they accumulated earlier in life.

A good example of the LCH theory in practice is saving for retirement. During your working years you save money for when you are no longer working, knowing that you may not have income when you're older.

The life cycle hypothesis, developed in the 1950s, posits that people tend to maintain a consistent spending level over their lifetimes. Over time, there have been criticisms leveled against the LCH. One is people don't always maintain a consistent pattern of consumption. Someone who is middle-aged with a family of four and a mortgage is likely to consume more than at a time of life when they are retired and have no dependents and own their home. However, the LHC is still considered an important part of modern economic theory.

Franco Modigliani. "Life cycle, individual thrift, and the wealth of nations." American Economic Review, 1986, Vol. 76, Issue 3, Pages 297-313.

Federal Reserve Bank of Richmond. " Life Cycle Hypothesis ."

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Life-cycle hypothesis: Ando and Modigliani

Post author: Viren Rehal
Post published: August 18, 2022
Post category: Consumption function / Macroeconomics
Post comments: 4 Comments

The life-cycle hypothesis was postulated by Ando and Modigliani in an attempt to explain the behaviour of consumption function in the long and short run. According to this theory, current consumption decisions are based on future expected income over an individual’s lifetime. The major advantage of this theory is that Ando and Modigliani incorporated the role of assets in determining consumption decisions. Other theories don’t incorporate assets into consumption ( absolute income hypothesis ) or the role of assets is only implicit ( permanent income hypothesis ).

MPC < APC in cross-sections

Over the lifetime of any individual, income is low in the early years of life. As people reach middle age, their income rises as they start earning more. In later years of life, however, income starts falling again to reach low levels owing to retirement or the inability to work as people grow older. Therefore, income starts from a low level, keeps increasing in middle age, and declines back to a low level in old age.

In the case of consumption, individuals are expected to maintain a constant or slightly increasing level of consumption as they keep growing older. Since consumption is dependent on future expected income, the present value of consumption is constrained by the present value of income.

APC and MPS at different age

During the early years, income is low as compared to consumption and individuals are borrowers during this period, i.e. APC is high. However, they expect their future income to rise during their middle age. Because income is higher than consumption level, they pay off their borrowings during this period and save for retirement in old age. With high income, APC is low because consumption is much lower as compared to income in this period. In the later years of the life-cycle, income is again below consumption level. Hence, this is a period of dissavings or negative savings by individuals, leading to a low APC.

Therefore, across different sections based on income levels, APC will be high for low-income groups. These low-income groups primarily include people in their early years of life and people in old age, who have low incomes. On average, APC will be high as the low-income group consists of higher than average young and older people. On the contrary, high-income groups will have a higher than average proportion of middle-aged people. This is because they have higher incomes. APC, in this case, will be lower because consumption is low compared to income level during middle age.

Hence, APC will decline as income increases and MPC<APC in cross sections because of different income levels in a life-cycle.

consumption function of Life-Cycle Hypothesis

According to the life-cycle hypothesis, the consumption of any individual is based on expected income in the future. If the expected income rises, the consumption of that consumer will also increase. Ando and Modigliani use the Present Value criterion to represent expected income in the future. Therefore, the consumption of an individual can be expressed as follows:

If the present value of expected income increases, then consumption of that consumer will increase by a given proportion ( theta ) of that increase in income.

If the income distribution and age of the population are stable along with the constant taste and preferences of consumers, then the aggregate consumption function can simply be obtained by summation of all individual consumption functions.

Present Value of expected future income

Future income is unknown and cannot be measured directly. Therefore, the present value of expected income has to be estimated indirectly. Ando and Modigliani divided income into two types- income labour and income from assets, and estimated the present value variable as follows:

In an efficient capital market, we can assume that the present value of income from assets is equal to the value of assets in the current time period. Therefore, we can substitute the second element of the equation as:

In the case of the first element of income from labour, we know the labour income in the current period and can therefore separate current income from the present value of expected income.

Therefore, the above equation simply divides the expected future labour income by the average life remaining of the population in years to estimate an average expected labour income. From this equation, we have:

In this equation, Y e is the only unknown which is an estimate of average expected labour income.

Ando and Modigliani found that assuming this average expected labour income as a function of current labour income worked well and they stated this as:

This implies that if current income increases, people expect average future income to rise as well. The amount of this rise is determined by the proportion coefficient (beta), such that an increase in average expected income is a proportion of current labour income.

Hence, we can modify the PV 0 equation and the consumption function as follows:

This equation represents the consumption function associated with the life-cycle hypothesis. Every variable in this equation can be measured which allows empirical estimation of the consumption function.

cyclical fluctuation and long-run consumption: empirical results

The consumption function put forward by Ando and Modigliani can be used to carry out empirical analysis to understand the behaviour of consumption in the long run and the effect of business cycles on consumption.

Ando and Modigliani applied this consumption function to annual data of the United States. They obtained the following results:

The marginal propensity to consume from labour income is 0.7. This means that a $1 increase in labour income will lead to a $0.7 increase in consumption. Similarly, the marginal propensity to consume from assets is 0.06 implying that a $1 increase in assets (net worth of assets) will lead to a $0.06 increase in consumption.

