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Life Cycle Hypothesis

This theory was developed by Franca Modigliani, Nobel Laureate of 1985, Richard Brumberg and Albert Ando in 1950s and 1960s. It is called MBA hypothesis. According to this theory, consumption is a function of the lifetime expected income of the person. The consumption depends on the resources available to the person, the rate of return to the capital, the spending plan and the age at which the plan is made. It depends on: 

i. Resources 

ii. Spending plan 

iii. Rate of return on capital 

iv. The age at which the plan is made 

According to Modigliani the point of departure of the life cycle model is the hypothesis that consumption and saving decision of household at each point of time reflects more or less conscious attempt to achieve the preferred distribution of consumption over the life cycle. Subject to the constraint imposed by the resources occurring to the household over it is a lifetime. Here the resources include all the income from assets or properties and also from current and expected income from human capital. 

Assumptions: There are the following assumptions of this hypothesis: 

i. The level of consumption increases gradually 

ii. The level of income depends upon the productive capacity of the person at different stages of life cycle. 

iii. Nothing is received as an inheritance and nothing is left as bequeath/ bequest i.e. all earned during the life time is consumed. 

iv. There is no change in the price level during/ throughout life. 

v. The rate of interest remains stable/ same. 



On the basis of these assumptions Ando and Modigliani had given three major stages in a person’s life and the respective consumption pattern. In the early age of life, the person dissevers and the consumption requirements are fulfilled by borrowing. In the middle age, the person earns income and it reaches to the peak level. At that time there is more saving for future consumption as well as for the past debt management. Similarly, in the old age, the person uses the earlier saving from the middle age. 

The main objectives of the person are to maximize the utility over the lifetime. The maximization the utility depends on the total resources available during the lifetime. Given the life expand of an individual the consumption is proportional to the resources but it depends on the consumer’s plan to spend and the spending plan is formulated during the early or later years. 

This hypothesis can be explained by the following diagrams: 




The figure shows that CCt is the consumption function which increases slowly from point C, therefore, it is non- proportional. In early age/years of life, the borrowing is used to fulfill consumption requirement along oT. In this stage the income curve/ function YoYY1, life below the consumption. In the middle age T1T2 the income increases and reaches to the peak level and starts to decreases but income level and starts to decrease but income is greater than consumption, there is saving. This stage is most productive age. In the old age along T2T3 the person uses earlier saving to fulfill consumption requirement. At this stage, the person will be again dissevering. From the figure, the sum of dissaving of earlier age and old age will be equal to the saving of middle age. The dissaving is denoted by and saving is denoted by 

In this way, the consumption function of an individual throughout life is stable and slightly increases along Ct. But income increases through YoYY1. Given these behavior of income and consumption, the current consumption of an individual is the function of the present value of lifetime income i.e. 

                                         

               
This hypothesis can be explained with cross-sectional data as well as time-series data. In the earlier period, the person borrows for consumption therefore APC is high thus APC is greater than MPC (APC > MPC). During middle age, the person saves more APC decreases but MPC remains constant. Hence, APC is greater than MPC. It shows the non-proportional consumption function. Similarly, in the short- run consumption varies with income, during recession income falls but MPC remains constant. Similarly, during recovery, the income increases but APC is greater than MPC. It shows the non- proportional the long-run Ct will be proportional i.e.

 Ct= λYt


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