The Life-cycle Hypothesis as a Tool of Theory and Policy

The life-cycle theory of savings was developed in the mid-1950s by Modigliani and Brumberg (1954) and until recently provided the conceptual foundations of almost all modern work on the consumption and saving pattern of the family. Although this theory has been extremely useful in macroeconomic modelling and empirical implementations based on time series, in recent years a large and growing number of writers have raised serious questions with regard to this hypothesis. In this chapter we shall contribute to this discussion of the scientific viability of the life-cycle hypothesis. Since the issue of bequests is critical to our view, we wish to address it first. The ‘life-cycle theory’ is a statement of how an economic unit, like a family, allocates its resources intertemporally between consumption and capital accumulation during the life-cycle. However, in our view what distinguishes this theory is the idea that each family is not viewed as part of an infinite chain of families, each with ties to the past and obligations to the future, but rather that it is viewed as a single (and selfish) decision maker, without inheritances from past generations and bequests to future generations. Within this conceptual frame-work, each family selects a consumption and accumulation plan based on the present value of the anticipated flow of its own lifetime incomes.