Let us apply these results to the life cycle consumption function:

Positive coefficient beta suggests that with an increase in current labour income, the average expected labour income increases. As current labour income increases by $1, the average expected labour income increases by $0.25.

MPC and APC

This estimated consumption function has a slope of 0.7 or MPC, corresponding to the coefficient of Y t L . The intercept of the consumption function is equal to 0.06a t because assets remain the same in the short run. As seen in the figure, APC is falling with a rise in labour income and MPC<APC in the short run consumption function.

In the long run, however, assets will not be constant. With an increase in assets, the short-run consumption functions will keep shifting upwards as the economy grows. Therefore, long-run consumption will be along the trend where APC is constant and APC=MPC along this long-run consumption.

The APC will be constant if the share of labour income in total income ( Y t L / Y t ) and the ratio of total assets to total income (at / Yt) remain constant in the long run as the economy grows along the trend. Ando and Modigliani observed that both these ratios remained fairly constant in the long run in the annual U.S. data. The labour share in income was around 75 per cent and the ratio of assets to income was around 3. Therefore, the estimated APC is:

criticism of Life-cycle Hypothesis

The life cycle hypothesis assumes that everyone is a rational consumer aiming to maximize utility based on expected income. However, this may not be necessarily true because not everyone’s consumption decisions are based on future income. Some individuals may not even consider future outcomes while spending in the current period. Or they may be impulsive and lacking in self-control. And, they do not focus on having a smooth consumption over a long period.
The life-cycle hypothesis assumes that every increase in current income leads to an increase in average future expected income. This may not be true in every case because every income change will not necessarily affect expected future income. For instance, a temporary tax that changes current income, but, consumers are aware that it is temporary and they will not change their expected future income.

Nevertheless, life-cycle theory explains consumer behaviour across cross sections, short run as well as long run. Additionally, it takes into account the role of wealth or assets in determining consumption and can be empirically tested.

Permanent income hypothesis, types of inflation: meaning, causes and consequences, monetary policy: meaning, objectives and types, this post has 4 comments.

T is described as remaining years to life, then why is (T-1) remaining years to employment?

“T-1” is not defined as the remaining years to employment. In the formula, it is the remaining life expectancy of the population.

Sorry, I mistook this website for another one!

That’s alright 🙂

Graph and Example

Let’s consider Mark who must spend $500 each month on food and clothing. If his marginal propensity to consume is 0.7 and tax rate is 0.3, we can write his consumption function as follows:

$$ \text{C}=\text{\$500}+\text{0.7}\times\ \text{Y}\times(\text{1}-\text{0.3}) $$

If we plot the consumption function above, we get a straight-line which is generally considered a good approximation of reality.

The slope of the consumption equals the marginal propensity to consume.

Average Propensity to Consume (APC)

Average propensity to consume , the ratio of total consumption to total disposable income, can be worked out by dividing consumption with total income as follows:

$$ \text{APC}=\frac{\text{C}}{\text{Y} _ \text{D}}=\frac{\text{c} _ \text{0}}{\text{Y} _ \text{D}}+\text{MPC}\times\ \frac{\text{Y} _ \text{D}}{\text{Y} _ \text{D}}=\frac{\text{c} _ \text{0}}{\text{Y} _ \text{D}}+\text{MPC} $$

In case of Mark, the average propensity to consume (APC) curve decreases with increase in total income. It is 2.13 when disposable income is $350 and drops to 0.84 when disposable income is $3,500.

Even the basic Keynesian consumption function is useful for a broad level analysis, some other economists have proposed refinements to the consumption function. These refinements on based on the intuition that consumers factor in their future earnings and interest rate in deciding their consumption level today. Two important alternate consumption functions are based on (a) life cycle hypothesis and (b) permanent income hypothesis. The life-cycle hypothesis argues that consumption is a function of both wealth and income. The permanent income hypothesis, on the other hand, postulates that people base their consumption decision only income which they reasonably expect to continue in future and not on any transitory one-off income.

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Theory of the Consumption Function

Milton Friedman

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What is the exact nature of the consumption function? Can this term be defined so that it will be consistent with empirical evidence and a valid instrument in the hands of future economic researchers and policy makers? In this volume a distinguished American economist presents a new theory of the consumption function, tests it against extensive statistical J material and suggests some of its significant implications. Central to the new theory is its sharp distinction between two concepts of income, measured income, or that which is recorded for a particular period, and permanent income, a longer-period concept in terms of which consumers decide how much to spend and how much to save. Milton Friedman suggests that the total amount spent on consumption is on the average the same fraction of permanent income, regardless of the size of permanent income. The magnitude of the fraction depends on variables such as interest rate, degree of uncertainty relating to occupation, ratio of wealth to income, family size, and so on. The hypothesis is shown to be consistent with budget studies and time series data, and some of its far-reaching implications are explored in the final chapter.

