Economics: A Contemporary Introduction 9th Edition by William McEachern

Exercise 3

Case Study: The Life-Cycle Hypothesis According to the lifecycle hypothesis, what is the typical pattern of saving for an individual over his or her lifetime? What impact does this behavior have on an individual's lifetime consumption pattern? What impact does the behavior have on the saving rate in the overall economy?
Reference Case Study:
Bringing Theory to Life
The Life-Cycle Hypothesis Do people with high incomes save a larger fraction of their incomes than those with low incomes? Both theory and evidence suggest they do. The easier it is to make ends meet, the more income is left over to save. 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 Exhibit 2-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 finance 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.