Intertemporal consumption
Encyclopedia
Economic theories of intertemporal consumption seek to explain people's preferences in relation to consumption
and saving over the course of their life. The earliest work on the subject was by Irving Fisher
and Roy Harrod
who described 'hump saving', hypothesizing that savings would be highest in the middle years of a person's life as they saved for retirement.
In the 1950s, more well-defined models built on discounted utility
theory and approached the question of inter-temporal consumption as a lifetime income optimization problem. Solving this problem mathematically, assuming that individuals are rational and have access to complete markets, Modigliani
& Brumberg (1954), Albert Ando, and Milton Friedman
(1957) developed what became known as the life-cycle model. This model predicts that people consume an annuity
of their expected lifetime income at all points in their life. Thus, the lifetime consumption profile was expected to be essentially flat, with people borrowing against future earnings during their early study and working life when income is low, saving greatly during their most productive working years and consuming saved assets during retirement. Windfall gain
s would be treated the same way as an unexpected increase in income - its lifetime annuity value would be consumed and the rest saved.
Attempts to test the life-cycle model against real world data have met with mixed success. In a review of the literature, Courant, Gramlich and Laitner (1984) note "but for all its elegance and rationality, the life-cycle model has not tested out very well." The main discrepancies between predicted and actual behaviour is that people drastically 'underconsume' early and late in their lifetime by failing to borrow against future earnings and not saving enough to adequately finance retirement incomes respectively. People also seem to 'overconsume' during their highest earning years, the elderly do not consume from their assets as would be expected (particularly from their household equity) and also treat windfall gains in a manner inconsistent with the life-cycle model. Specific alterations to the theory have been proposed to help it accommodate the data; a bequest motive
, capital market imperfections such as liquidity constraint
s, a changing individual utility function over time or a particular form of expectation as to future income.
Behavioural economists have proposed an alternate description of intertemporal consumption, the behavioural life cycle hypothesis. They propose that people mentally divide their assets into non-fungible mental accounts
- current income, current asset
s (savings) and future income. The marginal propensity to consume
(MPC) out of each of these accounts is different. Drawing upon empirical studies of consumption, superannuation and windfall gains they hypothesize that the MPC is close to one out of current income, close to zero for future income and somewhere in between with respect to current assets. These differing MPCs explain why people 'overconsume' during their highest earning years, why increasing superannuation contributions does not cause current savings to be reduced (as the life-cycle model implies) and why small windfall gains (which are coded as current income) are consumed at a high rate but a higher proportion of larger gains is saved.
Consumption (economics)
Consumption is a common concept in economics, and gives rise to derived concepts such as consumer debt. Generally, consumption is defined in part by comparison to production. But the precise definition can vary because different schools of economists define production quite differently...
and saving over the course of their life. The earliest work on the subject was by Irving Fisher
Irving Fisher
Irving Fisher was an American economist, inventor, and health campaigner, and one of the earliest American neoclassical economists, though his later work on debt deflation often regarded as belonging instead to the Post-Keynesian school.Fisher made important contributions to utility theory and...
and Roy Harrod
Roy Harrod
Sir Henry Roy Forbes Harrod was an English economist. He is best known for his biography of John Maynard Keynes and the development of the Harrod–Domar model, which he and Evsey Domar developed independently...
who described 'hump saving', hypothesizing that savings would be highest in the middle years of a person's life as they saved for retirement.
In the 1950s, more well-defined models built on discounted utility
Discounted utility
Discounted utility is an economics term in which economists, accountants, underwriters, and other financial analysts include the future discounted value of a good in its present value...
theory and approached the question of inter-temporal consumption as a lifetime income optimization problem. Solving this problem mathematically, assuming that individuals are rational and have access to complete markets, Modigliani
Franco Modigliani
Franco Modigliani was an Italian economist at the MIT Sloan School of Management and MIT Department of Economics, and winner of the Nobel Memorial Prize in Economics in 1985.-Life and career:...
& Brumberg (1954), Albert Ando, and Milton Friedman
Milton Friedman
Milton Friedman was an American economist, statistician, academic, and author who taught at the University of Chicago for more than three decades...