"Friedman argued that the best way to make sense of saving and spending was not, as Keynes had done, to resort to loose psychological theorizing, but rather to think of individuals as making rational plans about how to spend their wealth over their lifetimes. This wasn't necessarily an anti-Keynesian idea—in fact, the great Keynesian economist Franco Modi-gliani simultaneously and independently made a similar case, with even more care in thinking about rational behavior, in work with Albert Ando. But it did mark a return to classical ways of thinking—and it worked. The details are a bit technical, but Friedman's 'permanent income hypothesis' and the Ando-Modigliani 'life cycle model' resolved several apparent paradoxes about the relationship between income and spending, and remain the foundations of how economists think about spending and saving to this day."—Paul Krugman, New York Times

"Friedman described Keynes's theory of a declining propensity to consume as 'very imaginative and thoughtful.' But in A Theory of the Consumption Function (1957), he demonstrated that while the hypothesis seemed to make psychological sense, it was empirically false. In relating income to propensity to consume, Keynes had erred in not distinguishing between 'transitory' and 'permanent' income. In fact, consumption does not decline as incomes generally rise. Economists across the political spectrum agreed with Friedman's refutation of Keynes."—James A. Nuechterlein, Commentary

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Life-Cycle Hypothesis

Tejvan Pettinger

The Life-cycle hypothesis was developed by Franco Modigliani in 1957. The theory states that individuals seek to smooth consumption over the course of a lifetime – borrowing in times of low-income and saving during periods of high income.

Graph shows individuals save from 20 to 65

As a student, it is rational to borrow to fund education.
Then during your working life, you pay off student loans and begin saving for your retirement.
This saving during working life enables you to maintain similar levels of income during your retirement.

It suggests wealth will build up in working age, but then fall in retirement

Wealth in the Life-Cycle Hypothesis

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
R = Years until retirement. Remaining years of work
T= Remaining years of life

It suggests for the whole economy consumption will be a function of both wealth and income.

The implication is that if we have an ageing population, with more people in retirement, then wealth/savings in the economy will be run down.

Prior to life-cycle theories, it was assumed that consumption was a function of income. For example, the Keynesian consumption function . saw a more direct link between income and spending.

However, this failed to account for how consumption may vary depending on the position in life-cycle.

Motivation for life-cycle consumption patterns

Diminishing marginal utility of income. If income is high during working life, there is a diminishing marginal utility of spending extra money at that particular time.
Harder to work and earn money, in old age. Life Cycle enables people to work hard and spend less.

Does the Life-cycle theory happen in reality?

Mervyn King suggests life-cycle consumption patterns can be found in approx 75% of the population. However, 20-25% don’t plan in the long term. (NBER paper on economics of saving )

Reasons for why people don’t smooth consumption over a lifetime.

Present focus bias – People can find it hard to value income a long time in the future
Inertia and status quo bias . Planning for retirement requires effort, forward thinking and knowledge of financial instruments such as pensions. People may prefer to procrastinate – even though they know they should save more – and so saving gets put off.

Criticisms of Life Cycle Theory

It assumes people run down wealth in old age, but often this doesn’t happen as people would like to pass on inherited wealth to children. Also, there can be an attachment to wealth and an unwillingness to run it down. See: Prospect theory and endowment effect.
It assumes people are rational and forward planning. Behavioural economics suggests many people have motivations to avoid planning. People may lack the self-control to reduce spending now and save more for future.
Life-cycle is easier for people on high incomes. They are more likely to have financial knowledge, also they have the ‘luxury’ of being able to save. People on low-incomes, with high credit card debts, may feel there is no disposable income to save.
Leisure. Rather than smoothing out consumption, individuals may prefer to smooth out leisure – working fewer hours during working age, and continuing to work part-time in retirement.
Government means-tested benefits for old-age people may provide an incentive not to save because lower savings will lead to more social security payments.

Other theories

Permanent income hypothesis of Milton Friedman – This states people only spend more when they see it as an increase in permanent income.
Ricardian Equivalence – consumers may see tax cuts as only a temporary rise in income so will not alter spending.
Autonomous consumption – In Keynesian consumption function, the level of consumption that is independent of income.
Marginal propensity to consume – how much of extra income is spent.

Life Cycle Hypothesis

Published on :

21 Aug, 2024

Blog Author :

Edited by :

Reviewed by :

Dheeraj Vaidya

What Is Life Cycle hypothesis?

The life cycle hypothesis refers to an economic theory focusing on how individuals spend and save money over their lifetimes. It motivates people to save for retirement during their earnings period instead of spending all their incomes.

In other words, people like to maintain the same level of expenditure throughout their life, either by taking credit or using their income. It forms a hump-shaped graph related to consumers' savings and consumption patterns. People spend money keeping in mind their future increase in income. However, individuals save less in youth, more in middle age, and very little in old age.

Life Cycle Hypothesis Of Consumption Explained

Life Cycle Hypothesis & Permanent Income Hypothesis

Life cycle hypothesis vs keynesian theory, frequently asked questions (faqs), recommended articles.

