Life Cycle Hypothesis
Uploaded by
Md. Shakibul HassanLife Cycle Hypothesis
Uploaded by
Md. Shakibul HassanLife Cycle Hypothesis
As we know, while testifying Keynesian 'A bsolute lncome Hypothesi s', Kuznets found non-
proportional relation bet1,,veen income and consumption when he dealt with short-run data and
found proportional relation between them on the basis of long-run data. This event, later often
termed as ' Kuznets' Puzzle', led to development of various hypotheses as attempts towards
reconciliation of the said controversy. Like other two hypotheses (Relative Income Hypothesi s
and Permanent income Hypothesis) , ' Life Cycle Hypothesis' is the outcome of one such attempt.
'Life Cycle Hypothesis' , is also called the MBA hypothesis after the names of Modigliani ,
Brunsberg and Ando who developed it in 1963 .
Main idea
According to ' Absolute Income Hypothesis' , consumption and savings behaviour of an
individual is influenced by his absolute or current level of income. Contrarily, present hypothesi s
views individual as planning his consumption and savings behaviour over his entire life. This, he
does to allocate/distribute his income between consumption and savings in the best possible
manner through his entire life time. This allocation of income between consumption and savings
is guided by the fact that, in earlier periods of life people are able to work and, hence, can earn ;
but in the later pa11 of their life, they are unable to work, and, hence cannot earn. Accordingly,
people need to keep aside a portion of their income as savings during their working life such as
to finance their consumption expenditure during their old life .
Assumptions of the hypothesis
a) Life expectancy or length of life of the person under consideration is known with certainty.
b) Length of working life of the person under consideration is also known with certainty.
c) Savings don 't bring any interest income.
d) Savings takes place only with the intention to be able to meet old-age consumption expenses.
e) Throughout entire life a uniform level of consumption expenditure is maintained.
f) Initial years of life (before engaging in .any kind of work) is not considered.
g) A unirorm leve l of labour income is earned throughout the working life.
1
Symbols used and their explanation
NL= number of years of life; WL = number of years of working life
YL= uniform level of labour income; C = uni form level of planned consumption
Hence, N1_- W1_ = years of retired life
Model excluding property income
The individual's life-time income= WL X YL and his life-time consumption = NL X C
Now, the individual 's life-time consumption = His life-time · ~a'o\..bc, CA.\"' income
WL
That is, NL X C = WL X YL or, C = - . YL
NL
This is the consumption function. Here, WJNL is the fraction of life-time spent in working and,
is, th erefore, constant. That is, over the entire lite time the person uses a fraction of his labour
,,
income fo r consumption purposes. Correspond ing sav ings function stands to be:
Numerical example
Let, a person starts working at the age of 20, works till 65 and dies at 80. Find his consumption
and savings fun ctions and estimate his MPC and MPS.
Here. WL= 65-20 = 45 ; NL = 80-20=60
WL 45
Hence, C = - . YL = - . YL = 0.75 YL ; and MPC = dC/dY L= 0.75
NL 60
And, S = YL - C = YL - 0.75 YL = (1 - 0.75) YL = 0.25 YL; and MPS = cl S/dY L= 0.25
What have been discussed so far can be presented graphically as follows:
Y,C, S,
Maxi mum level of
Accumulated savings
0 V. L L Time
2
,
.
· • 1 year of- ,-vork.1ng 11. fe, total amount of accumulated savin gs
Here ' startin t,o from zero at tI1e ·1n1t1a
e retirement. Again , sta,ting from the
becomes maximum at the end of working life or just befor
year of retire ment, it starts falling and
higheS t attained level of accumulated savings at the first
ul ated savin gs= (Y L - C)WL and total
becomes nil at the time of death. Total amount of accum
amount of di ssav ing =(NL _ WiJC.
Model including property income
point of time 'T'. He has now to go for
Let, the individual gets 'W' amount of wealth at some
this period is = (N1. - T) X C and his
another (NL - T) years and hi s total consumption during
in come fo r thi s period is = W + (WL - T) X YL .
As, incom e suppo,ts consumption, so we can write ,
(NL -T) X C = w + (WL - T) X YL
Or, C = W ( _1_) + ( WL - T) y L
NL- T NL -T
= aW+ cY1.
1 W -T
= MPC out of labou r incom e,
(where, a= ( - - - ) = MPC out of wealth, and, c= NL - T
L
NL- T
Solving the Kuznets' puzz le
We have derived , C = aW + c Y1.
C W YL
Or, - = a - + c- (dividing throu gh by Yo)
Yo Yo Yo
w
If~ now, ratio of wealth to disposable income (-) and ratio of labo ur income to dispo sable
Yo
..£. an t; and, if, any one of them or both
income ( YL) are constant then Yo = APC will be const
Yo
on for the Kuznets' puzzle. In reality,
change, then, APC will also change. This suggests a soluti
derab ly stable; hence implying constant
over longe r periods of time, these two ratios are consi
w
consid erably; hence, im plyin g variable
A PC. On the other hand, in the short-run, -Yo ratio varies
APC.
