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Unformatted text preview: Life Cycle Theory of Consumption C o n s u m p tio n M a x im u m
W e a lth
S a v in g s C
D is s a v in g s T im e R e tir e D ie Franco Modigliani’s Life Cycle Theory of Consumption is based on the simple
idea that people would prefer to even out consumption over their lifetime rather
than have some periods where they are flush with cash and other periods where
they are starving in the streets.
The graph above takes this idea to the extreme and keeps the level of
consumption (at C bar) the same over your lifetime. During the years you are
working, you save money. When you retire, you live off your savings until you
die. The day you die the amount of money you have left is zero.
It is easy to make this model more realistic by including the fact that money earns
interest, that people have wealth from sources other than labor income, and that
people want to leave money to the kids. In reality some of the more difficult
problems for people involve estimating how their personal income will change
over time, when they will retire, when they will die, and the return that will be
earned on savings. Also the future of Government provided Social Security and
health care seems uncertain. Nonetheless, the basic idea that people want to
smooth out their consumption over their lifetime appears to be correct. 1 When you have a theory about consumption, you also at the same time have a
theory about saving because by definition people either save or consume their
income. Savings are vital for the growth of the economy over time. The life cycle
theory has served as a framework for evaluating the implications for the economy
of changes in the age distribution of the population, changes in retirement ages,
and changes in public programs such as social security. 2 ...
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This note was uploaded on 04/04/2012 for the course ECON 200H taught by Professor Staff during the Winter '11 term at Ohio State.
- Winter '11