write a short note on life cycle hypothesis

Quickonomics

Life-Cycle Hypothesis (Lch)

Definition of life-cycle hypothesis (lch).

The Life-Cycle Hypothesis (LCH) is an economic theory that suggests individuals base their consumption and savings decisions on their expected lifetime income rather than their current income. According to the LCH, individuals strive to maintain a stable standard of living throughout their lifetime by adjusting their savings and consumption patterns. This hypothesis takes into account the different stages of life, such as education, working years, and retirement, and assumes individuals plan and save accordingly for these stages.

To illustrate the Life-Cycle Hypothesis, let’s consider two individuals: Alan, a young professional just starting his career, and Sarah, a retiree. Alan expects his income to increase significantly over time as he gains experience and advances in his profession. To maintain a stable standard of living, he saves a portion of his income during his early working years, which allows him to enjoy a more comfortable retirement.

On the other hand, Sarah has already retired and relies on savings and pensions for her income. Since she is no longer earning a salary, her consumption decreases to meet her reduced income. She draws from her accumulated savings to support her lifestyle in retirement.

Throughout their lives, both Alan and Sarah make consumption and savings decisions based on their expected lifetime income, adjusting their behavior accordingly.

Why the Life-Cycle Hypothesis Matters

The Life-Cycle Hypothesis provides a framework for understanding individuals’ consumption and savings patterns over their lifetimes. It emphasizes the importance of long-term financial planning and highlights the trade-off between current consumption and saving for the future.

Understanding the Life-Cycle Hypothesis is useful for policymakers, financial planners, and individuals themselves. Policymakers can design policies and programs that support retirement savings and encourage long-term financial stability. Financial planners can help individuals develop strategies to achieve their desired lifestyles in retirement. Lastly, individuals can benefit from understanding their own consumption patterns and making informed decisions about savings and retirement planning.

To provide the best experiences, we and our partners use technologies like cookies to store and/or access device information. Consenting to these technologies will allow us and our partners to process personal data such as browsing behavior or unique IDs on this site and show (non-) personalized ads. Not consenting or withdrawing consent, may adversely affect certain features and functions.

Click below to consent to the above or make granular choices. Your choices will be applied to this site only. You can change your settings at any time, including withdrawing your consent, by using the toggles on the Cookie Policy, or by clicking on the manage consent button at the bottom of the screen.

Search Search Please fill out this field.
Financial Planning

What Is the Life-Cycle Hypothesis?

The Life-Cycle Hypothesis Explained

write a short note on life cycle hypothesis

Definition and Examples of the Life-Cycle Hypothesis

How the life-cycle hypothesis works, criticisms of the life-cycle hypothesis, life-cycle hypothesis theory vs. permanent income hypothesis theory.

Ridofranz / Getty Images

The life-cycle hypothesis (LCH) is an economic theory that suggests that individuals have a tendency to maintain the same level of spending over time. They achieve this goal by borrowing in when they're younger and their income is low, saving during their middle years when income is high, and living off their assets in their older years when income is low again.

Here’s a closer look at how the LCH works and why it’s important.

The LCH states that households save and spend their wealth in an effort to keep their consumption level steady over time. Even though wealth and income may vary over your lifetime, the theory states, your spending habits stay relatively the same.

Acronym: LCH
Alternate name: Life-cycle model

Saving for retirement is a good example of the LCH in action. You know your income may disappear when you’re older, so you save money during your working years to afford the same lifestyle later on.

The LCH predicts that, in general, you maintain the same level of consumption throughout your lifetime by:

Borrowing money when you’re young (either by borrowing money or liquidating assets you already own)
Saving more money when you’re middle aged and at the peak of your career
Living off the wealth you’ve accumulated when you’re old and retired

Franco Modigliani published the life-cycle hypothesis theory in 1954 with Richard Brumberg and later won a Nobel Prize for his economic analyses.

The LCH predicts that your savings habits follow a hump-shaped pattern as in the diagram below where your savings rate is low during your younger and older years and peaks during your middle years:

For example, suppose you make $20,000 this year, but you expect your income will increase to $80,000 next year because you’ve got a job lined up after you graduate from college.

According to the LCH, you may spend money today with your future income in mind, which may lead you to borrow money. As you reach the peak of your career, you’ll pay off any debt you accumulated and ramp up your savings. Then, you’ll draw down that savings in retirement so you can continue your same level of spending.

The LCH has withstood the test of time but it’s not without its flaws:

LCH Doesn’t Account for Financial Windfalls

Traditional LCH models don’t apply to individuals who run into financial windfalls or have sporadic income throughout their lives.

Take NFL players, for example. The LCH would imply that NFL players save considerable amounts of money while they’re at the peak of their careers so they can sustain the same level of consumption when they retire.

But the reality is that some NFL athletes go from enormously wealthy to near poverty shortly after the end of their careers. A 2015 National Bureau of Economic Research study that focused on LCH and the NFL predicted that an NFL player has a 15% to 40% chance of going bankrupt 25 years after they retire.

