According to the life-cycle hypothesis, what is the typical pattern of saving for an individual over his or her lifetime? W hat impact does this behavior have on an individual’s lifetime consumption pattern? What impact does the behavior have on the saving rate in th e overall economy

According to the life-cycle hypothesis, what is the typical pattern of saving for an individual over his or her lifetime? W hat impact does this behavior have on an individual’s lifetime consumption pattern? What impact does the behavior have on the saving rate in th e overall economy

Case Study 9.1: The Life-Cycle Hypothesis

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Do people with high incomes save a larger fraction of their incomes than those with low income? Both theory and
evidence suggest they do. The easier it is to make ends meet, the more income is left over for saving. Does it
follow from this that richer economies save more than poorer ones—that economies save a larger fraction of total
disposable income as they grow? In his famous book,
The General Theory of Employment, Interest, and Money
,
published in 1936, John Maynard Keynes drew
that conclusion. But as later economists studied
the data—such as that presented in the exhibit below—it became clear that
Keynes was wrong.
The fraction of disposable income saved in an economy
seems to stay constant as the economy grows.
So how can it be that richer people save more than poorer people, yet
richer countries do not necessarily save more than poorer ones? Several
answers have been proposed. One of the most important is the
life-cycle
model of consumption and saving
. According to this model, young people
tend to borrow to fi nance education and home purchases. In middle age,
people pay off debts and save more. In old age, they draw down their savings,
or dissave. Some still have substantial wealth at death, because they are not
sure when death will occur and because some parents want to bequeath
wealth to their children. And some people die in debt. But on average net
savings over a person’s lifetime tend to be small. The life-cycle hypothesis
suggests that the saving rate for an economy as a whole depends on, among
other things, the relative number of savers and dissavers in the population.
A problem with the life-cycle hypothesis is that the elderly do not seem to draw down their
assets as much as the theory predicts. One reason, already mentioned, is that some want to leave
bequests to children. Another reason is that the elderly seem particularly concerned about covering
unpredictable expenses such as from divorce, health problems, or living much longer than the
average life span. Because of such uncertainty, many elderly spend less and save more than the
life-cycle theory predicts. Researchers have found that those elderly who have not experienced a
divorce or health problems build their net wealth well into old age.
Still, the life-cycle hypothesis offers a useful theory of consumption patterns over a lifetime.
SOURCES:
Martin Browning and Thomas Crossley, “The Life-Cycle Model of Consumption and Saving,”
Journal of Economic
Perspective
15 (Summer 2001): 3–22;
OECD Economic Outlook
87 (May 2010); and James Poterba, Steven Venti, and David
Wise, “Family Status Transitions, Latent Health, and the Post Retirement Evolution of Assets,” NBER Working Paper 15789, (Febru
ary 2010).
QUESTION
1. According to the life-cycle hypothesis, what is the typical pattern of saving for an individual over his or her lifetime? W
hat impact does
this behavior have on an individual’s lifetime consumption pattern? What impact does the behavior have on the saving rate in th
e overall
economy?
9
life-cycle model of
consumption and
saving
young people borrow,
middle-agers pay off
debts and save, and
older people draw down
their savings; on average,
net savings over a lifetime
is usually little or nothing
U.S. Consumption Depends on Disposable Income
Consumer spending
(trillions of 2005 dollars)
0.0
1.0
2.0
3.0
4.0
5.1
4.5
Disposable income
(trillions of 2005 dollars)
5.0
6.0
7.0
8.0
9.0
10.0
11.0
9.0
8.0
7. 0
6.0
5.0
4.0
3.0
2.0
1. 0
0.0
1995
1985
1975
2005
2010
10.0
11. 0
SOURCE:
Based on estimates from the Bureau of Economic Analysis, U.S.
Department of Commerce. For the latest data, go to http://bea.gov/.
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6
6
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1
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4
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1
1
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1
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Case Study 9.2: Investment Varies Much More than Consumption
Consumption averaged 70 percent of GDP during the most recent decade, and investment varied from year to year and averaged 16 p
ercent
of GDP during the most recent decade. Now let’s compare the year-to-year variability of consumption and investment. The exhibit
below shows
the annual percentage changes in GDP, consumption, and investment, all measured in real terms. Two points are obvious. First, i
nvestment
fl uctuates much more than either consumption or GDP. For example, in the recession year of 1982, GDP declined 1.9 percent but i
nvestment
dropped 14.0 percent; consumption actually increased 1.4 percent. In 1984, GDP rose 7.2 percent, consumption increased 5.3 perc
ent, but
investment soared 29.5 percent. Second, fl uctuations in consumption and in GDP appear to be entwined, although consumption vari
es a bit
less than GDP. Consumption varies less than GDP because consumption depends on disposable income, which varies less than GDP.
During the six years of falling GDP over the last half century, the average decline in GDP was only 0.9 percent, but investment
dropped
an average of 13.6 percent. Consumption actually increased by an average of 0.3 percent. So
while consumption is the largest spending
component, investment varies much more than consumption and accounts for nearly all the year-to-year variability in real GDP
. Note that GDP
does not always fall during years in which a recession occurs. That’s because the economy is not necessarily in recession for t
he entire year.
For example, because the recession of 2001 lasted only eight months, GDP managed a small gain for the year of 1.1 percent and c
onsumption
grew 2.7 percent. It was the 7.0 percent fall in investment that caused the recession. That’s why economic forecasters pay spec
ial attention to
business expectations and investment plans.
SOURCES:
Economic Report of the President
, February 2010,
Survey of Current Business
90, various months for 2010; and
OECD Economic Outlook
87 (May 2010). For data and
articles about economic aggregates, go to the Bureau of Economic Analysis site at http://bea.gov/.
QUESTION
1. Why do economic forecasters pay special attention to investment plans? Take a look at the Conference Board’s index of leadi
ng economic
indictors at http://www.conference-board.org/. Which of those indicators might a