The life-cycle–permanent-income hypothesis (LC-PIH) predicts that the marginal
propensity to consume out of permanent income is large and that the marginal
propensity to consume out of transitory income is very small. Modern theories of
consumption assume that individuals want to maintain relatively smooth consumption
profiles over their lifetimes. Their consumption behavior is geared to their
long-term consumption opportunities—permanent income or lifetime income plus
wealth. With such a view, current income is only one of the determinants of consumption
spending. Wealth and expected income play a role too.
Observed consumption is much smoother than the simple Keynesian consumption
function predicts. Current consumption can be very accurately predicted from last
period’s consumption. Both these observations accord well with the LC-PIH.
The LC-PIH is a very attractive theory, but it does not give a complete explanation
of consumption behavior. Empirical evidence shows that the traditional consumption
function appears to also play a role.
The life-cycle hypothesis suggests that the propensities of an individual to consume
out of disposable income and out of wealth depend on the person’s age. It
implies that saving is high (low) when income is high (low) relative to lifetime
average income. It also suggests that aggregate saving depends on the growth rate
of the economy and on such variables as the age distribution of the population.
The rate of consumption, and thus of saving, could in principle be affected by
the interest rate. But the evidence, for the most part, shows little effect of interest
rates on saving.
The Barro-Ricardo equivalence proposition notes that debt represents future taxes.
It asserts that debt-financed tax cuts will not have any effect on consumption or
aggregate demand.
The U.S. saving rate is very low by international standards. Most private saving in
the United States is done by the business sector.