The life-cycle hypothesis is an economic theory about the constant maintenance level of consumption throughout their lifetime, even if it means getting a loan and going bankrupt at retirement.
Most people plan their retirement based on this theory. It is because they are well versed in economic studies during the three stages of life- youth for loan and expenditure, middle age for savings, and dissaving in retirement.
Life-Cycle Hypothesis and Permanent Income Hypothesis differ in the aspect of saving by people as in the former, and people tend to save and spend as per their demographics. In contrast, in the latter, it does not.
The life cycle hypothesis is criticized by many economists as its assumptions of constant consumption level and saving for self-consumption get contradicted in real life.

Life Cycle Hypothesis Of Consumption Explained

The life cycle hypothesis of consumption states that people plan their consumption upon a portion of their anticipated lifetime income. Therefore, according to the theory, researchers assume that at each stage of life on people's consumption level, one would experience no financial turmoil. Also, people do not save for future generations.

Italian-American economist Franco Modigliani propounded the life cycle hypothesis in 1954. Hence it was named the Modigliani life cycle hypothesis. However, his student, economist Richard Brumberg, also contributed to its development, for which both won Nobel Prizes in economics .

The life cycle hypothesis of consumption divides the life of a working employee into three stages: youth, middle-aged and old age. Expenditures at all stages depend on their future incomes. Each stage has special characteristics associated with earning , saving, and expenditure. These stages are discussed in the following table -


In this stage, individuals tend to consume and spend a lot. Hence, they earn more and like to take loans to maintain their lifestyle.	In this stage, people like to have stable finance for their families.	The income becomes zero, and dependency on pension and savings increases.
Their expenditure exceeds their income.	Here the expenditure remains the same, but their income gets increases.	They still try to maintain the level of expenditure as before.
Their savings become negative.	They manage to save some amount of money from their income after clearing all their debts.	All the savings get drawn, or dissaving occurs to maintain the expenditure with the risk of getting bankrupt.

Let us use the life cycle hypothesis graph to understand the concept.

In the above chart, one observes that to maintain the level of consumption and spending:

People take loans in the early earning stage.
People save from higher income, although they try to maintain the same spending level.
All the savings get spent on themselves, or dissaving happens at retirement.

Let us assume that Noah has a high-paying job with a multinational company . Early in their life, Noah took loans to shift from their native town to New York for their current job. Since Noah has to maintain high living standards, loans remain. However, Noah has planned to start saving once reaching the age of forty. Moreover, Noah has also planned to use all the saved funds for self-use without heeding the family's needs. Hence, Noah follows the life-cycle hypothesis theory.

Both theories deal with people's saving and spending habits and get called the permanent income hypothesis . But they remain different from each other in other aspects, as explained in the table below:

(LCH)
The life cycle hypothesis focuses more on savings motives.	This hypothesis does not focus on the motive for savings.
It tends to include wealth and income both for consumption functions.	It gets based on the expectations of individuals related to their savings.
LCH seems to focus on analytical aspects of wealth	PIH theory is more empirically oriented on income.
It takes into account the demographic factor of workers.	It does not take any demographic factors into account.
LCH theory has a fixed timeline: savings and consumptions happen only during an individual's lifetime.	PIH works on the infinite timeline of savings and consumptions for themselves and their heirs after they die.
People tend to save for own self.	People tend to save for own self and their offspring as well.
It got formulated in 1954.	It got formulated in 1957.

Although researchers repeatedly proved this theory right, it still gets criticized for the assumptions it employs. Let us study the criticism of the life cycle hypothesis by an economist in the following list:

The theory fails to account for celebrities with sporadic income that tend to end up bankrupt due to financial windfalls.
It also wrongly assumes that individuals try to maintain all their spending habits even if they have to take loans.
It advocates that people only like to save and spend for themselves.
It also supposes that the saving timeline will remain infinite.

The Life Cycle theory supplanted an earlier theory created by economist John Maynard Keynes in 1937. Keynes thought that saving was merely another good and that as people's wages increased, so would the percentage they set aside for savings. It suggested that as a country's earnings increased, a savings glut would arise, and as a result, aggregate demand and economic growth would stagnate.

Another issue is that Keynes' theory ignores changes in people's purchasing patterns over time. For instance, a middle-aged person who is the leader of a household will consume more than a retiree. The life cycle hypothesis theory has issues, even though subsequent research has typically backed it.

It was propounded jointly by Franco Modigliani and his student Richard Brumberg in 1954. They also got a Nobel prize for LCH theory.

The life-cycle hypothesis gets affected by the demographics, savings habits, and consumption levels of people during their lifetime.

It is an economic hypothesis that people get supposed to maintain their consumption habits all their lifetime, even if it means taking a loan in youth, saving in middle age, and dissaving in old age.

This article has been a guide to what is Life Cycle Hypothesis. Here, we explain it with graph, criticism, example and compare it with permanent income hypothesis. You can learn more about it from the following articles –

Permanent Income Hypothesis
Autonomous Consumption
Market Efficiency

Top 4 Types of Hypothesis in Consumption (With Diagram)

The following points highlight the top four types of Hypothesis in Consumption. The types of Hypothesis are: 1. The Post-Keynesian Developments 2. The Relative Income Hypothesis 3. The Life-Cycle Hypothesis 4. The Permanent Income Hypothesis.

