CONSUMPTION AND SAVING
1.a. According to the life-cycle theory of consumption, people try to maintain a fairly stable consumption
path over their lifetime. Individuals save during their working years so they can keep up the same
consumption stream after they retire. This implies that wealth increases steadily until retirement while
consumption remains stable. We should therefore expect the ratio of consumption to accumulated
saving (wealth) to decrease over time up to retirement.
1.b. After retirement, wealth is used up to finance consumption during the remaining years. Therefore the
ratio of consumption to accumulated saving (wealth) increases again after retirement, eventually
2.a. Suppose that you and your neighbor both work the same number of years until retirement and you
both have the same annual income. If your neighbor is in bad health and does not expect to live as
long as you do, she will expect to have fewer retirement years in which to use accumulated wealth to
finance a steady consumption stream. Your neighbor's goal for retirement saving will not be as high
as yours, and compared to you, she will have a higher level of consumption over her working years.
Since planned annual consumption (C) is determined by the number of working years (WL), the
number of years to live (NL), and income from labor (YL), we get the equation:
C = [(WL)/(NL)](YL).
WL and YL are the same for you and your neighbor, but NL is smaller for your neighbor. Therefore
you will have a lower level of consumption (C).
(Note: Students may come up with a variety of different answers. For one, your neighbor, who is
in bad health, currently has much larger medical bills than you do. Therefore she may not be able to
save as much for retirement, even if she might expect to live as long as you. On the other hand, she
may not have large medical bills now, but expects them later, as she gets older. This may induce her
to save more now. While such arguments are valid, instructors should point out that the answer
should be related to the life-cycle theory.)
2.b. If we assume for simplicity that the rate of return on Social Security is the same as the rate of return
on private saving, then the introduction of a Social Security system based on a trust fund should not
have any effect on your level of consumption. Social Security may be considered a form of "forced
saving," since you are forced to pay Social Security taxes during your working years and will, in
return, receive benefits during your retirement years. However, most likely you would have
voluntarily saved as much as the government is now “forcing” you to save with levying a Social
Security tax. Therefore your consumption behavior will not change. Still, the levying of a Social
Security tax reduces disposable income during your working years, increasing the ratio of
consumption to disposable income (the average propensity to consume). If private saving were simply
replaced with government saving, national saving would not be affected.