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HOMEWORK WEEK 8 Group 12: Joshua Dawes, Paul Niklaus, Arthers, Phoung

  1. Briefly, what is Modigliani?s life-cycle theory of consumption? For an individual, draw someone?s consumption schedule over their life. Now draw their wealth over their life. At which periods are they saving and dissaving?

The theory based on the idea that people make intelligent choices about how much they want to spend at each age, limited only by the resources available over their lives. By building up and running down assets, working people can make provision for their retirement, and more generally, tailor their consumption patterns to their needs at different ages, independently of their incomes at each age. This simple theory leads to important and non-obvious predictions about the economy as a whole, that national saving depends on the rate of growth of national income, not its level, and that the level of wealth in the economy bears a simple relation to the length of the retirement span.

  1. What effects do population growth and economic growth have on savings rates?

With population growth, there are more young people than old, more people are saving than are dissaving, so that the total dissaving of the old will be less than the total saving of the young, and there will be net positive saving. If incomes are growing, the young will be saving on a larger scale than the old are dissaving so that economic growth, like population growth, causes positive saving, and the faster the growth, the higher the saving rate. In fact, it doesn?t much matter whether it is population growth or growth in per capita incomes, what matters for saving is simply the rate of growth of total income.

  1. In the Modigliani model, do consumers consume from current income?

If such people expect their earnings to grow over time, they will nevertheless keep their consumption within their current incomes, thus inducing a close articulation, or ?tracking,? between consumption and income. In this case, although people are maximizing their expected lifetime utility, as postulated by the life-cycle theory under uncertainty, their consumption is effectively constrained by their current incomes. Such behavior is directly contrary to one of the central insights of the Modigliani model, that the profile of consumption can be detached from the profile of income, and much more like the pre-Modigliani and Keynesian accounts of saving. Very much the same result can be obtained in a theoretical model in which people want to borrow but cannot. People can save to smooth out their consumption, but they cannot have consumption greater than their income, except when they already have some assets in the bank.

  1. What is the impact in the model of an increase in transitory income?

The proportionality of consumption and income in the long-run is entirely consistent with the cross-sectional facts because, as we move up the income distribution, a higher and higher fraction of people are there on a temporary basis, with high transitory income, and thus a temporarily high saving ratio. The same argument explains why savings rates rise more rapidly with income among households who are farmers or small business proprietors, whose income tends to be relatively volatile, and why, at a comparable income level, black families save more than white families.

  1. What are the implications of the theory for savings rates over the economic cycle?

Yet the test does not depend on the shaky information on household saving from the surveys, relying only on the much more robustly measured age-profile of consumption. Perhaps the causation runs, not from growth to the saving rate, but from the saving rate to growth, something that is consistent with standard models of economic growth if transitions to equilibrium are very slow, and given that national rates of investment are (still) closely correlated with national rates of saving. While there is currently broad agreement on the existence of a correlation between saving and growth, there is no consensus on its causes.

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