Hypothesis Type # 1. The Post-Keynesian Developments:

Data collected and examined in the post-Second World War period (1945-) confirmed the Keynesian consumption function.

Time series data collected over long periods showed that the relation between income and consumption was different from what cross-section data revealed.

In the short run, there was a non-proportional relation between income and consumption. But in the long run the relation was proportional. By constructing new aggregate data on consumption and income from 1869 and examining the same, Simon Kuznets discovered that the ratio of consumption to income was fairly stable from decade to decade, despite large increases in income over the period he studied.

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This contradicted Keynes’ conjecture that the average propensity to consume would fall with increases in income. Kuznets’ findings indicated that the APC is fairly constant over long periods of time. This fact presented a puzzle which is illustrated in Fig. 17.10.

Studies of cross-section (household) data and short time series confirmed the Keynesian hypothesis — the relationship between consumption and income, as indicated by the consumption function C s in Fig. 17.10.

But studies of long time series found that APC did not vary systematically with income, as is shown by the long-run consumption function C L . The short-run consumption function has a falling APC, whereas the long-run consumption function has a constant APC.

Subsequent research on consumption attempted to explain how these two consumption functions could be consistent with each other.

Various attempts have been made to reconcile these conflicting evidences. In this context mention has to be made of James Duesenberry (who developed the relative income hypothesis), Ando, Brumberg and Modigliani (who developed the life cycle hypothesis of saving behaviour) and Milton Friedman who developed the permanent income hypothesis of consumption behaviour.

All these economists proposed explanations of these seemingly contradictory findings. These hypotheses may now be discussed one by one.

Hypothesis Type # 2. The Relative Income Hypothesis :

In 1949, James Duesenberry presented the relative income hypothesis. According to this hypothesis, saving (consumption) depends on relative income. The saving function is expressed as S t =f(Y t / Y p ), where Y t / Y p is the ratio of current income to some previous peak income. This is called relative income. Thus current consumption or saving is not a function-of current income but relative income.

Duensenberry pointed out that during depression when income falls consumption does not fall much. People try to protect their living standards either by reducing their past savings (or accumulated wealth) or by borrowing.

However as the economy gradually moves initially into the recovery and then in to the prosperity phase of the business cycle consumption does not rise even if income increases. People use a portion of their income either to restore the old saving rate or to repay their old debt.

Thus we see that there is a lack of symmetry in people’s consumption behaviour. People find it more difficult to reduce their consumption level than to raise it. This asymmetrical behaviour of consumers is known as the ratchet effect.

Thus if we observe a consumer’s short-run behaviour we find a non-proportional relation between income and consumption. Thus MPC is less than APC in the short run, as Keynes’s absolute income hypothesis has postulated. But if we study a consumer’s behaviour in the long run, i.e., over the entire business cycle we find a proportional relation between income and consumption. This means that in the long run MPC = APC.

Hypothesis Type # 3. The Life-Cycle Hypothesis :

In the late 1950s and early 1960s Franco Modigliani and his co-workers Albert Ando and Richard Brumberg related consumption expenditure to demography. Modigliani, in particular, emphasised that income varies systematically over peoples’ lives and that saving allows consumers to move income from early years of earning (when income is high) to later years after retirement when income is low.

This interpretation of household consumption behaviour forms the basis of his life-cycle hypothesis.

The life cycle hypothesis (henceforth LCH) represents an attempt to deal with the way in which consumers dispose off their income over time. In this hypothesis wealth is assigned a crucial role in consumption decision. Wealth includes not only property (houses, stocks, bonds, savings accounts, etc.) but also the value of future earnings.

Thus consumers visualise themselves as having a stock of initial wealth, a flow of income generated by that wealth over their lifetime and a target (which may be zero) as their end-of-life wealth. Consumption decisions are made with the whole series of financial flows in mind.

Thus, changes in wealth as reflected by unexpected changes in flow of earnings or unexpected movements in asset prices would have an impact on consumers’ spending decisions because they would enhance future earnings from property, labour or both. The theory has empirically testable implications for the relation between saving and age of a person as also for the role of wealth in influencing aggregate consumer spending.

The Hypothesis :

The main reason that an individual’s income varies is retirement. Since most people do not want their current living standard (as measured by consumption) to fall after retirement they save a portion of their income every year (over their entire service period). This motive for saving has an important implication for an individual’s consumption behaviour.

Suppose a representative consumer expects to live another T years, has wealth of W, and expects to earn income Y per year until he (she) retires R years from now. What should be the optimal level of consumption of the individual if he wishes to maintain a smooth level of consumption over his entire life?

The consumer’s lifetime endowments consist of initial wealth W and lifetime earnings RY. If we assume that the consumer divides his total wealth W + RY equally among the T years and wishes to consume smoothly over his lifetime then his annual consumption will be:

C = (W + RY)/T … (5)

This person’s consumption function can now be expressed as

C = (1/T)W + (R/T)Y

If all individuals plan their consumption in the same way then the aggregate consumption function is a replica of our representative consumer’s consumption function. To be more specific, aggregate consumption depends on both wealth and income. That is, the aggregate consumption function is

C = αW + βY …(6)

where the parameter α is the MPC out of wealth, and the parameter β is the MPC out of income.

