The Life-Cycle Hypothesis and Investment Varies Much More than Consumption

Please answer both (2) questions for the case study. Each question needs to be at least 150 words. Responses should be at least 150 words in length. You are required to use at least your textbook as source material for your responses. All sources used, including the textbook, must be referenced; paraphrased and quoted material must have accompanying citations.

Do people with high incomes save a larger fraction of their incomes than those with low income? 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 the exhibit below—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.

Consumption averaged 70 percent of GDP during the most recent decade, and investment varied from year to year and averaged 16 percent of GDP during the most recent decade. Now let’s compare the year-to-year variability of consumption and investment. The exhibit below shows the annual percentage changes in GDP, consumption, and investment, all measured in real terms. Two points are obvious. First, investment fluctuates much more than either consumption or GDP. For example, in the recession year of 1982, GDP declined 1.9 percent but investment dropped 14.0 percent; consumption actually increased 1.4 percent. In 1984, GDP rose 7.2 percent, consumption increased 5.3 percent, but investment soared 29.5 percent. Second, fluctuations in consumption and in GDP appear to be entwined, although consumption varies a bit less than GDP. Consumption varies less than GDP because consumption depends on disposable income, which varies less than GDP.