Life cycle

 

In the early 1950s, Franco Modigliani and his student, Richard Brumberg, developed a theory based on the observation that people make consumption decisions based both on resources available to them over their lifetime, and on their current life stage. Modigliani and Brumberg observed that individuals build up assets at the initial stages of their working lives. Later on during retirement, they make use of their stock of assets. The working people save up for their post-retirement lives and alter their consumption patterns according to their needs at different stages of their lives.
While based on an examination of individual behaviour, this theory provided important predictions for the economy as a whole. It predicts that the aggregate saving of a country is dependent on the rate of growth of national income, not its level. Also, the stock of wealth in an economy is related to the length of retirement span. Although there were initially many challenges to this theory of consumption, its relevance in economic thinking has been recently acknowledged.
We now consider the situation where population is stationary but average income earned at each age, and hence, aggregate income rises continuously over time due to increasing productivity. This also tends to lead to a positive rate of saving and a growing stock of wealth. This is because each successive cohort enjoys earning greater than the preceding cohorts, and thus a large level of consumption at each age—since, by assumption, the allocation of consumption over life remains unchanged in time. Moreover, this implies that the currently working generation will aim for a level of consumption in their post-retirement years larger than the consumption enjoyed by the currently retired individuals belonging to a less affluent generation. To support this future level of consumption post-retirement, the working individuals must save currently on a scale higher than the dissaving of the retired households. Hence even if population is stationary, net aggregate saving tends to be positive.
The findings of many economists bring out a problem in the life-cycle model. It was found out that the elderly do not dissave as quickly as has been said in the model. There are two explanations for the aforementioned behaviour of the elderly.
The first explanation is that the retired individuals are cautious about unpredictable expenses. The additional saving that arises due to this behaviour is called precautionary saving. Precautionary saving may be made for the probable event of living longer than expected and hence having to provide for a longer than the planned span of retirement. Another rational reason is possibility of ill-health and huge medical expenses. These probable events make the elderly save more.
The second explanation is that the elderly may save more so they can leave bequests to their children. This discourages dissaving at the expected rate.
Overall research on the retired section of the society show that the life-cycle model cannot completely explain consumer behaviour. Providing for retirement is an important reason for dissaving. However precautionary saving and bequests are also important.