(1957) developed what became known as the life-cycle model. This model predicts that people consume an annuity
Annuity (finance theory)
The term annuity is used in finance theory to refer to any terminating stream of fixed payments over a specified period of time. This usage is most commonly seen in discussions of finance, usually in connection with the valuation of the stream of payments, taking into account time value of money...
of their expected lifetime income at all points in their life. Thus, the lifetime consumption profile was expected to be essentially flat, with people borrowing against future earnings during their early study and working life when income is low, saving greatly during their most productive working years and consuming saved assets during retirement. Windfall gain
Windfall gain
-Types of Windfall Gains:The list of windfall gains includes, but is not limited to:*Lottery winnings*Unexpected inheritance*Gains from demutualization-Uses of Windfall Gains:What people do with windfall gains is subject to much debate...
s would be treated the same way as an unexpected increase in income - its lifetime annuity value would be consumed and the rest saved.
Attempts to test the life-cycle model against real world data have met with mixed success. In a review of the literature, Courant, Gramlich and Laitner (1984) note "but for all its elegance and rationality, the life-cycle model has not tested out very well." The main discrepancies between predicted and actual behaviour is that people drastically 'underconsume' early and late in their lifetime by failing to borrow against future earnings and not saving enough to adequately finance retirement incomes respectively. People also seem to 'overconsume' during their highest earning years, the elderly do not consume from their assets as would be expected (particularly from their household equity) and also treat windfall gains in a manner inconsistent with the life-cycle model. Specific alterations to the theory have been proposed to help it accommodate the data; a bequest motive
Bequest motive
A bequest motive seeks to provide an economic justification for the phenomenon of gratuitous, intergenerational transfers of wealth. In other words, to explain why people leave money behind when they die....
, capital market imperfections such as liquidity constraint
Liquidity constraint
A liquidity constraint in economic theory is a form of imperfection in the capital market. It causes difficulties for models based on intertemporal consumption.Many economic models require individuals to save or borrow money from time to time....
s, a changing individual utility function over time or a particular form of expectation as to future income.
Behavioural economists have proposed an alternate description of intertemporal consumption, the behavioural life cycle hypothesis. They propose that people mentally divide their assets into non-fungible mental accounts
Mental accounting
A concept first named by Richard Thaler , mental accounting attempts to describe the process whereby people code, categorize and evaluate economic outcomes....
- current income, current asset
Current asset
In accounting, a current asset is an asset on the balance sheet which can either be converted to cash or used to pay current liabilities within 12 months...
s (savings) and future income. The marginal propensity to consume
Marginal propensity to consume
In economics, the marginal propensity to consume is an empirical metric that quantifies induced consumption, the concept that the increase in personal consumer spending occurs with an increase in disposable income...
(MPC) out of each of these accounts is different. Drawing upon empirical studies of consumption, superannuation and windfall gains they hypothesize that the MPC is close to one out of current income, close to zero for future income and somewhere in between with respect to current assets. These differing MPCs explain why people 'overconsume' during their highest earning years, why increasing superannuation contributions does not cause current savings to be reduced (as the life-cycle model implies) and why small windfall gains (which are coded as current income) are consumed at a high rate but a higher proportion of larger gains is saved.
See also
- Albert Ando
- DissavingDissavingDissaving is negative saving. If spending is greater than income, dissaving is taking place. This spending is financed by already accumulated savings, such as money in a savings account, or it can be borrowed....
- Intertemporal choiceIntertemporal choiceIntertemporal choice is the study of the relative value people assign to two or more payoffs at different points in time. Most choices require decision-makers to trade-off costs and benefits at different points in time. These decisions maybe about savings, work effort, education, nutrition,...
- Permanent income hypothesisPermanent income hypothesisThe permanent income hypothesis is a theory of consumption that was developed by the American economist Milton Friedman. In its simplest form, the hypothesis states that the choices made by consumers regarding their consumption patterns are determined not by current income but by their longer-term...
- Temporal discountingTemporal discountingTemporal discounting refers to the tendency of people to discount rewards as they approach a temporal horizon in the future or the past . To put it another way, it is a tendency to give greater value to rewards as they move away from their temporal horizons and towards the "now"...
- Wealth elasticity of demandWealth elasticity of demandWealth elasticity of demand in microeconomics is the proportional change in the consumption of a good relative to a change in consumers' wealth...