Question

Empirical research suggests that the public pension system has reduced savings. Discuss this result in the context of the life-cycle model and the consequences of the wealth substitution effect, the retirement effect, and the bequest effect on savings decisions.

Answer 1

Life cycle hypothesis

Life-cycle hypothesis was developed by Franco Modigliani in ninteen fifty six. The theory states that every individuals seek to smooth his consumption over the course of a lifetime . At the time of no income he borrows , saves during periods of high income and dissaves after retirement.
A student borrow to fund his or her education.
After start working life, he pay off his loans and begin saving for your retirement.
This saving during working life enables you to maintain similar levels of income during your retirement.
ii)Wealth effect in life cycle

According to this theory, consumption will be a function of wealth, expected lifetime earnings and the number of years until retirement.
Consumption depends on

C= consumption
W = Wealth
R = Years before retirement.
Y = Income
T= Remaining years of life
This implies that consumption will be a function of both wealth and income.
Ii)Retirement effect
If we have an ageing population, with more people in retirement, then wealth/savings in the economy will be run down.And above all what people saves will be spent before retirement itself . Leaving nothing for the next generation
Before life-cycle theories, it was assumed that consumption was only a linear function of income.