Question

1. In the discussion of the life-cycle hypothesis, income was assumed to be constant during the period before retirement. For most people, however, income grows over their lifetimes. It was also assumed that individuals started out with zero wealth.

(a) How does the growth of income influence the lifetime pattern of consumption and wealth accumulation?

(b) Assume now that consumers can borrow (so their wealth can be negative). How does the growth of income influence the lifetime pattern of consumption and wealth accumulation?

Answer 1

1. (a) If we are considering the case an individual started out with zero wealth, and the income grows over their lifetimes. If we consider permanent income hypothesis, then here, with the increase in income of the people, people will not suddenly change their income patterns. They will not suddenly increase their spendings, what they will do is first they will they will try to save their increased income as much as possible. They will start spending their Increased income from a time period from when on they know they can spend this much money till the end of their life. With the growth of income, people will have an incentive to save more for their future. Hence, the lifetime consumption pattern will not change much, but the wealth accumulation will change. As people will save more the amount of wealth in the economy will also increase.

(b) If consumers can borrow which is a negative wealth, then they will try to pay off their debts as soon as possible. They will try to save as much money as possible when they have borrowed the money. With the increase in income they will try to pay off the debts gradually. Once they pay off the debt, they will try to save their income to live in a good state post retirement. Hence, the consumption will be low once they have borrowed money. Gradually that will increase once they have paid the debt. But that will not be that much, as they need to save money post retirement. Again, the wealth will decrease once they have borrowed the money, but it will gradually increase once they have paid back the money. Once they have paid off the debts, they will try to save the money for future savings. This is how the wealth accumulation will increase.