Life Cycle Theory of Savings

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Dictionary of Economics

Course (113 videos)

Life Cycle Theory of Savings

The Life Cycle Theory of Savings describes how a person’s spending and savings habits may change over the course of his or her lifetime.

As kids, we might earn a little pocket money or receive an allowance. But as we age and gain more experience, our income typically increases until we reach retirement. Similarly, we may spend less when we’re younger, increase spending during our prime working years, and then become more conservative again in retirement.

How does your income affect your spending and savings habits over time? Although every case is different, we'll cover some common patterns in this video.

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Transcript

What is the life cycle theory of savings? It's the theory about how a person chooses to spend and save throughout her lifetime. But before diving into these choices, we need to examine a person's typical income over time. Most people's incomes don't stay flat their entire lives, they change in predictable ways. Here's a typical pattern showing a person's income over their life, with their income on the vertical axis and time on the horizontal axis. When you're young and still in school, you might make a little bit of money waiting tables or occasionally mowing lawns. Your first job out of school -- it's going to pay a lot more. After a few years of experience and hopefully a few raises along the way, you make more than you ever have. Then, as you age, you look forward to retirement when your income falls. But you're no longer working and you could really enjoy your golden years. Now let's imagine if your consumption followed the same path as your income and you never saved or borrowed. You'd struggle when young, and you'd be unable to invest in an education. Then, you'd spend every cent you make during your prime working years. Well, that sounds like a lot of fun, but without any savings, your income will drop suddenly when you retire, and so will your consumption. Your golden years wouldn't be so golden.

 

So instead, people tend to follow a life cycle theory of savings. A person can start out consuming more than she makes, borrowing to fill that gap, and to pay for things like an education. Then during her prime working years, she makes more than she consumes, paying down her debt and saving the extra income for retirement. And when retirement comes, she can spend those savings and enjoy the golden years even without working. We call it "dissaving," but that just means spending your own savings. Now, of course, many people deviate from this exact path, depending on details. Most people, for example, they consume less in college than they do as professionals. Ramen noodles are no longer a staple of my diet, but generally speaking, many people follow a pattern of borrowing, saving and dissaving to smooth their consumption path over their lifetime.

 

 

If you'd like to learn more about the importance of saving early and often, click here. Or, if you'd like to test your knowledge on life cycle theory of savings, click here. Still here? Check out Marginal Revolution University's other popular videos.

 

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