The study said the high bankruptcy rates may be due to the fact that players:

Think their career will last longer than it typically does
Make poor financial decisions with the money they receive
Have social pressures to spend more than they should

LCH Assumes Your Consumption Level Will Stay the Same

The LCH predicts that you’ll maintain roughly your same level of spending by borrowing money when income is low and saving when income is high. But this isn’t always realistic.

For example, younger workers may not have access to the credit needed to fund their ideal level of spending now. So, naturally, their consumption habits would change as their income increased and those options became available to them.

Likewise, a family with parents in their 30s with three young kids, student loan debt, and a mortgage may consume more now than they will in their 70s when they’re retired, possibly debt-free, and no longer have dependents to care for.

Both the LCH theory and the permanent income hypothesis (PIH) theory seek to understand how individuals spend and save money. The main difference is that the LCH is based on a finite timeline where a person saves only enough to sustain their spending habits during their lifetime. The PIH, on the other hand, is based on an infinite timeline where a person saves enough for both themselves and their heirs.

Key Takeaways

The life-cycle hypothesis (LCH) is an economic theory that describes how an individual maintains roughly the same level of consumption over time by saving when their income is high and borrowing when income is low.
The LCH predicts that wealth accumulation follows a hump-shaped curve where you have a low savings rate when you’re young, a high rate when you’re middle-aged, and a low rate again when you’re old.
Some experts criticize the LCH because consumption doesn’t always stay consistent over time. For example, a middle-aged worker with three kids and a mortgage probably consumes more than they will when they’re retired with no debt or dependents.

Massachusetts Institute of Technology. " The Collected Papers of Franco Modigliani, Volume 6 ."

Federal Reserve Board. " A Primer on the Economics and Time Series Econometrics of Wealth Effects ," Page 8.

Carnegie Mellon University. " The Life Cycle Theory of Consumption ," Page 340.

National Bureau of Economic Research. " Bankruptcy Rates Among NFL Players With Short-Lived Income Spikes ," Page 8.

Centre for Economic Studies and Finance. " Working Paper No. 140: The Life-Cycle Hypothesis, Fiscal Policy,and Social Security ," Page 7.

All Subjects

Intermediate Macroeconomic Theory

Study guides for every class, that actually explain what's on your next test, life-cycle hypothesis, from class:.

The life-cycle hypothesis is an economic theory that suggests individuals plan their consumption and savings behavior over their lifetime, aiming to smooth consumption across different stages of life. This theory emphasizes the importance of forward-looking behavior, where people save during their working years to fund consumption during retirement, balancing short-term and long-term financial needs.

congrats on reading the definition of life-cycle hypothesis . now let's actually learn it.

5 Must Know Facts For Your Next Test

The life-cycle hypothesis was developed by economists Franco Modigliani and Richard Brumberg in the 1950s as a way to understand savings behavior.
According to this hypothesis, individuals do not consume all of their income in the present; instead, they save a portion to maintain a stable level of consumption during retirement.
The life-cycle hypothesis accounts for life events such as education, family formation, and retirement, influencing individual savings rates and consumption patterns.
This theory contrasts with the assumption of a static consumption function, which suggests that current income directly determines consumption without considering future income expectations.
Critics argue that the life-cycle hypothesis may not fully explain consumption behavior in younger or low-income individuals who may not have the same saving capabilities or foresight.

Review Questions

The life-cycle hypothesis explains that individuals base their consumption decisions on their expected lifetime income rather than just their current income. They save during their higher-earning years to ensure they can maintain a stable level of consumption even when their income decreases, such as during retirement. This forward-looking behavior allows individuals to smooth out their consumption over different life stages, ensuring that they do not face drastic changes in their living standards as their financial situation evolves.
The life-cycle hypothesis has significant implications for government policies surrounding retirement savings and social security. Understanding that individuals tend to save for retirement encourages policymakers to promote savings programs, like tax-advantaged retirement accounts. Additionally, recognizing that some individuals may not adequately prepare for retirement could lead governments to implement social safety nets or universal basic income programs aimed at providing financial support during retirement years, ultimately ensuring citizens can maintain their consumption levels.
While the life-cycle hypothesis provides a solid framework for understanding savings and consumption behavior, it has limitations in its real-world applicability. Critics point out that it may oversimplify consumer behavior by assuming rational planning and foresight, which is not always the case. Many individuals face uncertainties about future income, unexpected life events, or lack financial literacy, leading them to deviate from the predictions of the model. Additionally, cultural factors and economic conditions can significantly influence saving habits, suggesting that a more nuanced approach is necessary to fully understand consumer behavior across different populations.

Related terms

Marginal Propensity to Consume (MPC) : The proportion of additional income that a consumer will spend on consumption rather than saving.

A theory that posits individuals base their consumption on their expected long-term average income rather than current income.

Intertemporal Choice : The decision-making process individuals use when considering trade-offs between costs and benefits occurring at different times.