What is the Life Cycle Hypothesis (LCH)?
The Life Cycle Hypothesis (LCH) is an economic theory that describes people’s spending and saving habits throughout their lives. The theory states that individuals seek to smooth consumption throughout their lives by borrowing when their income is low and saving when their income is high.
The concept was developed by economists Franco Modigliani and his student Richard Brumberg in the early 1950s.
- The Life Cycle Hypothesis (LCH) is an economic theory developed in the early 1950s that posits that people plan their expenses throughout their lives, taking into account their future income.
- An LCH chart shows a hump-shaped pattern of wealth accumulation that is low during youth and old age and high in middle age.
- One consequence is that younger people have a greater capacity to take investment risks than older people who need to use accumulated savings.
Understanding the life cycle hypothesis
The LCH assumes that people plan their expenses throughout their lives, taking into account their future income. Consequently, they go into debt when they are young, assuming that future income will allow them to pay it off. They then save during middle age to maintain their consumption level when they retire.
A graph of an individual’s spending over time shows a hump-shaped pattern in which wealth accumulation is low during youth and old age and high during middle age.
Life cycle hypothesis versus Keynesian theory
The LCH replaced an earlier hypothesis developed by economist John Maynard Keynes in 1937. Keynes believed that savings were just another good and that the percentage of individuals allocated to their savings would increase as their income increased. This presented a potential problem in that it implied that as a nation’s income increased, excess savings would occur and aggregate demand and economic output would stagnate.
Another problem with Keynes’s theory is that it did not address people’s consumption patterns over time. For example, a middle-aged individual who is head of the family will consume more than a retiree. Although subsequent research has generally supported the LCH, it also has its problems.
The LCH has largely supplanted Keynesian economic thinking about spending and saving patterns.
Special Considerations for the Life Cycle Hypothesis
The LCH makes several assumptions. For example, the theory assumes that people deplete their wealth during old age. Often, however, wealth is passed on to children or older people may not be willing to spend their wealth. The theory also assumes that people plan ahead when it comes to building wealth, but many procrastinate or lack the discipline to save.
Another assumption is that people earn more when they are of working age. However, some people choose to work less when they are relatively young and continue working part-time when they reach retirement age.
As a result, one implication is that younger people are better able to take investment risks than older people, which remains a widely accepted principle of personal finance.
Other notable assumptions are that those with high incomes are better able to save and have greater financial knowledge than those with low incomes. People with low incomes may have credit card debt and less disposable income. Lastly, safety nets or resource-verified benefits for the elderly can discourage people from saving as they anticipate receiving a higher social security payment when they retire.