Life Cycle Theory of Savings

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.

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