Life cycle income hypothesis

macroeconomics

1. Life cycle income hypothesis By: Amrina abid

2. Introduction In a series of paper written in 1950 Franco Modigliani and his collaborators Albert and Richard Brumberg used fisher’s model consumer behavior to study the consumption function. This theory emphasizes that the consumer and save out of the total life income and plan to provide for the retirement.

3. Definiton Life cycle hypothesis asserts that savings and consumption decisions of household reflect a plan for an optimal consumption pattern over their lifetime, subject to the constraint of their resources. We can also define this hypothesis as: “the theory of consumption that emphasizes the role of savings and borrowing and transferring resources from those time in life when income is high to those time when income is low such as from working years to retirement”.

4. Main theme This theory of consumption by modgiliani explains the fact that consumption of a person in a time period(t) depends upon the current income and future income. C t =f( P y ,P t ) Y t = current income P y = present value of future income C t = consumption in a time period

5. Important characteristics In this theory Modiglianis introduced a new element. This new element is “ AGE OF CONSUMER UNIT” According to this theory person’s life divided into three stages

6. Explanation These stages are childhood, middle age, old age. Consumption rises gradually, income rises sharply over the early working years peaks and decline, especially with the retirement. The pattern of consumption and income is result in dissaving in the early years and late stage of life cycle. And in the middle years, income high and consumption is low which results positive saving.

7. Short run consumption function (SRCF) SRCF shows a non proportional relationship between consumption and income. The value of MPC is less than APC. General form: C= C o +C y

8. Long run consumption function (LRCF) LRCF shows a proportional relationship between income and consumption. The value of APC remains constant and equal to MPC. The value of APC is less than 1.

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