Intertemporal Choice - Modigiliani's Life Cycle Income Hypothesis

Modigiliani's Life Cycle Income Hypothesis

The Life Cycle Hypothesis is based on the following model:

subject to

ΣLC_t(1+r)-t = ΣNY_t(1+r)-t + Wo

U(C_t): satisfaction received from consumption in time period 't'

C_t:level of consumption,

Y_t: income

δ: rate of time preference ( a measure of individual preference between present and future activity)

Wo: initial level of income producing assets

Typically, a person’s MPC(marginal propensity to consume) is relatively high during young adulthood, decreases during the middle-age years, and increases when the person is near or in retirement. The Life Cycle Hypothesis(LCH) model defines individual behavior as an attempt to smooth out consumption patterns over one's lifetime somewhat independent of current levels of income. This model states that early in one's life consumption expenditure may very well exceed income as the individual may be making major purchases related to buying a new home, starting a family, and beginning a career. At this stage in life the individual will borrow from the future to support these expenditure needs. In mid-life however, these expenditure patterns begin to level off and are supported or perhaps exceeded by increases in income. At this stage the individual repays any past borrowings and begins to save for her or his retirement. Upon retirement, consumption expenditure may begin to decline however income usually declines dramatically. In this stage of life, the individual dis-saves or lives off past savings until death.