What is the life-cycle theory of consumption?

 

The theory states that individuals seek to smooth their consumption over the course of their lifetime. They borrow in times of low-income period and save during periods of high income. Thus spending is planned over the lifetime, taking into account the future income. Wealth accumulation is low during young and old age and high during the middle age.

Step-by-step explanation

It is a hump shape as Wealth accumulation is low during young and old age and high during the middle age.

It suggests wealth will build up in working age, but then fall in retirement.

The theory states consumption will be a function of wealth, expected lifetime earnings and the number of years until retirement.

Consumption will depend on

C = (W+RY)/T

• C= consumption
• W = Wealth
• R = Years until retirement. Remaining years of work
• Y = Income
• T= Remaining years of life

It suggests for the whole economy consumption will be a function of both wealth and income. If we have an ageing population, with more people in retirement, then wealth/savings in the economy will be run down.

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