Question

​​​​​​Describe Modigliani’s life-cycle hypothesis. How do consumers maintain a constant level of consumption over time? How does this hypothesis resolve the seemingly contradictory pieces of evidence regarding consumption behavior found by Kuznets?

Answer 1

Background Information
Most of the people does work (of any nature) after study and has a criteria for spending, saving and investing. Modigliani's life-cycle hypothesis is related to this aspect. Keynes and Kuznets proposed a theory on this aspect. But that did not prove to be accurate. In the early 1950s, Franco Modigliani proposed a theory on the basis of observation that people take consumption decisions based on the following parametres
1. Resources available to them over their lifetime, and
2. Resources available to them during their current life stage.

This theory has its own importance- this theory provides important predictions for the economy as a whole. It anticipates that the aggregate saving of a country is dependent on the rate of growth of national income, not level of National Income. Further, the stock of wealth in a country is related to the length of retirement span.

What is Modigliani's life-cycle hypothesis?

What criteria is used by individuals in decision making related to allocating income between consumption and saving?Franco Modigliani ife cycle hypothesis puts a proposition that people try to maintain roughly the same level of consumption throughout their lifetimes. They take debt or liquidating assets in the early and late phases of life (when their income
is low) and pursue savings during their prime earning years when their income level is at peak. As per this theory, wealth accumulation of an individual follows a “hump-shaped” pattern — that is, low level near the beginning of adulthood and in old age, and peaking in the middle.

This concept can be explained with the help of an example. Let

Implications:

An increase in current income of labour by $100 will increase consumption by Rs. 72. An increase in Wealth of Rs. 100 would increase consumption by $ 6. Consequently, as per this estimate, the MPC out of such a transient income flow is of the order of 0.06, the MPC out of wealth.

The Modigliani theory rejects Keynesian
view that a country’s aggregate saving rate is driven by
total level of income of that country.The savings ratio is dependent on the growth rate of income. When income in a country is growing, every new generation has higher consumption expectations when compared to the previous one.
Consequently,To maintain their higher consumption when they get older,these younger workers in a growing economy will save more and the dissaving of those cohorts from the past (who are now retirees) will be less than the current workers’ savings rate.

Contradiction between Modigliani and Kuznets

In 1946, Simon Kuznets (from Harvard
University) studied and investigated national income in the United States between the year 1869 and 1938. After research he found that the saving ratio in America had almost barely changed during the above period, despite large
increases in per capita income. However Modigliani rectified this theory.