BA 206The Life-Cycle Hypothesis

Do people with high incomes save a larger fraction of their incomes than those with low incomes? Both theory and evidence suggest they do. The easier it is to make ends meet, the more income is left over for saving. Does it follow from this that richer economies save more than poorer ones—that economies save a larger fraction of total disposable income as they grow? In his famous book, The General Theory of Employment, Interest, and Money, published in 1936, John Maynard Keynes drew that conclusion. But as later economists studied the data—such as that presented in Exhibit 2—it became clear that Keynes was wrong. The fraction of disposable income saved in an economy seems to stay constant as the economy grows.

So how can it be that richer people save more than poorer people, yet richer countries do not necessarily save more than poorer ones? Several answers have been proposed. One of the most important is the life-cycle model of consumption and saving. According to this model, young people tend to borrow to finance education and home purchases. In middle age, people pay off debts and save more. In old age, they draw down their savings, or dissave. Some still have substantial wealth at death, because they are not sure when death will occur and because some parents want to bequeath wealth to their children. And some people die in debt. But on average net savings over a person’s lifetime tend to be small. The life-cycle hypothesis suggests that the saving rate for an economy as a whole depends on, among other things, the relative number of savers and dissavers in the population.

Other factors that influence the saving rate across countries include the tax treatment of interest, the convenience and reliability of saving institutions, national customs, and the relative cost of a household’s major purchase—housing. In Japan, for example, about 25,000 post offices nationwide have offered convenient savings accounts. Japan Post held more than $2 trillion in savings deposits in 2007, making it the world’s largest bank. The postal system accounts for about one-third of Japan’s total savings. (This saving system was on track to be privatized in late 2007.) Also, a home buyer in Japan must come up with a substantial down payment, one that represents a large fraction of the home’s purchase price, and housing there is more expensive than in the United States. Finally, borrowing is considered by some Japanese to be shameful, so households save to avoid having to borrow. Because saving in Japan is necessary, convenient, and consistent with an aversion to borrowing, the country has one of the highest saving rates in the world. In 2006, for example, Japanese households saved 20 percent of their disposable income compared with a saving rate of only about 4 percent in the United States. The saving rate is high in Japan even though interest rates there hover near zero percent (the interest rate on savings deposits in 2007 was only about 0.2 percent).


Sources: Michael Steineberger, “The Global Savings Glut,” New York Times, 11 December 2005; Martin Browning and Thomas Crossley, “The Life-Cycle Model of Consumption and Saving,” Journal of Economic Perspective 15 (Summer 2001): 3–22; OECD Economic Outlook 81 (May 2007); and Japan’s Postal Savings Home Page at
 http://www.yu-cho.japanpost.jp/e_index.htm.

Questions: According to the life-cycle hypothesis, what is the typical pattern of saving for an individual over his or her lifetime? What impact does this behavior have on an individual’s lifetime consumption pattern? What impact does the behavior have on the saving rate in the overall economy? 

 

Submit a 2-3 page (body) paper written and cited using APA format discussing the above case study and questions.

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    BA 206The Life-Cycle Hypothesis

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