Theories that attempt to explain how income and consumption vary over the life cycle include the life-cycle hypothesis, the permanent-income
Table 1 Percent Change in Average Household Spending Between 1987 and 1997 by Selected Categories: Consumer Expenditure Surveys, 1987 and 1997 SOURCE: Consumer Expenditure Surveys, 1987 and 1997
hypothesis, and precautionary savings. The life-cycle hypothesis (Ando and Modigliani, 1963) suggests that consumers try to maintain a relatively stable level of consumption over their lifetime. In practice, this means that younger people borrow to meet consumption needs, middle-aged people save as large a proportion of income as possible, and older people spend down their assets when their income is reduced in retirement. The permanent-income hypothesis (Friedman, 1957) suggests that consumers adjust their spending level to their perceived level of future income and that they dissave in retirement. The precautionary-saving model (Deaton, 1992) suggests that older people are extremely cautious about spending down their assets because they are uncertain about how long they will live, about the cost of health care in the future, and about the possibility of becoming impoverished.