Life cycle hypothesis

In economics, the life-cycle hypothesis (LCH) is a model that strives to explain the consumption patterns of individuals.

The life-cycle hypothesis suggests that individuals plan their consumption and savings behaviour over their life-cycle. They intend to even out their consumption in the best possible manner over their entire lifetimes, doing so by accumulating when they earn and dis-saving when they are retired. The key assumption is that all individuals choose to maintain stable lifestyles. This implies that they usually don't save up a lot in one period to spend furiously in the next period, but keep their consumption levels approximately the same in every period.

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.

Assume that there is a consumer who expects to live for another T years and has wealth of W. The consumer also expects to annually earn income Y until he retires R years from now. In this situation, the consumer's resources over his lifetime consist both of his initial wealth endowment, W, and of his lifetime earnings, RY. Note that the interest rate is assumed to be zero. If the interest rate were positive, we would have to account for the interest earned on savings.

The consumer can distribute his lifetime resources over the remaining T years of his life. He divides W + RY equally among T years and in each year he consumes

The consumption function of this person can be written as

If every individual in the economy plans consumption in this manner, then the aggregate consumption function will be quite similar to the individual one. Thus, the aggregate consumption function of the economy is

where a is the marginal propensity to consume for wealth and b is the marginal propensity to consume for income.

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