Ando and Modigliani have formulated a consumption function which is known as the Life Cycle Hypothesis*. According to this hypothesis, consumption is a function of lifetime expected income of the consumer. The consumption of the individual consumer depends on the resources available to him, the rate of return on capital, the spending plan, and the age at which the plan is made. The present value of his resources includes income from assets or wealth or property and from current and expected labour income. Thus his total resources consist of his income and wealth.
The life cycle hypothesis is based on the following assumptions:
- There is no change in the price level during the life of the consumer.
- The rate of interest paid on assets is zero.
- The consumer does not inherit any assets and his net assets are the result of his own savings.
- His current savings result in future consumption.
- He intends to consume his total lifetime earnings plus current assets.
- He does not plan any bequests.
- There is certainty about his present and future flow of income.
- The consumer has a definite conscious vision of life expectancy.
- He is aware of the future emergencies,opportunities and social pressures which will impinge upon his consumption spending.
- The consumer is rational.
Given these assumptions, the aim of the consumer is to maximise his utility over his lifetime which will, in turn, depend on the total resources available to him during his lifetime. Given the life-span of an individual, his consumption is proportional to these resources. But the proportion of resources that the consumer plans to spend will depend on whether the spending plan is formulated during the early or later year of his life. As a rule, an individual’s average income is relatively low at the beginning of his life and also at the end of his life. This is because in the early years of his life, he has little assets (wealth) and during the late years, his labour- income is low. It is, however, in the middle of his life that his income,both from assets and labour, is high.
As a result, the consumption level of the individual throughout his life is somewhat constant or slightly increasing, shown as the CC1 curve in Fig. 1, the Y0YY1 curve shows the individual consumer’s income stream during his lifetime T. During the early period of his life represented by T1 in the figure., he borrows or dissaves CY0B amount of money to keep his consumption level CB which is almost constant. In the middle years of his life represented by T1T2, he saves BSY amount to repay his debt and for the future. In the last years of his life represented by T2T, he dissaves SC1Y1 amount.
The consumption function can be expressed as :
Ct = f (Vt ) …(1)
where Vt = total resources at time t.
Vt = f (Yt + YeLt + At ) …(2)
By substituting equation (2) in (1) and making (2) linear and weighted average of different income groups, the aggregate consumption function is
Ct = α1Yt + α2YeL + α3At …(3)
where α1 = MPC of current income, α2 = MPC of expected labour income; and α3 = MPC of assets or wealth.
Now APC is APC is constant in the long-run because a portion of labour income in current income and the ratio of total assets to current income are constant when the economy grows. On the basis of the life cycle hypothesis, Ando and Modigliani made a number of studies in order to formulate the short-run and long-run consumption functions. A cross-section study revealed that more persons in the low-income groups were at low income level because they were at the end period of their lives. Thus their APC was high. On the other hand, more than average persons belonging to the high-income groups were at high income levels because they were in the middle years of their lives. Thus their APC was relatively low. On the whole, the APC was falling as income rose thereby showing APC>MPC. The observed data for the U.S. revealed the APC to be constant at 0.7 over the long-run.
The Ando-Modigliani short-run consumption function is shown by the CS curve in Fig. 2. At any given point of time, the CS curve can be considered as a constant and during short-run income fluctuation, when wealth remains fairly constant, it looks like the Keynesian consumption function. But its intercept will change as a result of accumulation of wealth (assets) through savings As wealth increases overtime, the non- proportional short-run consumption function CS shifts upward to CS1 to trace out the long-run proportional consumption function. The long-run consumption function is CL, showing a constant APC as income grows along the trend. It is a straight line passing through the origin. The APC is constant over time because the share of labour income in total income and the ratio of wealth (assets) to total income are constant as the economy grows along the trend.
1. The life cycle hypothesis solves the consumption puzzle. According to this hypothesis, the short-run consumption function would be non- proportional as in the short-run time series estimates. Its intercept (αW in Fig. 2) measures the effect of wealth and the life cycle consumption function looks like the Keynesian consumption function as CS in the figure But it holds only in the short run when wealth is constant. Aswealth grows (αW1), this consumption function shifts upward as CS1. The shifting of the CS to CS1 traces out the long-run consumption function, CL.
This is consistent with the evidence from long-run time series data that the long-run consumption function is proportional. The slope of the CL curve shows that the average propensity to consume does not fall as income increases. In this way, Audo-Modigliani solved the consumption puzzle.
2. The life cycle hypothesis reveals that savings change over the life time of a consumer. If a consumer starts his life in adulthood with no wealth, he will save and accumulate wealth during his working years. But during retirement, he will dissave and run down his wealth. Thus the life cycle hypothesis implies that the consumer wants smooth and uninterrupted consumption over his lifetime. During working years, he saves and when retires, he dissaves.
3. The life cycle hypothesis also implies that a high-income family consumes a smaller proportion of his income than a low-income family. In its peak earning years, (shown as portion BSY in Fig. 1), its income is more than its consumption and its APC is the lowest. But in the case of a low-income family and a retiree family, the APC is high.
The life cycle hypothesis is not free from certain criticisms.
1. Plan for Lifetime Consumption Unrealistic
The contention of Audo and Modigliani that a consumer plans his consumption over his lifetime is unrealistic because a consumer concentrates more on the present rather than on the future which is uncertain.
2. Consumption not directly related to Assets
The life cycle hypothesis pre-supposes that consumption is directly related to the assets of an individual. As assets increase, his consumption increases and vice versa. This is also unwarranted because an individual may reduce his consumption to have larger assets.
3. Consumption depends on Attitude
Consumption depends upon one’s attitude towards life. Given the same income and assets, one person may consume more than the other.
4. Consumer not Rational and Knowledgeable
This hypothesis assumes that the consumer is rational and has full knowledge about his income and future lite time. This is unrealistic because no consumer is fully rational and knowledgeable.
5. Estimation of Variables not Possible
This theory depends on many variables such as current income, value of assets, future expected labour income, etc., the estimation of so many variables is very difficult and not possible.
6. Liquidity Constraints
This hypothesis fails to recognize the existence of liquidity constraints for a consumer. Even if he possesses a definite and conscious vision of future income, he may have little opportunity for borrowing in the capital market on the basis of expected future income. As a result, consumption may response more to changes in current income than predicted on the basis of the life cycle hypothesis.
Despite these, the life cycle hypothesis is superior to the other hypotheses on consumption function because it includes not only wealth as a variable in the consumption function but also explains why APC >MPC in the short-run and APC is constant in the long-run.