3.3 - life cycle hypothesis (aggregate demand)

franco modigliani, 1957

individuals ____ consumption over their lifetime

smooth

individuals ____ in times of low income

borrow

individuals ____ in times of high income

save

students

• borrow (via student loans) to fund education

working aged individuals

• start saving to buy big ticket items

• save for retirement (health problems, maintaining standards of living)

• diminishing marginal utility of spending extra money (decreased desire to spend more money)

retirees

• have stopped work

• use/aquire wealth

• wealth accrues (increases) over time

• wealth effect (spending confidence)

• some assets decline, so they get sold (to keep smooth consumption)

how many people in the UK don’t plan in the long term?

20-25%

life cycle hypothesis limits: assumes rationality

• sometimes we act irrationally

• don’t consider the future

life cycle hypothesis limits: inertia/info failure

• takes effort to plan retirement

• you must be forward thinking/not procrastinate

• people may not know consider financial info regarding retirement

life cycle hypothesis limits: present focus bias

• people only focus on the present

• find it hard to value income in the long term/prep for the future

life cycle hypothesis limits: unwillingness to run down wealth

• don’t want to sell declining assets

• due to sentimentality, illiquidity (dirty house), or would like to leave as inheritance

factors affecting life cycle hypothesis: high vs low income

• high income may have financial knowledge

• they use theories to plan

• low income may not have financial knowledge/enough income to smooth consumption

factors affecting life cycle hypothesis: developed vs developing economies

• developed economies have means-tested benefits (welfare) → don’t save

• developing economies don’t have these scemes, they MUST save. they can find this theory useful