Implications :

Fig. 17.11 shows the relationship between consumption and income in terms of the life cycle hypothesis. For any initial level of wealth w, the consumption function looks like the Keynesian function.

But the intercept αW which shows what would happen to consumption if income ever fell to zero, is not a constant, as is the term a in the Keynesian consumption function. Instead the intercept αW depends on the level of wealth. If W increases; the consumption line will shift upward parallely.

So one main prediction of the LCH is that consumption depends on wealth as well as income, as is shown by the intercept of the consumption function.

Solving the consumption puzzle:

The LCH can solve the consumption puzzle in a simple way.

According to this hypothesis, the APC is:

C/Y = α(W/Y) + β … (7)

Since wealth does not vary proportionately with income from person to person or from year to year, cross-section data (which show inter-individual differences in income and consumption over short periods) reveal that high income corresponds to a low APC. But in the long run, wealth and income grow together, resulting in a constant W/Y and a constant APC (as time-series show).

If wealth remains constant as in the short run the life cycle consumption function looks like the Keynesian consumption function, consumption function shifts upward as shown in Fig. 17.12. This prevents the APC from falling as income increases.

This means that the short-run consumption income relation (which takes wealth as constant) will not continue to hold in the long run when wealth increases. This is how the life cycle hypothesis (LCH) solves the consumption puzzle posed by Kuznets’ studies.

Other Predictions :

Another important prediction made by the LCH is that saving varies over a person’s lifetime. The LCH helps to link consumption and savings with the demographic considerations, especially with the age distribution of the population.

The MPC out of life-time income changes with age. If a person has no wealth at the beginning of his service life, then he will accumulate wealth over his working years and then run down his wealth after his retirement. Fig. 17.13 shows the consumer’s income, consumption and wealth over his adult life.

Consumption, Income and Welath Over the Life Cycle

If a consumer smoothest consumption over his life (as indicated by the horizontal consumption line), he will save and accumulate wealth during his working years and then dissave and run down his wealth after retirement. In other words, since people want to smooth consumption over their lives, the young — who are working — save, while the old — who have retired — dissave.

In the long run the consumption-income ratio is very stable, but in the short run it fluctuates. The life cycle approach explains this by pointing out that people seek to maintain a smooth profile of consumption even if their lifetime income flow is uneven, and thus emphasises the role of wealth in the consumption function.

Theory and Evidence: Do Old People Dissave?

Some recent findings present a genuine problem for the LCH. Old people are found not to dissave as much as the hypothesis predicts. This means that the elderly do not reduce their wealth as fast as one would expect, if they were trying to smooth their consumption over their remaining years of life.

Two reasons explain why the old people do not dissave as much as the LCH predicts:

(i) Precautionary saving:

The old people are very much concerned about unpredictable expenses. So there is some precautionary motive for saving which originates from uncertainty. This uncertainty arises from the fact that old people often live longer than they expect. So they have to save more than what an average span of retirement would warrant.

Moreover uncertainty arises due to the fact that the medical expenses of old people increase faster than their age. So some sort of Malthusian spectre is found to be operating in this case. While an old person’s age increases at an arithmetical progression his medical expenses increase in geometrical progression due to accelerated depreciation of human body and the stronger possibility of illness.

The old people are likely to respond to this uncertainty by saving more in order to be able to overcome these contingencies.

Of course, there is an offsetting consideration here. Due to the spread of health and medical insurance in recent years old people can protect themselves against uncertainties about medical expenses at a low cost (i.e., just by paying a small premium).

Now-a-days various insurance plans are offered by both government and private agencies (such as Medisave, Mediclaim, Medicare, etc.). Of course, the premium rate increases with age. As a result the old people are required to increase their saving rate to fulfill their contractual obligations.

However, to protect against uncertainty regarding lifespan, old people can buy annuities from insurance companies. For a fixed fee, annuities offer a stream of income over the entire life span of the recipient.

(ii) Leaving bequests:

Old people do not dissave because they want to leave bequests to their children. The reason is that they care about them. But altruism is not really the reason that parents leave bequests. Parents often use the implicit threat of disinheritance to induce a desirable pattern of behaviour so that children and grandchildren take more care of them or be more attentive.

Thus LCH cannot fully explain consumption behaviour in the long run. No doubt providing for retirement is an important motive for saving, but other motives, such as precautionary saving and bequest, are no less important in determining people’s saving behaviour.

Another explanation, which differs in details but entirely shares the spirit of the life cycle approach is the permanent income hypothesis of consumption. The hypothesis, which is the brainchild of Milton Friedman, argues that people gear their consumption behaviour to their permanent or long term consumption opportunities, not to their current level of income.

