Economic theories of intertemporal consumption seek to explain people's

preferences In psychology, economics and philosophy, preference is a technical term usually used in relation to choosing between alternatives. For example, someone prefers A over B if they would rather choose A than B. Preferences are central to decision the ...

in relation to

consumption Consumption may refer to: *Resource consumption *Tuberculosis, an infectious disease, historically * Consumption (ecology), receipt of energy by consuming other organisms * Consumption (economics), the purchasing of newly produced goods for curren ...

and

saving Saving is income not spent, or deferred consumption. Methods of saving include putting money aside in, for example, a deposit account, a pension account, an investment fund, or as cash. Saving also involves reducing expenditures, such as recur ...

over the course of their lives. The earliest work on the subject was by Irving Fisher and

Roy Harrod Sir Henry Roy Forbes Harrod (13 February 1900 – 8 March 1978) was an English economist. He is best known for writing '' The Life of John Maynard Keynes'' (1951) and for the development of the Harrod–Domar model, which he and Evsey Domar dev ...

, 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 were built on

discounted utility In economics, discounted utility is the utility (desirability) of some future event, such as consuming a certain amount of a good, as perceived at the present time as opposed to at the time of its occurrence. It is calculated as the present disco ...

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 was a Japanese-born economist. Biography He was born in Tokyo, as a member of family running Ando Corporation, a major construction company. He didn't join the family business, and came to the United States after World War II. He received hi ...

, and

Milton Friedman Milton Friedman (; July 31, 1912 – November 16, 2006) was an American economist and statistician who received the 1976 Nobel Memorial Prize in Economic Sciences for his research on consumption analysis, monetary history and theory and the ...

(1957) developed what became known as the life-cycle model. See for details. The life-cycle model of consumption suggests that consumption is based on average lifetime income instead of income at any given age. First, young people borrow to consume more than their income, next, as their income rises through the years, their consumption rises slowly and they begin to save more. Lastly, during their retirement these individuals live off of their savings. Furthermore this theory implies that consumption is smoothed out relative to a person's income which is the reason economists set consumption proportional to potential income rather than actual income. 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 {{Short description, Justification for leaving money to others A bequest motive seeks to provide an economic justification for the phenomenon of intergenerational transfers of wealth. In other words, to explain why people leave money behind when th ...

, capital market imperfections such as liquidity constraints, a changing individual

utility function As a topic of economics, utility is used to model worth or value. Its usage has evolved significantly over time. The term was introduced initially as a measure of pleasure or happiness as part of the theory of utilitarianism by moral philosoph ...

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 Behavior (American English) or behaviour (British English) is the range of actions and mannerisms made by individuals, organisms, systems or artificial entities in some environment. These systems can include other systems or organisms as wel ...

hypothesis. They propose that people mentally divide their assets into non-fungible mental accounts – current income, current assets (savings) and future income. The

marginal propensity to consume In economics, the marginal propensity to consume (MPC) is a metric that quantifies induced consumption, the concept that the increase in personal consumer spending ( consumption) occurs with an increase in disposable income (income after taxes and ...

(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.

References

*Fisher, I (1930): ''The Theory of Interest'' *Harrod, R. (1948): ''Towards a Dynamic Economics'' *Friedman, M. (1957): ''A Theory of the Consumption Function'' *Modigliani, F. & Brumberg, R. (1954): 'Utility analysis and the consumption function: An interpretation of cross-section data'. In: Kurihara, K.K (ed.): ''Post-Keynesian Economics'' *Shefrin, H. & Thaler, R. (1992): 'Mental Accounting, Saving and Self-Control'. In: Lowenstein, G. & Elster, J. (eds.) ''Choice over Time'' {{Consumption Intertemporal economics Consumption fr:Cycle de vie (commerce)#Théorie du cycle de vie en sciences économiques

See also

References