Consumption Life Cycle Theory

After Keynes, another economist Franco Modigliani developed a different approach to explain the relationship between consumption and disposable income for prudent consumers. It is called ‘life cycle hypothesis’.

“The point of departure of the life cycle model is the hypothesis that consumption and saving decisions of households at each point of the time reflects a more or less conscious attempt at achieving by the preferred distribution of consumption over the cycle, subject to the constraint imposed by the resources accruing to the household over its lifetime”.

A household’s level of consumption depends not just on current income but also, and more importantly, on long-term expected earnings. Individuals are assumed to plan a pattern of consumption expenditure based on expected earning over their lifetime.

A prudential household plans his consumption expenditure which may provide for occasional rainy days and take care of extra future needs such as schooling of children, construction of house, meeting day-to-day expenses after retirement. Individuals very often get incremental income, windfall gains, income incentives, etc. they save a part of this additional income to provide for known and unknown future consumption expenditure.

In brief, the current spending of a prudent household is closely related to his expected average lifetime income.   

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