An individual does not plan consumption within a period solely on the basis of income within the period; rather, consumption is planned in relation to income over a longer period. It is to this hypothesis that we turn now. We may now turn to Friedman’s permanent income hypothesis, which suggests an alternative explanation of long-run income-consumption relationship.

Hypothesis Type # 4. The Permanent Income Hypothesis :

Milton Friedman’s permanent income hypothesis (henceforth PIH) presented in 1957, complements Modigliani’s LCH. Both the hypotheses argue that consumption should not depend on current income alone.

But there is a difference of insight between the two hypotheses while the LCH emphasises that income follows a regular pattern over a person’s lifetime, the PIH emphasises that people experience random and temporary changes in their incomes from year to year.

The PIH, Friedman himself claims, ‘seems potentially more fruitful and in some measure more general” than the relative income hypothesis or the life-cycle hypothesis.

The idea of consumption spending that is geared to long-term average or permanent income is essentially the same as the life cycle theory. It raises two further questions. The first concerns the precise relationship between current consumption and permanent income. The second question is how to make the concept of present income operational, that is how to measure it.

The Basic Hypothesis :

According to Friedman the total measured income of an individual Y m has two components : permanent income Y p and transitory income Y t . That is, Y m – Y p + Y t .

Permanent income is that part of income which people expect to earn over their working life. Transitory income is that part of income which people do not expect to persist. In other words, while permanent income is average income, transitory income is the random deviation from that average.

Different forms of income have different degrees of persistence. While adequate investment in human capital (expenditure on training and education) provides a permanently higher income, good weather provides only transitorily higher income.

The PIH states that current consumption is not dependent solely on current disposable income but also on whether or not that income is expected to be permanent or transitory. The PIH argues that both income and consumption are split into two parts — permanent and transitory.

A person’s permanent income consists of such things as his long term earnings from employment (wages and salaries), retirement pensions and income derived from possessions of capital assets (interest and dividends).

The amount of a person’s permanent income will determine his permanent consumption plan, e.g., the size and quality of house he buys and, thus, his long term expenditure on mortgage repayments, etc.

Transitory income consists of short-term (temporary) overtime payments, bonuses and windfall gains from lotteries or stock appreciation and inheritances. Negative transitory income consists of short-term reduction in income arising from temporary unemployment and illness.

Transitory consumption such as additional holidays, clothes, etc. will depend upon his entire income. Long term consumption may also be related to changes in a person’s wealth, in particular the value of house over time. The economic significance of the PIH is that the short run level of consumption will be higher or lower than that indicated by the level of current disposable income.

According to Friedman consumption depends primarily on permanent income, because consumers use saving and borrowing to smooth consumption in response to transitory changes in income. The reason is that consumers spend their permanent income, but they save rather than spend most of their transitory income.

Since permanent income should be related to long run average income, this feature of the consumption function is clearly in line with the observed long run constancy of the consumption income ratio.

Let Y represent a consumer unit’s measured income for some time period, say, a year. This, according to Friedman, is the sum of two components : a permanent component (Y p ) and a transitory component (Y t ), or

Y = Y P + Y t …(8)

The permanent component reflects the effect of those factors that the unit regards as determining its capital value or wealth the non-human wealth it owns, the personal attributes of the earners in the unit, such as their training, ability, personality, the attributes of the economic activity of the earners, such as the occupation followed, the location of the economic activity, and so on.

The transitory component is to be interpreted as reflecting all ‘other’ factors, factors that are likely to be treated by the unit affected as ‘accident’ or ‘chance’ occurrences, for example, illness, a bad guess about when to buy or sell, windfall or chance gains from race or lotteries and so on. Permanent income is some sort of average.

Transitory income is a random variable. The difference between the two depends on how long the income persists. In other words, the distinction between the two is based on the degree of persistence. For example education gives an individual permanent income but luck — such as good weather — gives a farmer transitory income.

It may also be noted that permanent income cannot be zero or negative but transitory income can be.

Suppose a daily wage earner falls sick for a day or two and may not earn anything. So his transitory income is zero. Similarly if an individual sales a share in the stock exchange at a loss his transitory income is negative. Finally permanent income shows a steady trend but transitory income shows wide fluctuation(s).

Similarly, let C represent a consumer unit’s expenditures for some time period. It is also the sum of a permanent component (C p ) and a transitory component (C t ), so that

C = C p + C t … (9)

Some factors producing transitory components of consumption are: unusual sickness, a specifically favourable opportunity to purchase and the like. Permanent consumption is assumed to be the flow of utility services consumed by a group over a specific period.

The permanent income hypothesis is given by three simple equations (8), (9) and (10):

Y = Y p + Y t …(8)

C – C p + C t …(9)

C p = kY p , where k = f (r, W, u) …(10)

Here equation (6) defines a relation between permanent income and permanent consumption. Friedman specifies that the ratio between them is independent of the size of permanent income, but does depend on other variables in particular: (i) the rate of interest (r) or sets of rates of interest at which the consumer unit can borrow or lend; (ii) the relative importance of property and non-property income, symbolised by the ratio of non-human wealth to income (W) (iii) the factors symbolised by the random variable u determining the consumer unit’s tastes and preference for consumption versus additions to wealth. Equations (8) and (9) define the connection between the permanent components and the measured magnitudes.

