Life-cycle hypothesis

The life-cycle hypothesis presents a well-defined linkage between the consumption plans of an individual and her income and income expectations as she passes from childhood, through the work participating years, into retirement and eventual decease. Early attempts to establish such a linkage were made by Irving Fisher (1930) and again by Harrod (1948) with his notion of hump saving, but a sharply defined hypothesis which carried the argument forward both theoretically and empirically with its range of well-specified tests for cross-section and time series evidence was first advanced by Modigliani & Brumberg (1954). Both their paper and advanced copies of the permanent income theory of Milton Friedman (1957) were circulating in 1953. Both the Modigliani-Brumberg and the Friedman theories are referred to as life-cycle theories.

The main building block of life-cycle models is the saving decision, i.e., the division of income between consumption and saving. The saving decision is driven by preferences between present and future consumption (or the utility derived from consumption). Given the income stream the household receives over time, the sequence of optimal consumption and saving decisions over the entire life can be computed. Note that the standard life-cycle model as presented here is firmly grounded in expected utility theory and assumes rational behavior.

The typical shape of the income profile over the life cycle starts with low income during the early years of the working life, then income increases until a peak is reached before retirement, while pension income during retirement is substantially lower. To make up for the lower income during retirement and to avoid a sharp drop in utility at the point of retirement, individuals will save some fraction of their income during their working life and dissave during retirement. This results in a hump-shaped savings profile over the life cycle – the main prediction of the life-cycle theory.

Unfortunately, this prediction does not hold in actual household behavior. It is fair to say the reasons for this failure of the simple life-cycle model are still not understood. Rodepeter & Winter (1998) provide empirical evidence for Germany and discuss some extensions of the life-cycle model that might help to understand actual savings behavior. An important direction of current research tries to apply elements of behavioral economics to life-cycle savings decisions.

Continue to: Life-cycle hypothesis: a review of the literature

See also: saving, consumption, income, intertemporal decisions, retirement decisions

Literature: Fisher (1987), Modigliani & Brumberg (1954), Rodepeter & Winter (1998)

Entry by: Ralf Rodepeter and Joachim Winter

June 17, 1999
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