Life Cycle Hypothesis

The life cycle hypothesis refers to an economic theory focusing on how individuals spend and save money over their lifetimes. It motivates people to save for retirement during their earnings period instead of spending all their incomes.

In other words, people like to maintain the same level of expenditure throughout their life, either by taking credit or using their income. It forms a hump-shaped graph related to consumers' savings and consumption patterns. People spend money keeping in mind their future increase in income. However, individuals save less in youth, more in middle age, and very little in old age. 

• The life-cycle hypothesis is an economic theory about the constant maintenance level of consumption throughout their lifetime, even if it means getting a loan and going bankrupt at retirement.
• Most people plan their retirement based on this theory. It is because they are well versed in economic studies during the three stages of life- youth for loan and expenditure, middle age for savings, and dissaving in retirement.
• Life-Cycle Hypothesis and Permanent Income Hypothesis differ in the aspect of saving by people as in the former, and people tend to save and spend as per their demographics. In contrast, in the latter, it does not.
• The life cycle hypothesis is criticized by many economists as its assumptions of constant consumption level and saving for self-consumption get contradicted in real life.

The life cycle hypothesis of consumption states that people plan their consumption upon a portion of their anticipated lifetime income. Therefore, according to the theory, researchers assume that at each stage of life on people's consumption level, one would experience no financial turmoil. Also, people do not save for future generations.

Italian-American economist Franco Modigliani propounded the life cycle hypothesis in 1954. Hence it was named the Modigliani life cycle hypothesis. However, his student, economist Richard Brumberg, also contributed to its development, for which both won Nobel Prizes in economics.

The life cycle hypothesis of consumption divides the life of a working employee into three stages: youth, middle-aged and old age. Expenditures at all stages depend on their future incomes. Each stage has special characteristics associated with earning, saving, and expenditure. These stages are discussed in the following table -

Let us use the life cycle hypothesis graph to understand the concept.

In the above chart, one observes that to maintain the level of consumption and spending:

• People take loans in the early earning stage.
• People save from higher income, although they try to maintain the same spending level.
• All the savings get spent on themselves, or dissaving happens at retirement.

Let us assume that Noah has a high-paying job with a multinational company. Early in their life, Noah took loans to shift from their native town to New York for their current job. Since Noah has to maintain high living standards, loans remain. However, Noah has planned to start saving once reaching the age of forty. Moreover, Noah has also planned to use all the saved funds for self-use without heeding the family's needs. Hence, Noah follows the life-cycle hypothesis theory.

Both theories deal with people's saving and spending habits and get called the permanent income hypothesis. But they remain different from each other in other aspects, as explained in the table below:

Although researchers repeatedly proved this theory right, it still gets criticized for the assumptions it employs. Let us study the criticism of the life cycle hypothesis by an economist in the following list:

• The theory fails to account for celebrities with sporadic income that tend to end up bankrupt due to financial windfalls.
• It also wrongly assumes that individuals try to maintain all their spending habits even if they have to take loans.
• It advocates that people only like to save and spend for themselves.
• It also supposes that the saving timeline will remain infinite.

The Life Cycle theory supplanted an earlier theory created by economist John Maynard Keynes in 1937. Keynes thought that saving was merely another good and that as people's wages increased, so would the percentage they set aside for savings. It suggested that as a country's earnings increased, a savings glut would arise, and as a result, aggregate demand and economic growth would stagnate.

Another issue is that Keynes' theory ignores changes in people's purchasing patterns over time. For instance, a middle-aged person who is the leader of a household will consume more than a retiree. The life cycle hypothesis theory has issues, even though subsequent research has typically backed it.

This article has been a guide to what is Life Cycle Hypothesis. Here, we explain it with graph, criticism, example and compare it with permanent income hypothesis. You can learn more about it from the following articles –

• Permanent Income Hypothesis
• Autonomous Consumption
• Market Efficiency