Friedman assumes that the transistory components of income and consumption are uncorrelated with one another and with the corresponding permanent components, or

P ytyp = P ctcp = P ytct = 0 …(11)

where p stands for the correlation coefficient between the variables designated by the subscripts. The assumption that the third component in equation (11) — between the transitory components of income and consumption — is zero is indeed a strong assumption.

As Friedman says:

“The common notion that savings,…, are a ‘residue’ speaks strongly for the plausibility of the assumption. For this notion implies that consumption is determined by rather long-run considerations, so that any transitory changes in income lead primarily to additions to assets or to the use of previously accumulated balances rather than to corresponding changes in consumption.”

In Fig. 17.14 we consider the consumer units with a particular measured income, say which is above the mean measured income for the group as a whole — Y’. Given zero correlation between permanent and transitory components of income, the average permanent income of those units is less than Y 0 ; that is, the average transitory component is positive.

The average consumption of units with a measured income Y 0 is, therefore, equal to their average permanent consumption. In Friedman’s hypothesis this is k times their average permanent income.

If Y 0 were not only the measured income of these units but also their permanent income, their mean consumption would be Y 0 or Y 0 E. Since their mean permanent income is less than their measured income (i.e., the transitory component of income is positive), their average consumption, Y 0 F, is less than Y 0 E.

By the same logic, for consumer units with an income equal to the mean of the group as a whole, or Y, the average transitory component of income as well as of consumption is zero, so the ordinate of the regression line is equal to the ordinate of the line 0E which gives the relation between Y p and C p .

For units with an income below the mean, the average transitory component of income is negative, so average measured consumption (CC”) is greater than the ordinate of 0E (BC’). The regression line (C = a + bY), therefore, intersects 0E at D, is above it to the left of D, and below it to the right of D.

If k is less than unity, permanent consumption is always less than permanent income. But measured consumption is not necessarily less than measured income. The line OH is a 45° line along which C = Y.

The vertical distance between this line and IF is average measured savings. Point J is called the ‘break-even’ point at which average measured savings are zero. To the left of J, average measured savings are negative, to the right, positive; as measured income increases so does the ratio of average measured savings to measured income.

Friedman’s hypothesis thus yields a relation between measured consumption and measured income that reproduces the broadest features of the corresponding regressions that have been computed from observed data. The point is that consumption expenditures seem to be proportional to disposable income in the long run.

In the short run, on the other hand, the consumption-income ratio fluctuates considerably. In sum, current consumption is related to some long-run measure of income (e.g., permanent income) while short-run fluctuations in income tend primarily to affect the level of saving.

Estimating Permanent Income :

Dornbusch and Fischer have defined permanent income as “the steady rate of consumption a person could maintain for the rest of his or her life, given the present level of wealth and income earned now and in the future.”

One might estimate permanent income as being equal to last year’s income plus some fraction of the change in income from last year to this year:

Sumit Agarwal 4 ,
Wenlan Qian 4 &
Ruth Tan 4

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According to the Keynesian consumption function, household spending is wholly determined by current income. Permanent Income Hypothesis and the Life Cycle Hypothesis, however, theorize that households plan their consumption based on long-term income expectations. These standard consumption models have been augmented to include imperfections in the financial market such as liquidity constraints, precautionary saving, income uncertainty, lifetime uncertainty, bequest motive, intertemporal non-separability, intratemporal non-separability as well as behavioral factors such as mental accounting, hyperbolic preferences and social influences.

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Consumption
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Life-Cycle Hypothesis

Motivation for life-cycle consumption patterns

Does the Life-cycle theory happen in reality?

Criticisms of Life Cycle Theory

Other theories

15 thoughts on “Life-Cycle Hypothesis”

What Is the Life-Cycle Hypothesis (LCH)?

What Is the Life-Cycle Hypothesis in Economics?

Key Takeaways

Life-cycle hypothesis: Ando and Modigliani

MPC < APC in cross-sections

APC and MPS at different age

consumption function of Life-Cycle Hypothesis

Present Value of expected future income

cyclical fluctuation and long-run consumption: empirical results

MPC and APC

criticism of Life-cycle Hypothesis

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Life-Cycle Hypothesis

Motivation for life-cycle consumption patterns

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Criticisms of Life Cycle Theory

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Life Cycle Hypothesis

What Is Life Cycle hypothesis?

Table of contents

Life Cycle Hypothesis & Permanent Income Hypothesis

Life Cycle Hypothesis Of Consumption Explained

Top 4 Types of Hypothesis in Consumption (With Diagram)

Hypothesis Type # 1. The Post-Keynesian Developments:

Hypothesis Type # 2. The Relative Income Hypothesis :

Hypothesis Type # 3. The Life-Cycle Hypothesis :

The Hypothesis :

Implications :

Theory and Evidence: Do Old People Dissave?

Hypothesis Type # 4. The Permanent Income Hypothesis :

The Basic Hypothesis :

Estimating Permanent Income :

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